What does it mean for real property to be secured by or encumbered by debt?

Transcription

1 What does it mean for real property to be secured by or encumbered by debt? Todd Golub Beverly Katz David A. Miller Baker & McKenzie LLP Internal Revenue Service Ernst & Young LLP Chicago, Illinois Washington, D.C. Dallas, Texas American Bar Association Section of Taxation 2011 Midyear Meeting January 20-22, 2011 Boca Raton Resort and Club Boca Raton, Florida

2 Required Circular 230 Disclosure Any U.S. tax advice contained herein is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. 2

3 Agenda Importance of relationship between debt and property Secured by and sections 108(c) and 465(b)(6) Mortgage and section 856(c) Encumbered by and section 707 Subject to and section 752 Recourse v. nonrecourse for purposes of section

4 Secured by sections 108(c)(3) and 465(b)(6) Section 108(c)(3) debt is not qualified real property business indebtedness unless it is secured by real property Section 465(b)(6) debt is not qualified nonrecourse financing unless it is secured by real property What does secured by mean? 4

5 PLR PLR debt secured by an interest in a disregarded SMLLC owning real property is secured by real property for purposes of section 108(c)(3)(A) 5

6 Reg. Sec (b)(4) and (5) A recourse loan to an LLC classified as a partnership (or to a disregarded SMLLC) that owns real estate will be treated as secured by real property so long as The only person liable to repay the debt is the LLC The LLC owns only real property (or incidental personal property) The lender may proceed only against real property held by the borrower LLC 6

7 Reg. Sec T(o) Secured debt" means a debt that is on the security of any instrument (such as a mortgage, deed of trust, or land contract) (i) (ii) (iii) That makes the interest of the debtor in the qualified residence specific security for the payment of the debt, Under which, in the event of default, the residence could be subjected to the satisfaction of the debt with the same priority as a mortgage or deed of trust in the jurisdiction in which the property is situated, and That is recorded, where permitted, or is otherwise perfected in accordance with applicable State law 7

8 Reg. Sec T(o) (cont d) A debt will not be considered to be secured by a qualified residence if it is secured solely by virtue of a lien upon the general assets of the taxpayer 8

9 Secured by other sections Treas. Reg. Sec (b)(2) a loan is secured only if it is on the security of any instrument (such as a mortgage, deed of trust, or land contract) which makes the interest of the debtor in the property specific security for the payment of the loan Treas. Reg. Sec (a)(2)(ii) a loan is secured whenever the seller has the right to take title or possession of the property in the case of a default 9

10 Mortgage and section 856 Section 856(c)(3) qualifying income includes interest on obligations secured by mortgages on real property or on interests in real property What is a mortgage for this purpose? 10

11 Mortgage Rev. Proc , C.B. 336 Loans secured by an interest in a partnership or a disregarded entity treated as a mortgage secured by an interest in real property in certain cases 11

12 Mortgage G.C.M (March 5, 1986) Addresses whether an unrecorded mortgage is nevertheless a mortgage for purposes of section 856 and states The common law meaning of the word "mortgage" is an interest in land created by a written instrument providing security for the performance of a duty or the payment of a debt (citing Black's Law Dictionary) We believe it is well settled that the meaning of the word "mortgage" is a conveyance of a [security] interest in property intended by the parties at the time of its making to be security for the payment of money or the doing of some prescribed act There is no requirement in the Code or the regulations that a mortgage be recorded in order to qualify as a "mortgage 12

13 Mortgage PLR A (Feb. 24, 1972) Addresses whether a sale/leaseback characterized as a financing for federal income tax purposes gives rise to a mortgage for purposes of section 856 The deed executed by the nominal seller was treated as giving rise to a mortgage which acts as security for the loan arising from the sale/leaseback 13

14 Encumbered by and section 707 A liability that encumbers property is a qualified liability for purposes of Treas. Reg. Sec (a)(6)(i) only if (A) it was incurred by the partner more than two years prior to the earlier of the date the partner agrees in writing to transfer the property or the date the partner transfers the property to the partnership and has encumbered the transferred property throughout that two-year period (B) it was not incurred in anticipation of the transfer of the property to a partnership, but was incurred by the partner within the two-year period prior to the earlier of the date the partner agrees in writing to transfer the property or the date the partner transfers the property to the partnership and it has encumbered the transferred property since it was incurred 14

15 Encumbered by American Heritage and Black s Law Dictionaries American Heritage: To put a heavy load on; burden To hinder or impede the action or performance of To burden with legal or financial obligations Black s Law Dictionary: A claim, lien, charge, or liability attached to and binding real property; e.g., a mortgage; judgment lien; mechanics lien; lease; security interest; easement or right of way; accrued and unpaid taxes 15

16 Encumbered by Honey v. United States, 963 F.2d 1083 (8th Cir. 1992) Court addressed whether a taxpayer had any unencumbered funds for purposes of section 6672 The court concluded a broad definition was appropriate (based on the fact that the purpose of section 6672 is to ensure that trust fund taxes are paid) and defined encumbered funds as follows: Funds are encumbered only where the taxpayer is legally obligated to use the funds for a purpose other than satisfying the preexisting employment tax liability and if that legal obligation is superior to the interest of the IRS in the funds. 16

17 Subject to and section 752 Treas. Reg. Sec (a)(2) a partner's share of the nonrecourse liabilities of a partnership includes the amount of any taxable gain that would be allocated to the partner under section 704(c) if the partnership disposed of (in a taxable transaction) all partnership property subject to one or more nonrecourse liabilities in full satisfaction of those liabilities 17

18 Subject to and exculpatory debt Assume an LLC classified as a tax partnership incurs a state law recourse liability that is nonrecourse for purposes of section 752 Assets are treated as subject to the liability if the creditor would have a claim against the assets in the event of default. See PLRs , , and

19 Examples The focal point of each of the following examples is whether the debt: Is secured by the asset for purposes of section 108(c) (in which case a cancellation of such debt may be eligible to be excluded under section 108(c) by taxpayers other than C corporations) Is a mortgage for purposes of section 856 (in which case the loan may be a qualifying asset generating qualifying income for a REIT); Encumbers the asset for purposes of section 707 (in which case the contribution of the asset to a partnership subject to such debt might not be treated as part of a disguised sale) 19

20 Example 1 simple case A B Lender Recourse loan Mortgage LLC Secured by? Mortgage? Encumbered by? What if the mortgage is not recorded? Real Property 20

21 Example 2 no state law security interest A B Lender $100 recourse loan LLC Real Property Secured by? Mortgage? Encumbered by? Impact of fraudulent conveyance law? Any difference if LLC is a disregarded SMLLC? FMV $110 21

22 Example 3 no state law security interest multiple assets A B Lender $100 recourse loan LLC Asset 1, 2 and 3 (Total FMV = $110) Secured by? Mortgage? Encumbered by? What if Assets 1 and 2 are real property, but Asset 3 is not? 22

23 Example 4 no state law security interest A B Lender $100 recourse loan LLC Secured by? Mortgage? Encumbered by? Impact of fraudulent conveyance law? What if LLC covenants not to incur any additional debt so long as the debt is outstanding? Sell any assets? Make any distributions? Executes a pledge agreement with respect to all of its assets? All of the foregoing? Any difference if LLC is a disregarded SMLLC? Asset 1, 2 and 3 (FMV = $300) 23

24 Example 5 loan secured by interest in a disregarded SMLLC Lender $100 loan Pledge of membership interest A SMLLC Secured by? Mortgage? Encumbered by? Asset 1, 2 and 3 ($300) What if Assets 1 and 2 are real property, but Asset 3 is not? What if all three assets are real property, but SMLLC may sell an asset at any time or acquire non-real property at any time? 24

25 Switching gears recourse v. nonrecourse Important for Section 465 Section 704(b) Section 752 Section 1001 etc. Focal point section 1001 ONLY Competing schools of thought Examples 25

26 A matter of perspective Substance matters but what is substance for this purpose? Creditor s rights? Debtor s obligation? Perspective controls conclusion 26

27 Competing schools of thought creditor s rights v. debtor s obligation Creditor s rights Is a creditor effectively limited to a single asset? If so, the debt is nonrecourse Does this test also apply to debt incurred by a corporation? Debtor s obligation? Is the loan recourse against all of the taxpayer s asset? If so, the debt is recourse without regard to whether it owns a single asset or multiple assets A state law recourse loan to a disregarded SMLLC arguably should not be treated as recourse to the taxpayer/owner of the disregarded SMLLC Impact of a guaranty by the members/partners? 27

28 Example 6 state law recourse loan to an LLC with multiple assets A B Bank State law recourse loan LLC Multiple Assets Creditor s rights recourse Debtor s obligation recourse 28

29 Example 7 state law nonrecourse loan to LLC secured by all assets LLC happens to own A B Bank State law nonrecourse loan LLC Multiple Assets Creditor s rights presumably nonrecourse (as loan is not recourse under state law). Is this example substantively different from the prior one? Debtor s obligation nonrecourse 29

30 Example 8 state law recourse loan to an LLC with a single asset A B Bank State law recourse loan LLC Single Asset Creditor s rights legally recourse, but effectively nonrecourse - Does it matter whether LLC is a special purpose entity? - What if LLC subsequently acquires additional assets? Debtor s obligation recourse 30

31 Example 9 state law recourse loan to a corporate borrower with a single asset Bank State law recourse loan Corporation Single Asset Are/should the rules be different for corporations than partnerships or disregarded entities? Creditor s rights legally recourse, but effectively nonrecourse? Debtor s obligation recourse 31

32 Example 10 state law recourse loan to LLC LLC owns an interest in a disregarded SMLLC with multiple assets A B Bank State law recourse loan LLC (no other assets) SMLLC Creditor s rights? Debtor s obligation recourse Multiple Assets 32

33 Example 11 state law recourse loan to a corporate borrower Bank State law recourse loan Public Company (no other assets) Holdco Multiple Subsidiaries Creditor s rights legally recourse, but effectively nonrecourse? Are/should the rules be different for corporations than partnerships or disregarded entities? Debtor s obligation recourse 33

34 Example 12 state law recourse loan to an LLC with a single asset guaranteed by owner of LLC A B Bank State law recourse loan LLC Single Asset Creditor s rights without guaranty, legally recourse, but effectively nonrecourse. With guaranty? What if LLC is taxed as a corporation? Debtor s obligation recourse (without regard to guaranty) 34

35 Example 13 state law recourse loan to an LLC with a single asset guaranteed by owner of LLC A B Bank State law nonrecourse loan LLC Single Asset Creditor s rights without guaranty, nonrecourse. With guaranty? What if LLC is taxed as a corporation? Debtor s obligation without guaranty, nonrecourse. With guaranty? 35

36 Example 14 state law recourse loan to disregarded SMLLC LLC owns an interest in a disregarded SMLLC with a single asset A B LLC (no other assets) Bank State law recourse loan SMLLC Single Asset Creditor s rights legally recourse, but effectively nonrecourse Debtor s obligation may be recourse or nonrecourse, depending upon whether you look to the legal obligor or who the obligor is for tax purposes 36

37 Example 15 state law recourse loan to disregarded SMLLC LLC has multiple assets A B LLC (other assets) Bank State law recourse loan SMLLC Single Asset Creditor s rights legally recourse, but effectively nonrecourse - Does it matter if SMLLC subsequently acquires other assets? Debtor s obligation may be recourse or nonrecourse, depending upon whether you look to the legal obligor or who the obligor is for tax purposes 37

38 Example 16 state law recourse loan to disregarded SMLLC SMLLC has multiple assets A B LLC (no other assets) Bank State law recourse loan SMLLC Multiple Assets Creditor s rights recourse? What if LLC subsequently acquires additional assets? Debtor s obligation may be recourse or nonrecourse, depending upon whether you look to the legal obligor or who the obligor is for tax purposes 38

39 Great Plains Gasification Associates, et al., v. Commissioner, 92 T.C.M. 534 (2006) Pledge of Subsidiary Shares (Pledged Shares) to Secure DOE Guaranty Parent GP Subsidiary Lender $1.5 Billion Loan Great Plains Guaranty DOE Coal Gasification Plant 39

40 Great Plains Gasification (cont d) Loan was not nonrecourse by its terms Great Plains defaulted on the loan DOE paid off the loan and foreclosed on the plant, bidding $1.0 billion Following year, DOE released remaining debt ($500 million) upon receipt of Pledged Shares Issues: Was the entire $1.5 billion debt discharged on the foreclosure? Was the debt nonrecourse? 40

41 Great Plains Gasification (cont d) Holdings: Great Plains did not abandon the project prior to the foreclosure sale Recourse/nonrecourse determination is made at partnership level Debt is nonrecourse if creditor s remedies limited to pledged assets (citing Raphan) Tax Court analyzed old IRC section 752 regulations Debt held nonrecourse because partnership could not acquire other assets 41