TAX MANAGEMENT REAL ESTATE JOURNAL

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1 TAX MANAGEMENT REAL ESTATE JOURNAL a monthly professional review of current tax, legislative and economic developments I Personally Guaranteed a Loan on a Real Estate Deal That s Gone Sour Now What Do I Do? by Kenneth W. Bosworth, Esq., Lawrence J. Feller, Esq., Kenneth A. Goldstein, Esq., Kristin L. Dunlap, Esq., and Kenneth Klassman, Esq. * In today s economy, more and more real estate investors are finding themselves in the situation where they have personally guaranteed a loan on a real estate deal that is not performing. The investor is now faced with personal exposure to the lender and the other investors/ partners in the deal, often in an amount that greatly exceeds the value of that investor s assets. This article explores the circumstances * The co-authors are attorneys in the real estate group and wealth protection planning group of Horwood Marcus & Berk Chartered (HMB). HMB s real estate group provides the firm s clients with depth and experience in a broad range of real estate matters, both at a national and local level, including all aspects of acquisition and development, financing, construction and ownership. We work in conjunction with our wealth protection planning attorneys to structure the most tax favorable acquisitions, joint ventures and dispositions, while also providing alternatives for proper risk allocation. More information about HMB and the coauthors biographies can be found at that lead an investor to become liable on a personal guaranty, the issues that need to be addressed when dealing with and discussing options with the lender, the various legal and tax considerations that come into play, and the strategies that you should consider if you find yourself in this precarious position. The Deal I Should Have Turned Down There are many different ways a person may find himself or herself personally liable to a lender or the other investors/partners on a real estate deal. The following is just one scenario that is playing out for real estate investors all over the country today. In 2006, a real estate entrepreneur identified a piece of commercial real estate in a secondtier market that appeared to have the appropriate demographics to support the redevelopment of the property into a higher performing center. The entrepreneur purchased the property at a seven cap, which was, and still is, by general standards, believed to be a fairly good deal in the marketplace. The center was 30% vacant, but the entrepreneur accepted that vacancy rate because the intent was to re-tenant the center with higher paying, more creditworthy tenants, stabilize the center, and sell the property a few years down the road at a five cap. The entrepreneur was excited about the opportunity and decided to invest his own capital and also to bring in a few close friends and family members as investors. The entrepreneur and the investors organized a limited liability company to acquire the property. As part of the financing package, each of the investors was asked to TAX MANAGEMENT INC.

2 sign a personal guaranty, joint and several with each other investor, in favor of the mortgage lender. Believing there was not any real risk that the guaranty would ever be triggered, each investor agreed to sign. At the time of acquisition, the LLC had borrowed $3,000,000 to acquire the property. Over the course of the next two years, as a result of renovations to the property, the LLC had increased the debt to $5,000,000. In 2008, the commercial real estate market stagnated, several tenants left the property, and then there was no market for replacement tenants, leaving the center 50% vacant. The LLC owes the lender $5,000,000 in principal, which started accruing interest at default interest rates since the LLC can no longer afford to keep current on the loan. The most recent appraisal of the property estimates its value at approximately $3,000,000. Accordingly, each investor faces joint and several liability of approximately $2,000,000 to the lender. The entrepreneur who put the deal together was also facing personal liability on several other deals that have gone bad. Some of the investors have liquid assets that would cover the entire $2,000,000 obligation, while others are teetering on the edge of bankruptcy. What To Do Now Understanding Your Position The general rule that applies to this situation and others like it is that there is no single solution. In order to determine the best course of action once a guarantor group realizes that it owns an asset that is worth substantially less than the debt owed to the lender, the group needs to evaluate all factors relevant to the group s situation. This is exactly what the lender will be doing, and if it is not, then this will allow the guarantor group to be one step ahead of the lender. The Property. One of the primary concerns of the lender, if not the most significant concern, is evaluating whether the current owner/ operator is the right person to carry out the day-to-day operations at the property. If the loan is in default, the lender has the right to foreclose on its mortgage and legally compel the removal of the operator or put a receiver in its place. To the extent that the operator is also a guarantor, he or she has an interest in retaining his or her position as the operator so that s/he can maintain and improve the collateral value of the property, thereby minimizing, and, with any luck, avoiding, any liability under the guaranty. For this reason, it behooves the operator to stay in frequent contact with his or her lender once a loan goes into default, and to be responsive to the lender s requests for information. The lender likely will want detailed information about the steps that the operator is taking to improve the value of the collateral so that it can assess whether its interests are best served by continuing its relationship with the operator versus removing the operator and replacing the operator with more qualified personnel, typically a third-party receiver. In some cases, for liability purposes, a lender may hire independent consultants to advise it on how to handle a particular property and its guarantor group. When the operator is interviewed by the lender or an independent consulting firm, the operator should be prepared to demonstrate why s/he is the best candidate to maintain and improve the value of the collateral. This includes explaining, among other things: (i) the plan for the property, (ii) what facts and circumstances support the plan, (iii) the issues leading up to the current default status of the loan (presumably through no fault of the operator), (iv) the steps the operator is taking or will take to maintain and improve the property in accordance with the plan, and (v) the new financial projections for the property. The lender and the independent consulting firm also will want to understand: (i) the marketplace in which the property is located, (ii) the competition within the marketplace, (iii) the competitive advantages and disadvantages of the property, and (iv) how the operator is marketing the property in order to ensure that the operator is maximizing the strengths and minimizing the weaknesses of the property. The goal in all of this is to show the lender and the independent consulting firm that the operator fully grasps the seriousness of the situation that it is in, that the plan is well thought out and well reasoned, and that the plan has a realistic chance of success within a time frame that is acceptable to the lender. The Loan Documents. Each guarantor should review the loan documents, ideally with the assistance of an attorney, to assess the nature and extent of the guarantor s liability to the lender. In particular, each guarantor should review and confirm the terms of the guaranty document. For instance, the guarantor should determine whether a guaranty is a guaranty of payment and performance, or just a guaranty of collection. Upon a default by the borrower, a guaranty of payment and performance cre Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.

3 ates an obligation on the part of the guarantor regardless of whether the lender has pursued collection from the borrower. A guaranty of collection binds the guarantor only after all attempts to obtain payment from the borrower have failed. Each guarantor should also review its guaranty document to determine the extent of the liability to the other guarantors. For example, a joint and several guaranty among all guarantors means that the lender can pursue any one or all of the guarantors for the full amount owed to the lender. A guaranty that is several, but not joint, means the lender can pursue each guarantor for only its respective obligation. This is most common in syndicated or participant loans. A guaranty also may be limited in any number of ways, including: (i) a maximum dollar amount, (ii) a certain amount of time, (iii) a specified event, such as a threshold occupancy or percentage of the property sold, or (iv) certain bad boy acts of the guarantor, such as fraud, bankruptcy, mishandling of project funds, or misrepresentation concerning the loan (all of which are discussed in more detail below). In the absence of any limits, typically the guaranty is with full recourse to the guarantor without exception. In addition, in many real estate deals, each guarantor will be held fully responsible for environmental liabilities (no matter the limitation of the guaranty), so the extent of this potential liability will need to be fully evaluated if there are environmental concerns with the property. When reviewing bad boy guaranties, it is important to understand fully the circumstances that convert the obligation to a full recourse guaranty. For instance, a misrepresentation of the guarantor s financial position could trigger the guaranty to become full recourse. If this is the case, the guarantor should be extremely careful to make sure that it is fully and accurately disclosing all of its assets and liabilities. To the extent the document holds the guarantor liable for items such as the return of security deposits to the lender, prepaid rent, real estate taxes, and insurance proceeds, the guarantor should make sure that it adheres to the strict requirements of the guaranty and that appropriate procedures exist to ensure that the party responsible for handling the cash for the operator does not create liability for the guarantor. Another issue that arises with bad boy limited guaranties is, if multiple guaranties were delivered to the lender, it is possible that the action of a co-guarantor or the borrower (which may not be controlled by the guarantor) may cause a guarantor to become liable under its guaranty, including potentially becoming fully liable for the entire loan balance. These dynamics should be fully understood by the guarantor when deciding its next steps with respect to the lender and the co-guarantors. If a limitation does exist, the guarantor should determine the scope of the limitation, as it most likely will play a role in determining the guarantor s strategy for dealing with the lender. For example, if a guaranty is limited to a certain amount of principal plus corresponding interest, plus any fees incurred by the lender to collect such amounts, one strategy may be for the guarantor to propose to pay the limited portion of the principal amount in full in exchange for complete forgiveness of the interest and fees incurred by the lender. Ultimately, the decision whether to remit payment to the lender depends upon a number of factors, including: (i) the value of the collateral relative to the outstanding balance of the loan, (ii) the financial position of the guarantor, (iii) the financial position of the other guarantors, and (iv) the existence or nonexistence of a contribution agreement. The lender s financial position also plays a part in the guarantor s strategy. In today s environment, many financial institutions are taking their last gasps and trying to get as much money in the door as they can as fast as they can, which may put the guarantor group in a better position to minimize its risk. Rights and Obligations Among Guarantors Under the Partnership Documents. In many cases, the guarantors will have entered into an operating agreement or some other type of partnership agreement, which sets forth various rights and obligations with respect to each other and will greatly affect the outcome of the guarantors negotiations with the lender and with each other. For instance, the partnership documents might specifically address the circumstance in which the guarantors become personally liable to the entity s lender. If this is the case, the partnership documents might identify the responsibility of each guarantor as to the other guarantors and the penalties for not complying with such obligations. The guarantor obviously needs to be aware of the consequences of not complying with the 2009 Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 3

4 terms of the partnership documents. It is also important for the guarantor to understand that, subject to any legal limitations that might apply by operation of law, the partnership documents govern the rights and obligations among the guarantors themselves, but not the relationship between the guarantors and the lender. Accordingly, the guarantors must keep in mind both the rights and obligations provided for in the partnership documents and how those rights and obligations come into play in light of any action the lender may take against the guarantor group. For instance, the partnership documents may provide that each guarantor is responsible for a share of the ultimate liability to the lender consistent with its investment interest in the entity. However, if the guarantors have executed joint and several guaranties with the lender, the lender will likely pursue all guarantors and seek payment from any guarantor that has the financial capacity to make the lender whole, in which case the rights and obligations of each member/guarantor under the partnership documents come into play only after the lender has collected all of the indebtedness owed to it. Another issue that is likely to be addressed in the partnership documents is who controls the decision-making of the borrowing entity. This is particularly relevant because, in a typical real estate transaction, each guarantor is required to be responsible for the obligations incurred by the borrowing entity, no matter whether that guarantor participated in the creation or modification of those obligations. For instance, the borrowing entity is the party that, with the lender s consent, has the right to extend the loan, increase the indebtedness incurred by the borrowing entity, make day-today decisions concerning the property such as whether or not to pursue a particular tenant at the property, and if so, on what terms, and whether or not to sell the property, potentially for an amount less than the indebtedness owed to the lender. All of these events can greatly impact the liability of each individual guarantor. A properly drafted guaranty would not allow a guarantor to escape liability simply because the guarantor did not participate in a particular decision of the borrowing entity or perhaps was unaware that the decision was even made, and in most cases will expressly disclaim these types of defenses. Accordingly, in many regards, the guarantor becomes beholden to the parties who have decision-making authority on behalf of the borrowing entity. Sometimes the partnership documents permit the removal of a decision maker. If such a provision exists, it should be carefully reviewed and evaluated by each guarantor before negotiations with the lender. It may become readily apparent that interest of the decision maker of the borrowing entity is not necessarily aligned with the interest of the guarantor group as a whole. One example is where the decision maker happens to be an individual who has little or no personal assets but is entitled to tremendous gain if the project can be repositioned. This decision maker has incentive to take greater risks to position the project, such as incurring additional indebtedness on behalf of the borrowing entity, on the premise that he or she has nothing to lose. This places the other guarantors in a dangerous position. Even if the operating agreement does not provide for the removal of the decision maker, it may be appropriate for the guarantor group to discuss an amendment to the operating agreement that will allow for greater participation by the guarantor group as a whole in decisionmaking. Contribution Rights Under Common Law. Carefully drafted partnership documents are also important with respect to the rights and obligations a co-guarantor may have against the other co-guarantors so as to not leave the remedies up to the courts. Even if the guarantors have not entered into an express agreement setting forth their respective responsibility for a jointly and severally guaranteed debt, the law (at least in Illinois) provides a common law right of contribution. Under this right, the co-guarantors become liable to contribute their proportionate share of the amount paid, provided a co-guarantor is not insolvent, in which case the insolvent co-guarantor is not included in determining the proportions. As a general rule, the right to contribution does not arise unless and until there is a default (as determined by the underlying loan documents). When given the choice, a guarantor should always try to control the situation itself, rather than leaving the outcome to the discretion of a judge. Discussions with the Lender Once they understand their position, the guarantors need to consider how best to approach the lender. What can you say to a lender? When and how do you Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.

5 get your attorney involved? Does each guarantor need his/her own counsel? These are very important questions that can have a huge impact on the discussions among the guarantors themselves and ultimately with the lender. What can you say to a lender? Best practices dictate that you mark any written communication to the lender with For Settlement Discussion Purposes Only. Although offers of settlement or compromise generally are not admissible at trial to prove liability, such offers can be admissible if the statements made by a party during settlement negotiations are inconsistent with that party s position during the trial, or if the statements are being used to prove the existence of a binding settlement agreement. Furthermore, to the extent that a statement made during settlement negotiations is used to show something other than liability, such as witness bias, the statements would be admissible within the discretion of the judge. When and how do you get your attorney involved? The decision to engage an attorney to represent the guarantor group in its interactions with the lender once the loan is in default is also more complicated than one might think. This decision gives rise to the question of whom that attorney is representing when the attorney is engaged by the group. Although the guarantor group has a common interest in navigating its way out of a defaulted loan and minimizing its group liability to the lender, the guarantors may have different agendas with respect to that process, and there also may be legal conflicts of interest among the guarantors. For example, similar to the issues related to the decision maker discussed above, one or more guarantors with little or no assets may wish to negotiate an extension of the loan and incur additional indebtedness on the basis that they can still realize an upside in the property even if their equity is worthless. Conversely, a few guarantors may desire to turn the keys of the property over to the lender because they don t believe there is any upside that warrants their continued involvement. Other guarantors with assets may not want to increase their liability, especially if they have lost confidence in the property or its operator. Such guarantors may be inclined to continue to work with the lender, rather than lose considerable sums under the guaranties, because they know they cannot collect against their co-guarantors. Contractual rights to indemnification also may dictate a particular guarantor s interest in how it addresses the default status of the loan. For instance, the lender may be willing to agree to lend additional money to the project to perhaps fund tenant improvements, broker s commissions, and other necessary operating costs, on the condition that the guarantors provide a certain amount of capital toward the project or provide additional collateral. A contribution agreement among the guarantors may require one guarantor to be responsible for only a small fraction of the amount of the total capital required by the guarantors as a whole, whereas the same contribution agreement may require a substantial contribution by another guarantor. The guarantor who is required to contribute only a small portion of any required capital from the lender may be best served by funding his share and advocating that the other guarantors fund their respective shares, on the premise that his interests are best served if the project is recapitalized by the guarantors collectively and he is responsible only for a smaller portion of such recapitalization. On the other hand, a guarantor who, pursuant to the contribution agreement, is responsible to fund the significant portion of such recapitalization may view the lender s request for additional capital or collateral as throwing good money after bad, particularly if such guarantor has limited liquid funds, and, therefore, he or she may prefer to resist the lender s request for additional capital or collateral. Accordingly, even when one might think that the guarantors interests are aligned, there are several circumstances in which the interest of the guarantors and how they may want to handle a particular demand may differ. This issue highlights the importance of the decision-making on behalf of the borrowing entity. If decision-making is based on a majority of ownership, and ownership of the entity was consistent with the sharing percentages set forth in the contribution agreement, the guarantor who is responsible for the most significant portion of the recapitalization might be able to dictate that the borrowing entity would not agree to any such amendments. While it is important to point out that decision-makers in the borrowing entity likely have a fiduciary duty to the borrowing entity and its owners, which requires that the decisions makers make decisions in the best interest of the borrowing entity and its owners, 2009 Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 5

6 that decision-making authority likely would be protected by the business judgment rule. As long as such decisions are premised on valid business reasons, which typically are not difficult to establish, the decision-maker will be protected. Does each guarantor need its own counsel? Given the conflicts that can arise among the guarantors as a whole, it may be prudent for each guarantor to retain separate counsel to make sure that individual best interests are being served. This counsel not only can advise the guarantor on its rights with respect to each of the guarantors, but also can assist the guarantor on more personal matters, such as asset protection planning. Any asset protection that would take place in light of liability posed by the guarantor s guaranty to the lender must be conducted subject to applicable fraudulent conveyance laws. To the extent the guarantor has assets that exceed the guarantor s contingent liabilities, there is still an opportunity to protect those assets. The guarantor s counsel can also assist the guarantor in determining whether or not to submit an updated personal financial statement to the lender, which is worth discussing in more detail. Updating Your Personal Financial Statement. Once a loan goes into default, a lender will want to evaluate all information relevant to the loan, including the creditworthiness of the guarantors. Accordingly, the lender likely will ask the guarantor group to provide updated financial statements and each individual s most recently filed tax return. One important factor that will dictate how a lender will handle a particular defaulted loan is the creditworthiness of the guarantor group as a whole. If, for instance, the lender were to determine that the guarantors had little or no assets for the lender to pursue, the lender might be less inclined to try to exact any type of specific performance from the guarantor group on the basis that guarantors may reasonably believe that there is little downside to not complying with the lender s demands. If, on the other hand, the lender believes that the guarantors have significant assets from which to recover all or a portion of the guaranteed indebtedness, the lender is more likely to use that leverage to compel certain performance by the guarantor group, including recapitalizing the property or providing additional collateral to the lender in exchange for the lender s promise to make certain discreet loan advances toward the property. When a guarantor is asked to update his or her personal financial statement with the lender, the guarantor needs to be very careful. The act of delivering financial information to the lender, in and of itself, creates liability on the part of the guarantor to the lender. For instance, to the extent that the guarantor provides inaccurate or incomplete information to the lender, it may be liable to the lender or fraud or misrepresentation. The guarantor should be particularly concerned about being accused of committing fraud and causing the lender to incur additional debt on the basis of fraud, which may preclude the guarantor from obtaining a discharge in a later filed personal bankruptcy. In addition to common law theories of fraud and misrepresentation, the guarantor needs to be mindful of the representations, warranties, and covenants set forth in the form of personal financial statement itself. Almost every form of personal financial statement contains representations and warranties, such as a guarantor s warranty that all information provided is true and complete. One particularly important item disclosed in the personal financial statement is the manner in which the guarantor s assets are titled. The guarantor should clearly identify how assets are titled, such as whether assets are titled in LLCs or other entities. For example, a lender will attribute more value to an asset that is titled in a guarantor s name than to an asset that is titled in an LLC owned by the guarantor. If the asset were titled in the individual s name, the lender could seize upon the asset once it obtains a judgment against the guarantor. If the asset is held through an LLC, generally the lender can obtain only a charging order against the guarantor s economic interest in the LLC, unless the LLC is a single member LLC, in which case some courts have allowed the lender to seize all of the guarantor s membership interests of the LLC and in turn the assets of the LLC. A charging order entitles the lender to payment of its claim out of distributions otherwise payable to the guarantor/member; however, it does not entitle the lender to any other rights of a member, such as the right to force a distribution or liquidation. Further complicating a lender s position is the position that a charging order requires the lender to reflect the member s share of LLC income, if any, on the Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.

7 lender s tax return. If this position is held to be valid, the lender may be required to recognize income as a result of the charging order, without the ability to force a cash distribution to cover such tax liability. In a closely held company, generally it is not difficult for the manager or member, as applicable, to withhold distributions or at least minimize LLC distributions while a lender holds a charging order. This affords the guarantor/member significant leverage in negotiating with the lender compared to the situation where the guarantor owns the asset in its own name. Accordingly, the guarantor should be careful to make sure it is disclosing assets held in LLCs, because such disclosure can significantly affect the lender s evaluation of the guarantor s creditworthiness. Given the potential liability created by the delivery of the personal financial statement itself and the important role that the personal financial statement may play in dictating the lender s decision to extend the loan, on the one hand, or call the loan, on the other hand, the guarantor should consult with an attorney when completing the personal financial statement and should confirm, in consultation with an attorney, that, from a strategic standpoint, it makes sense to deliver a personal financial statement. Tax Considerations Further complicating the negotiations with the lender are the tax effects of any proposed modifications to (or cancellation of) the loan documents. The tax concepts surrounding this type of default scenario are complex and vary greatly depending on the facts. Another issue also may need to be determined on an individual basis. However, the following summarizes the basic tax concepts involved. If the lender agrees to reduce the principal balance of the loan, this principal reduction will result in the recognition of cancellation of debt (COD) income to the borrower, such income taxable as ordinary income in an amount of the principal reduction, unless one of the exceptions applies. The exceptions that are most likely to apply are the bankruptcy, insolvency, or qualified real property business indebtedness exceptions. Note that if the borrower is a partnership or an LLC taxable as a partnership, insolvency is tested at the partner or member level. The amount paid by the guarantor on its guaranty either will be treated as a capital contribution by the guarantor to the borrower, or will be deductible by the guarantor as a bad debt. If the payment is treated as a capital contribution, the payment will not have any income tax effect. However, the payment will increase the guarantor s basis in his or her interest in the borrower. If the payment is deductible by the guarantor as a bad debt, the character of the deduction will depend on whether the bad debt is treated as a business bad debt or a nonbusiness bad debt. A business bad debt is deductible against ordinary income whether or not the debt is totally or partially worthless. A nonbusiness bad debt is deducted as a short-term capital loss and must be totally worthless. The character of the bad debt deduction as a business bad debt or a nonbusiness bad debt will depend on whether or not the obligation was made in connection with the guarantor s trade or business. This determination is highly dependent on the particular facts and circumstances. However, if the main purpose of the guaranty was to protect or increase the guarantor s investment in the borrower, the bad debt will be considered a nonbusiness bad debt. In any event, to the extent that there is a right of subrogation against other guarantors, the bad debt deduction may not be taken until such right becomes worthless. Regardless of whether the borrower transfers the property to the lender by giving the lender a deed in lieu of foreclosure or the lender forecloses on the property, the transfer of the property to the lender is treated for tax purposes as a sale of the property to the lender, and the borrower will recognize income or loss to the extent that the outstanding balance of the debt exceeds the borrower s basis in the property. However, if the debt is considered recourse debt as a result of the guaranty, the borrower may recognize COD income (unless one of the exceptions applies) equal to the difference between the principal amount of the debt and the fair market value of the property. In such a case, the borrower would also recognize gain or loss equal to the difference between the fair market value of the property and the borrower s basis in the property. If this transaction results in a capital loss to the borrower, and the borrower does not have sufficient capital gains to offset this capital loss, this could result in the borrower paying income tax on the ordinary COD income and leaving the borrower with a currently nondeductible capital loss. Conclusion Unfortunately, it seems that every day, another real estate deal goes bad. Every investor hopes that it is not their deal that does, but if so, there are steps that an investor can take to minimize the damage. Although the facts of every deal are different, the key is to apply to those facts the legal and tax considerations that are addressed in this article with respect to the lender and the other guarantors, so that the best possible strategy can be determined and the precarious 2009 Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 7

8 situation in which an investor may find itself can be resolved in a manner that is beneficial to all parties Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.