Distressed Real Estate Workouts, Trades And Loan Purchases: Tax Consequences Matter

Published date23 May 2020
AuthorMr Richard M Corn, Steven L. Lichtenfeld and Stuart L. Rosow
Subject MatterFinance and Banking, Real Estate and Construction, Tax, Insolvency/Bankruptcy/Re-structuring, Debt Capital Markets, Financial Services, Insolvency/Bankruptcy, Real Estate, Income Tax, Capital Gains Tax
Law FirmProskauer Rose LLP

The COVID-19 pandemic has been wreaking havoc on the economy generally, and with respect to many asset classes of real estate, specifically, and the general consensus now is this unfortunate situation will not abate for some time in the future. Not surprisingly, with businesses closed, employees furloughed, and revenue streams severely challenged, many owners of real estate and their tenants are simply not making rent and debt service payments. When that happens, the value of the real estate is reset, leaving the equity and possibly some of the debt impaired. When fighting for survival it might seem like tax considerations are an afterthought, but they should not be'the tax consequences of the actions that can arise from this loss in value, including modifications of real estate loans, foreclosures, debt-for-equity exchanges, purchases of distressed debt or real estate, and the like, can be significant and may often be major drivers of the ultimate decisions taken by the various stakeholders.

I. Trying to Save the Investment: Forbearances, Modifications, Amendments

So, as an owner of real property starts experiencing distress as a result of rent defaults or, in the case of hotels, almost non-existent occupancy, both the owner and the lenders (senior, mezzanine, and all the rest) will start feeling the pinch. What types of things can happen?

As one very straightforward possibility, an owner might just stop paying interest due on the debt. With respect to current-cash-pay interest, the lender may make a case that it should not recognize any income on the interest'it didn't receive it, after all! While this may present a decent case under applicable federal tax law (at least if the lender can conclude, at the very least, that there is a reasonable doubt as to whether the interest will ever be collected), the IRS takes a different position with respect to original issue discount ("OID"). In particular, the IRS insists that the lender continue to accrue OID at its usual rate, even if the owner is threatening to never pay, and even if the owner is in a bankruptcy proceeding which would limit its ability to pay even if payment becomes due'although note that this is just the IRS's position, courts have yet to approve of this conclusion (nor have they rejected it, either, to be fair).

The owner and lenders could discuss modifications or forbearances with respect to the loans. The consequences of such modifications or forbearances depend on many factors, including the size of the tranche of the loan in question, whether the loans are "publicly traded," the nature of the modifications, and other factors.

If the modifications are "significant," then, for federal tax purposes, the owner is treated as paying off the "old," unmodified loan for a new loan (one issued with the modified terms). Under such an exchange, the lender may recognize gain or loss. How much gain or loss? Well, if the total outstanding amount of the tranche of loan in question is $100 million or less, the gain or loss might be zero'at least, if the face amount of the loan didn't change as part of the modification, there is no OID on the original loan, and the lender hasn't written off the loan for federal tax purposes in whole or in part already. This is because the "value" of the loan can often in such circumstances be treated as equal to the face amount of the loan, for federal tax purposes.

But if the total amount outstanding on the loan is greater than $100 million and the loan is "publicly traded" (as defined in the relevant tax regulations, which, it should be noted, uses a very broad definition of "publicly traded"'it may be enough if one or more brokers are willing to provide an indicative quote to purchase or sell the debt), the "new" loan must be valued at fair market value. For a distressed loan, that probably means the loan will have a value that will be less than its face amount'which means the lender might recognize a tax loss (based on the difference between the value of the loan and the lender's tax basis)1 and the borrower might recognize cancellation of debt income ("CODI")'basically, income from having the loan treated as "forgiven" in the amount of the difference between the face amount of the loan and the fair market value of the loan.

Other consequences could arise from such an exchange. The "new" loan will have a deemed issue price equal to its fair market value on the date of the modification, but the face amount might be significantly higher. As such, the "new" loan could have significant OID, triggering substantial additional interest inclusion to the lenders. And, the loan may have so much OID that special tax rules applicable to high-yield high-OID notes could trigger, which can force the borrower to defer (or even completely lose) interest deductions on a portion of the interest paid or accrued on the note.

It's not all bad, perhaps. For borrowers that are insolvent2 or in bankruptcy, the CODI could be partially or entirely excluded from income, although first, the borrower must reduce tax attributes (like losses or the tax basis in depreciable assets) in the amount of the excluded CODI, and second, for a borrower that is a flowthrough for federal tax purposes (like most limited partnerships or limited liability companies ), the availability of the exclusion is determined at the owners' level, not the flowthrough's level'in other words, the exclusion is available to an owner only if the owner itself is either insolvent or in a bankruptcy proceeding (and thus it doesn't matter if the LLC...

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