Handling Real Estate Workouts: Basics and Beyond

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Bridget Jenkins
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1 Handling Real Estate Workouts: Basics and Beyond Michael Hirschfeld Dechert LLP, New York (212) Wednesday, March 25, Dechert LLP

2 Practical Observation The facts, the facts, the facts Learn them early on! 1

3 Cancellation of Indebtedness Income Generates ordinary income General Rule Owe $ 100 Pay back 80 Income $ 20 2

4 Planning Any ways to make COD go away? 3

5 Two Basic Rules to Keep in Mind Debt reduction is ordinary income, that is, COD income Regardless of whether debt is recourse or nonrecourse By contrast, sale of property subject to debt generally generates capital gain Debt balance is part of amount realized But could generate a tax loss! 4

6 Foreclosure If debt is recourse then Property is treated as-- Sold for its FMV (generating potential capital gain) Excess of debt over FMV is COD income If debt is nonrecourse then Property is treated as sold for amount of the debt FMV is irrelevant! 5

7 Foreclosure Example Debt = $1,000x FMV = $800x AB = $300x Foreclosure IF nonrecourse debt-- Property sale-gain=$700x ($1,000x-$300x) Foreclosure IF recourse debt-- Property sale-gain=$500x; COD=$200x 6

8 Insolvency Exception No income recognized BUT only to extent of insolvency, which means excess of liabilities over FMV of property But do not apply at partnership level. 7

9 Bankruptcy Exception No COD BUT must be discharged by court order pursuant to the plan Do not apply at partnership level. 8

10 Purchase Price Reduction Exception But only between original buyer and original seller. 9

11 Principal Residence Exception Up to $2 million. 10

12 Related party debt acquisition Can you avoid COD by having a related party buy the debt? Internal Revenue Code says no. 11

13 Real estate Any special breaks? 12

14 Qualified Real Property Business Indebtedness Section 108(a)(1)(D) COD Exclusion Applies to all except for C corporations Debt to acquire real property used in a trade or business AND is secured by realty Exclusion = FMV - Prin. Amt. Of Debt But exclusion not in excess of AB of depreciable real property 13

15 Partnerships & Workouts Entity v. aggregate theory Let s take a look at what happens here: 14

16 The Troubled Partnership When the partnership realizes a discharge of indebtedness, there are two sets of rules that are relevant: COD Subchapter K Partnership realizes COD COD passes through to each partner (generally) Partner level determinations of any exclusions 15

17 The Troubled Partnership (con t) Whether or not the partnership is bankrupt or insolvent is usually irrelevant Timing of COD recognition on last day of partnership s years Basis rules reduction of liability = deemed distribution of money 16

18 If you avoid losing your property, are you tax wise OK You agree to MODIFY the terms of your debt instrument to stay alive. What happens? 17

19 What is a modification? Anything=modification Significant modification=legal rights & obligations that are altered & economic degree to which they are changed is significant Nearly anything=significant 18

20 Significant Modification Change in interest rate 25 basis points original terms exception Change in obligor OK if non-recourse If recourse obligation, answer depends on form of transaction and effect on payment expectations 19

21 Modifying Debt Obligations Debt that is significantly modified is treated as exchanged for old debt (Treas. Reg ) This can have a tax impact (unless it can be a tax-free recap, which is hard to assert) where: Vulture capitalist bought debt at a discount or Company may have written down some of the debt 20

22 Real life example Buyer acquires creditor s position in a $100M Note for $60M After purchase, buyer renegotiates terms of debt by dropping interest rate by 100 points Taxable exchange of Old Debt for New Debt Buyer s Realized Gain = $40M but installment sale but interest charge 21

23 Lesson to be learned Modify debt BEFORE you acquire it! After acquisition, just sit with it! 22

TAX ASPECTS OF DEBT RESTRUCTURING, WORKOUTS & FORECLOSURE May 2004

TAX ASPECTS OF DEBT RESTRUCTURING, WORKOUTS & FORECLOSURE May 2004 WENDI L. KOTZEN BALLARD SPAHR ANDREWS & INGERSOLL, LLP 1735 Market Street, 51 st Floor Philadelphia, PA 19103-7599 kotzenw@ballardspahr.com