Troubled Commercial Real Estate Debt Restructure 2010 Real Estate Conference June 17, 2010 Robert W. Reardon Partner, Real Estate and Commercial Lending Practices 404.504.7774 Charles R. Beaudrot, Jr. Partner, Tax and Real Estate Capital Markets Practices 404.504.7753
General Goals in Loan Restructure Goals of Lender Receive payment in full of debt Preserve value of collateral Obtain control of property Prevent regulator intervention 2
General Goals in Loan Restructure Goals of Borrower Operate its business at property Maintain control of property Protect equity investment in property Prevent personal liability for the debt to Lender 3
Preliminary Issues Prenegotiation Agreements Set out the terms and conditions under which the parties will enter into discussions toward a potential workout Basically an agreement of the parties to negotiate in good faith without concern that the subject of the negotiation can be used in subsequent litigation 4
Preliminary Issues Lender Due Diligence Current financial information Is the Borrower creditworthy Are there creditworthy guarantors Does the property generate sufficient cash-flow to operate and pay debt service Loan Document Review Reveal any weaknesses in documentation Title and UCC searches to confirm no title issues Current Appraisal of the property Does current value support loan-to-value underwriting Will the property support the debt if exercise of remedies becomes necessary 5
Preliminary Issues Borrower Due Diligence - Know Your Lender Does lender have incentive to re-structure rather than to exercise remedies Is the lender hindered by regulatory or other oversight from working out the loan Does the Borrower have a generally good history with the lender or is this a one-off negotiation 6
Restructure Strategies Loan Modification Forbearance Agreements Foreclosure Deed in Lieu of Foreclosure Bankruptcy 7
Loan Modification Lender Goals Continue income stream and pay off Loan Keep Loan in performing status re: regulators Maintain business relationship with borrower/customer Clean up deficiencies in Loan documentation Avoid having to take back collateral 8
Loan Modification Borrower Goals To allow Borrower to repay the Loan in the normal course of business To obtain concessions with respect to time for payment or amount of periodic payments To reduce personal liability To obtain release of certain collateral 9
Basic Description Forbearance Agreements Lender agrees to stand still in the exercise of remedies for a Borrower default for a period of time in consideration of Borrower s performance under the agreement 10
Forbearance Agreements Provisions of Agreement Agreement by Lender to forbear for some period of time May include payment relief Generally includes performance milestones for the Borrower Sales targets Periodic principal curtailments May require Borrower to provide additional collateral Reaffirmations, releases and waivers Cross default/cross-collateralization 11
Forbearance Agreements Benefits to Lender Defers lender s acquisition of property Avoid operating costs Avoid marketing costs May avoid litigation/bankruptcy by Borrower Allows loan document deficiencies to be corrected Lender may obtain general releases from Borrower/Guarantors 12
Forbearance Agreements Benefits to Borrower Avoids foreclosure or suit on note/guaranty May provide relief from payment in whole or part Allows time to improve property operations or find buyer or additional equity 13
Forbearance Agreement Disadvantages Lender Does not improve loan status from a regulatory standpoint Loan and collateral status deterioration during forbearance period 14
Forbearance Agreement Disadvantages Borrower Delays but does not eliminate foreclosure risk Borrower often required to release rights and defenses May be required to provide additional collateral for debt 15
Foreclosure Definition Remedy by which Lender sells the collateral that Borrower has pledged to secure its loan to Lender Real Property Power of sale in deed to secure debt permits non-judicial sale of real property In Georgia, sales conducted 1 st Tuesday of each month Advertisement for 4 weeks prior to sale Sale is an absolute auction for cash conducted at the county courthouse where property is located 16
Foreclosure Personal Property Includes sales of tangible and intangible property Tangible equipment; furniture; fixtures; etc. Intangible contract rights; securities; membership interests in LLCs, etc. Subject to the Uniform Commercial Code Sales conducted after advertisement in accordance with the UCC 17
Foreclosure Benefits to Lender Finality Time - In Georgia, real property can be foreclosed within a 60-day period Preservation of collateral value by gaining control 18
Foreclosure Disadvantages To Lender Cost of operating/marketing Lender may not have expertise to operate property In case of regulated banks, time to hold property is limited 19
Foreclosure Borrower Continuing Liability Non-Recourse Loan Once foreclosure complete, Borrower liability terminated except for carve-out liability Fraud, misrepresentation Use of property revenue outside terms of loan documents Bankruptcy filing by Borrower 20
Foreclosure Borrower Continuing Liability Recourse Loan If a real property foreclosure, Lender must confirm sale before pursuing Borrower or any guarantor for deficiency If UCC sale, Lender must conduct sale in commercially reasonable manner or deficiency cannot be pursued 21
Deed in Lieu of Foreclosure Benefit to Lender Avoids potential lawsuit/bankruptcy to stop foreclosure Cooperative Borrower may allow Lender enhance collateral position 22
Deed in Lieu of Foreclosure Disadvantages If any title issues, Lender takes subject to them 23
Deed in Lieu of Foreclosure Benefit to Borrower Avoids publication of sale 24
Bankruptcy Advantages to Lender Property and Borrower subject to court review and control Gain control of property revenue/cash collateral May be able to structure a sale free and clear of liens 25
Bankruptcy Disadvantages Lender is stayed from pursuing its remedies during pendency Potential to have lien stripped or Borrower plan crammed down If any deficiency in Lender s documents, these may be exploited in bankruptcy 26
Bankruptcy Benefits to Borrower Creditors actions are stayed during the pendency Borrower has opportunity to present a plan to restructure its debt Borrower or Trustee have ability to attack validity of secured creditor s liens and security instruments 27
Bankruptcy Disadvantages Borrower s actions are constrained by court Lender may obtain rights to cash collateral If Borrower is a single-purpose entity Lender may be able to obtain relief from stay in relatively short time 28
Tax Consequences and Issues Giving Up the Property Foreclosure and Deed in Lieu Transfer Are Sales 29
Tax Consequences and Issues Non-Recourse Debt Debt Minus Basis = Gain or Loss Debt $1,000,000 $1,000,000 Basis 700,000 1,200,000 Gain(Loss) $ 300,000 $ (200,000) 30
Tax Consequences and Issues Recourse Debt Part Sale and Part CODI FMV of Property (Up to Debt) Equals Sales Price Debt in Excess of FMV Equals Cancellation of Debt Income ( CODI ). 31
Tax Consequences and Issues CODI is Ordinary Income Character of Sale Gain or Loss depends on character of property Capital Gain (e.g. raw land held for investment) or 1231 Capital Gain (e.g. rental property) or Ordinary Income (e.g. subdivision/dealer property) Impact of 1231 loss on characterization of future gains - Five Year Rule 32
Tax Consequences and Issues Modification of Debt: (a) (b) (c) Principal Balance Reduction Equals CODI; Purchase of Debt at a Discount by Borrower or its Related Party Produces CODI Modification of Debt Needs Exchange Analysis. Generally Okay for Borrower Unless Reductions in Interest Rate, Payments Create FMV Less Than Face Amount of Original Note Under Applicable Federal Rate Test. Lender ORIGINAL NOTE Borrower NEW NOTE 33
Tax Consequences and Issues IRC 108(a)-Gross income does not include amounts from discharge of indebtedness if: - The discharge occurs in Title 11 (bankruptcy) case - (partner level) - The discharge occurs when taxpayer is insolvent - (partner level) - The discharge relates to qualified farm indebtedness - The discharge relates to qualified real property business indebtedness realized by a taxpayer other than a C corporation - The discharge relates to qualified principal residence indebtedness realized before January 1, 2013 34
Tax Consequences and Issues What is QRPBI? Generally, any debt incurred or assumed in connection with and secured by real property used in the taxpayer s trade/business. Broad sense of what is covered land, improvements, mineral interests. Application by Partnerships Whether debt is QRPBI is determined at the entity level, but basis limitation and reduction are made at partner level. S Corporations Whether debt is QRPHI is determined at the entity level, as are basis limitation and basis reduction. 35
Tax Consequences and Issues Tax Deferral Strategies (i) Like-Kind Exchanges for Sale Gains. 36
Tax Consequences and Issues Tax Deferral Strategies (ii) Reduction in Depreciable Basis for Certain Qualified Debt *Does not work for inventory property. 37
Tax Consequences and Issues Tax Deferral Strategies (iii) New CODI Deferral Law: Debt forgiveness this year, defer gain until 2014 and then recognize 20% per year for 5 years. (a) Compare foreclosure capital gain now with CODI deferral for average of 7.5 years. (b) Forgive debt first? Then deed in lieu to Lender? Tax rate in 2014? 38
Tax Consequences and Issues Tax Deferral Strategies (iv) Arrange purchase of note by unrelated party. * Borrower partners can own up to 49.9% of purchaser 39
Tax Consequences and Issues Tax Deferral Strategies (v) Admit Lender into Borrower (or form a new joint venture) in Exchange for Contribution of the Note (a) Issue: FMV of Partnership Interest Take advantage of new CODI Deferral Law? (b) Triggers Negative Capital Accounts of Partners as Debt Disappears Deficit Restoration Obligation? 40
Tax Issues to the Acquiror of Debt Does the Borrower care? NOL s or Loss on Transaction? 41
Tax Issues to the Acquiror of Debt Buying debt has tax risks for the purchaser most commonly in the form of phantom income due to deemed exchanges under the Cottage Savings Regulations (Treas. Reg. 1.1001-3 et seq.) 42
Tax Issues to the Acquiror of Debt For tax purposes, it is usually better to modify debt before purchase. 43
Tax Issues to the Acquiror of Debt Purchases of debt raise significant O.I.D. and market discount issues for the purchaser. 44
Tax Issues to the Acquiror of Debt Accounting issues are complex, especially in connection with the acquisition of a pool of loans. 45
Tax Issues to the Acquiror of Debt Beware of possible reverse character conversions of ordinary income into capital loss. 46
Thank You For Joining Us for Troubled Commercial Real Estate Debt Restructure Please contact our speakers with any questions after the presentation. Robert W. Reardon Partner, Real Estate and Commercial Lending Practices 404.504.7774 rreardon@mmmlaw.com Charles R. Beaudrot, Jr. Partner, Tax and Real Estate Capital Markets Practices 404.504.7753 cbeaudrot@mmmlaw.com 47