Foreclosures, Like‐Kind Exchanges and LLC Restructurings – Deferring the Gain that Arises from the Disposition of Distressed Property
June, 2013
Presented by:
Mary Cunningham, President, Chicago Deferred Exchange Company
Edward Hannon, Partner, Freeborn & Peters LLP
Identifying the Potential Tax Costs of
Foreclosure or a Deed in Lieu of Foreclosure
1. Recourse Debt – potential for cancellation of indebtedness income and capital gain.
2. Non‐Recourse Debt. – Gain measured by amount of non‐recourse debt if this amount exceeds the property’s fair market value.
– No cancellation of indebtedness income if foreclosure, deed in lieu or other sale or exchange of the property.
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Example
Outstanding Loan Amount
Fair Market Value of the Property
Adjusted Tax Basis of the Property
Accumulated Depreciation
$20.5 million
$17.0 million
$7.3 million
$6.0 million
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Example (Continued)
Borrower Tax Costs on Foreclosure
if Loan is Non‐Recourse Debt
Deemed Selling Price
Tax Basis
Gain
$20,500,000
$7,300,000
$13,200,000
Depreciation Recapture
Tax Rate (Assumed)
Tax on Recapture
$6,000,000
30%
$1,800,000
Capital Gain
Tax Rate (Assumed)
Tax on Capital Gain
$7,200,000
25%
$1,800,000
Total Tax
$3,600,000
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Example (Continued)
Borrower Tax Costs on Foreclosure
if Loan is Recourse Debt
Deemed Selling Price (FMV)
Tax Basis
Gain
$17,000,000
$7,300,000
$9,700,000
Tax on $6 Million of Depreciation Recapture
$1,800,000
Capital Gain
Tax Rate
Tax on Capital Gain
$3,700,000
25%
$925,000
CODI
Tax Rate
Tax on CODI
$3,500,000
45%
$1,575,000
Total Tax
$4,300,000
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How Can a Like Kind Exchange Be Used To Defer This Gain
• Gain from sale or exchange (both recourse and non‐
recourse debt).
• Cancellation of indebtedness income (recourse debt*).
*Non‐recourse debt if no sale or exchange.
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Review Example
If non-recourse debt
Taxable Gain
CODI
If recourse debt
Taxable Gain
CODI
$13,200,000
$ -0-
$9,700,000
$3,500,00
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Deed in Lieu Like Kind Exchanges
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Deed in Lieu of Foreclosure
• Peter Cooper Village/Stuyvesant Town Center
• In October 2006, BlackRock Realty and Tishman Speyer acquired the 56‐building, 11,000 apartment complex from MetLife for $5.4 billion.
• It was the largest single residential real estate sale in the country’s history.
• The property was acquired with $3 billion senior debt and $1.4 billion of mezzanine debt.
Deed in Lieu of Foreclosure
• Peter Cooper Village/Stuyvesant Town Center
• The new owners engaged in an aggressive tenant eviction campaign in an effort to raise rents and triple the operating income from the property.
• Their efforts were met with lawsuits from tenant groups that worked their way up to the NY State Supreme Court before settling in November 2012.
Deed in Lieu of Foreclosure
• Peter Cooper Village/Stuyvesant Town Center
• In January 2010, the owners turned the property over to their lenders, in lieu of a foreclosure, after being unable to service the remaining $3 billion of debt.
• At the time the property was turned over, the estimated FMV
of the property was just over $2 billion.
Deed in Lieu of Foreclosure
Investor Acquisition: October 2007
FMV:
$ 8 million
Non‐recourse debt: $ 7 million
Carry‐over basis:
$ 3 million
Investor Disposition: January 2013
FMV:
$ 5 million
Non‐recourse debt: $ 6 million
Deed in Lieu of Foreclosure
• In January 2013, Investor turns the property over to its Lender, in lieu of a foreclosure.
Investor
Property
Lender
Deed in Lieu of Foreclosure
• What are the tax implications?
• Can the transaction be structured as an exchange under IRC Section 1031?
• What hurdles does the Investor face?
Investor
Property
Lender
Deed in Lieu of Foreclosure
• The transfer of encumbered property to a lender is treated as a sale.
• The entire $6 million of non‐recourse debt is included in calculating the “amount realized”.
$6 Million
Investor
Property
Lender
Deed in Lieu of Foreclosure
• Amount realized from sale:
• Carry‐over basis:
• Realized gain: $ 6 million $ 2.5 million
$ 3.5 million
• Investor has $3.5 million of gain that may be recognized if a tax‐deferred exchange is not effectuated.
Deed in Lieu of Foreclosure
• How is the exchange documented?
$6 Million
Investor
Assignment of Rights under Settlement Agreement
Property
Q.I.
Lender
Written Notice of Assignment
Investor & QI sign an Exchange Agreement and a Qualified Trust Agreement.
Investor assigns its rights under the Settlement Agreement to the QI.
Deed in Lieu of Foreclosure
• How is the exchange documented?
Investor
Investor identifies replacement property within 45 days.
Q.I.
Deed in Lieu of Foreclosure
• How is the exchange documented?
Investor
Investor Assigns its rights under the Replacement Property Contract to the QI
Property
Q.I.
Replacement Property Seller
Written Notice of Assignment
Deed in Lieu of Foreclosure
• Will the Lender cooperate?
• Is there an “exchange” if the Investor receives no cash consideration for the transfer of the property?
• Is the forgiveness of debt adequate consideration?
• What document serves as the “contract of sale” to be assigned to the QI?
• Is there a formal Settlement Agreement?
• When does tax ownership transfer?
Deed in Lieu of Foreclosure
• Does Investor have the means to acquire replacement property?
• Can Investor find replacement property with assumable debt?
• Would a zero‐cash flow property be an appropriate investment?
Using the Safe Harbor Reverse Exchange for Foreclosure Situations
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Safe Harbor Reverse Like Kind Exchanges
• Rev. Proc. 2000 ‐37
• Can be used as “exchange last” or “exchange first”
• Timing issues if foreclosure property is to be relinquished property.
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Parking Arrangements and Foreclosure Situations
EAT
Parked Property
Relinquished Property
Foreclosure Property
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Parking Arrangements and Foreclosure Situations
• Taxpayer wants to acquire property out of foreclosure at auction in a reverse exchange using Rev. Proc. 2000‐37.
• Taxpayer needs to have cash to attend the auction.
• The Exchange Accommodation Titleholder will be the grantee if the Taxpayer is the successful bidder.
• The auction house needs to agree to transfer the property to an entity that is owned by the EAT.
• If the balance of the purchase price for the property is financed, the lender needs to understand the EAT’s role.
• When does tax ownership transfer?
Using the Like Kind Exchange Rules
In Connection with the Qualified
Real Property Business Indebtedness Election
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What to do with Cancellation of Indebtedness
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Overview of the Qualified Real Property
Business Indebtedness Election
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Qualified Real Property Business Indebtedness
• Qualified real property business indebtedness is indebtedness that was incurred or assumed by the taxpayer in connection with real property used in a trade or business that is secured by real property.
• Amounts excluded under Code Section 108(c)(1)(A) cannot exceed the aggregate adjusted tax basis of the depreciable property held by the taxpayer immediately prior to the discharge of indebtedness.
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Qualified Real Property Business Indebtedness
• The exclusion of Code Section 108(c) cannot exceed the sum of (x) the principal amount of the debt less than (y) the fair market value of the property, as reduced by other qualified real property business indebtedness that is secured by the property.
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• Must file an election to get the benefits ‐ IRS Form 982.
• C corporations cannot make the election.
• For partnerships the election is made at the partner level.
• Applies to encumbered property and other eligible properties held by the electing taxpayer.
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The Fair Market Value Limitation
• “Property specific insolvency test”
• Exclusion is limited to the – The outstanding principal amount of the debt.
– LESS the “net fair market value” of the property, (fair market value as reduced by other QRPBI secured by the property that is not being discharged).
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Basis Limitation
Exclusion cannot exceed the aggregate basis of “depreciable real property” held by the taxpayer immediately before the discharge.
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Consequences of the QRPBI Exclusion
• Basis reduction on first day of next year. • Basis reduction accelerated if property is sold by year end.
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Consequences of the
QRPBI Election
• Basis reduction is deemed to be attributable to depreciation deductions. • Recapture income is taxed as ordinary income to the extent reduction exceeds straight‐line amount.
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Example
CODI Potential Ordinary Income on Sale $900,000
Amount Treated as Accelerated Depreciation Tax Rate Potential Tax Cost on Sale $900,000 45% $405,000 36
Effect of Subsequent Like Kind Exchange on Recognition of QRPBI Recapture
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Deferral of Gain and CODI in Work‐Outs
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Borrower Recapitalization Structure
Assumed Facts: Loan Outstanding:
Note Purchase Price:
Fair Market Value:
Note Purchaser
$20.5 million Loan
$20.5 million
$16.5 million
$17.0 million
Owner
Borrower LLC
Personal Guarantee
Property
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Potential COD Income
Original Loan New Mortgage Mezz Loan Cancellation of Indebtedness $20.5 million
$12.0 million $5.0 million $3.5 million 40
Borrower Recapitalization Structure
Senior Lender
$12 million mortgage loan
$5 million
mezz loan F/N
Note Purchaser
Class A units
and $12 Million
Borrower‐Owner
Class B units
(non‐voting)
Newco
F/N
$3.5 million write-down of the original loan in
connection with the refinancing.
Property
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Tax Issues
1.
2.
3.
4.
Related Party Debt Rules
OID for Note Purchase
CODI / QRPBI Election
Deemed distribution from reduction in partner’s share of partnership liabilities.
5. Treatment of Mezz Loan as indebtedness.
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Questions?
Mary Cunningham
Executive Vice President
Chicago Deferred Exchange
135 S. LaSalle Street
Suite 1940
Chicago, IL 60603
mary.cunningham@cdec1031.com
(312) 580‐9601
Edward J. Hannon
Partner
Freeborn & Peters LLP
311 S. Wacker Drive – Suite 3000
Chicago, IL 60606
ehannon@freeborn.com
(312) 360‐6596
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Edward J. Hannon
Mr. Hannon has been named a “Leading Lawyer” in the areas of International Business
and Trade Law, Real Estate Law and Finance and Tax Law in 2009, 2010, 2011 and
2012. He has also been named to the Irish Legal 100 in 2010, 2011 and 2012. A
seasoned tax advisor, Mr. Hannon regularly advises property owners, real estate
investors, note purchasers and developers in connection with tax, governance, entity
formation and other matters related to real estate partnerships and joint ventures. His
work in this area includes note purchaser transactions, including the restructuring of
existing borrower entities in connection with borrower recapitalizations.
Mr. Hannon also has significant experience in "development joint ventures" and the use
of limited liability companies in the formation of joint ventures between landowners and
developers for the development or repositioning of real estate projects. Mr. Hannon also
advises U.S. and foreign business owners in the tax-free acquisition and disposition of
U.S.–based businesses and the use of limited liability companies in various tax-oriented
acquisition structures
Mr. Hannon currently serves on the Board of Directors of the Illinois CPA Society as the
Board Secretary and member of the executive committee. He has also been a member
of the adjunct faculty at DePaul University Graduate School of Business where he has
taught courses within the MBA program on Tax and Structural Planning for Real Estate
Transactions. For additional information about Mr. Hannon, please visit
www.freeborn.com.
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Mary Cunningham
Mary Cunningham, President of Chicago Deferred Exchange Company, the
nation’s premier provider of IRC Section 1031 Like-Kind Exchange (LKE) services,
is responsible for a staff dedicated to providing trust and consulting services to
attorneys, accountants, real estate and tax professionals nationwide. Ms.
Cunningham brings more than 18 years of exchange expertise in the field of LKE
services, is a frequent lecturer at real estate and tax forums across the country on
the topic of tax-deferred exchange strategies and has represented her industry on
various legislative issues with the IRS National Office, members of the House of
Representatives and the United States Senate.
Ms. Cunningham has the expertise that comes from direct involvement with
thousands of tax deferred exchanges of diverse assets, including FCC Licenses,
Trademarks, Commercial Aircraft, Pipelines, Automobile Fleets and every type of
real property. A 1996 graduate of the American Banker’s Associations National
Graduate Trust School, Ms. Cunningham completed her undergraduate studies in
business administration at Miami University in Oxford, Ohio.
Since 1989, CDEC has been the nation’s premier provider of IRC Section 1031
Like-Kind Exchange services, with offices in Chicago, San Diego, San Francisco,
and New York. CDEC acts as a Qualified Intermediary in forward LKEs, commonly
referred to as “Starker” exchanges, and as Exchange Accommodation Titleholder
(EAT) in reverse exchanges under Revenue Procedure 2000-37.
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