On the heels of the last global financial crisis, many private equity funds and other investors found themselves with opportunities to acquire real estate-secured debt obligations in the secondary markets at prices significantly less than the face amounts of those obligations.
Borrowers and sponsors of existing leveraged real estate projects took advantage of opportunities to acquire (directly or indirectly) the outstanding debt on their projects at a significant discounts, as did unrelated investors who were busy raising funds to acquire third-party distressed debt, often with an eye toward ultimately securing ownership of the underlying collateral.
Although the longer-term impact of the COVID-19 pandemic on real estate capital markets is not yet clear, early reports are that market participants may be positioning themselves for similar opportunities.
The federal income tax consequences associated with investments in distressed real estate loans have always been, and continue to be, not only complex, but sometimes counterintuitive and unexpected.
Moreover, as seems to be the case following each down cycle, some of the tax rules in this area have been modified or updated in important ways since the last go around. Thus, it is important for any market participant to carefully consider potential tax issues and, wherever practicable, address them at the outset.
The key areas of the federal tax law that frequently need to be navigated in these types of transactions include: (1) rules applicable to related party purchases of debt, (2) tax regulations applicable to significant modification of debt instruments, (3) the market discount rules, and (4) tax rules applicable to loan-to-own transactions.
The discussion below will highlight some of the key issues arising in these four areas of the tax law, as well as provide some tax planning strategies for parties engaging in transactions involving sales of distressed real estate debt in secondary markets.
Related Party Purchases of Debt
It is a fairly well-known principle of the tax law that a borrower who repurchases or retires debt for an amount less than the amounts owing on the debt will be required to recognize cancellation of indebtedness, or COD, income for tax purposes.
What is perhaps not as well known, however, is that a borrower can sometimes be required to recognize COD income even in circumstances where the full amount of the debt remains owing. For example, if an investor who is deemed related to the borrower acquires debt from the lender at a discount, the acquisition will generally trigger taxable COD income to the borrower in an amount equal to the discount, even though the full amount of indebtedness is still owing.
Moreover, if a related investor purchases debt at a discount under circumstances that trigger COD income to the borrower, the tax law also requires the investor to include the discount into taxable income as interest over the remaining term of the debt (i.e. as so-called original issue discount, or OID), thereby creating potential phantom taxable income to the investor as well.
Although the borrower would generally be permitted to claim tax deductions for the OID accruals in the same amounts and at the same times as the OID income accruals to the purchaser, the ability of the borrower to fully utilize these deductions may be subject to one or more limitations imposed by the tax law.
Also, to the extent that the ultimate ownership of the borrower and the related note purchaser is not exact, the benefits of such deductions accrued to the borrower will not inure to the same persons.
Clearly, an important question that needs to be addressed in connection with a purchase of an outstanding debt instrument at a discount is whether the purchasing entity is related to the borrower.
The tax code has very detailed rules (including complex and broad constructive-ownership and attribution rules) that define related parties for this purpose. Generally speaking, an entity that purchases the debt will be treated as related to the borrowing entity if either entity owns (or is treated as owning) more than 50% of the other entity or the same persons own (or are treated as owning), directly or indirectly, more than 50% of both the purchasing entity and the borrower entity.
But an important thing to note is that the determination of relatedness here is based on equity ownership percentages, not management control or voting percentages.
This can be important, for example, in the context of a private equity real estate fund, which may actually consist of many different investment funds or vehicles, each of which is managed and controlled by the same sponsor, but which may be comprised of different groups of investors, either in whole or in part.
Thus, one investment vehicle managed by the fund sponsor can potentially make a discount purchase of an outstanding debt instrument issued by another investment vehicle managed by the same sponsor without triggering the aforementioned adverse tax consequences to the borrower or the purchaser, so long as the investors in each vehicle are sufficiently different (i.e. have less than 50% commonality of equity owners).
In cases where the purchaser of the debt is, in fact, related to the borrower, the tax law does contain various exceptions which, if applicable, might allow the borrower to exclude or defer the resulting COD income from taxable income.
Perhaps the most well-known exception here is the so-called insolvency exception, pursuant to which a taxpayer can exclude COD income (with a trade-off of also reducing other tax attributes, such as a net operating losses), to the extent that the taxpayer is insolvent (generally defined as having debts in excess of assets) at the time the COD income arises.
The difficulty with using the insolvency exception in the context of real estate projects is that real estate projects are often owned and operated through entities which are classified as partnerships for tax purposes. In the case of an entity which is classified for tax purposes as a partnership, the tax rules require that the insolvency determination be made on a partner-by-partner basis, based on each partner's individual balance sheet.
Thus, it can often be difficult, especially for individual partners in leveraged real estate partnerships, to qualify for this exemption, as such individuals tend to be high net worth and, thus, hopelessly solvent.
On the other hand, private equity real estate funds frequently utilize various types of special purpose corporate entities in connection with specific projects (such as so-called blocker corporations), and these corporate entities typically would be better able to qualify for the insolvency exception as to their share of any COD income than do noncorporate partners.
For a noncorporate partner in a real estate partnership, the one COD income exception that is more likely to come into play is the exception that applies in the case of "qualified real property business indebtedness."
Under this exception, a high net worth individual who has a share of COD income from a leveraged real estate project can elect to exclude such amounts from taxable income (again, with the trade-off of having to reduce certain tax attributes) if certain requirements are met.
The requirements for this exception principally include the following: The debt must be secured by real estate used in a trade or business (for this purpose, most types of actively managed rental properties can qualify as a trade or business); the debt must have been incurred in connection with the acquisition or improvement of the property, or refinance of such acquisition/improvement debt (i.e., so-called cash-out refinancing debt won't qualify); and the real estate must be underwater (i.e. value less than debt).
Phantom Tax Issues Triggered by Debt Modifications
Perhaps the most surprising tax consequences associated with transactions involving distressed real estate debt are those associated with significant modifications of the debt. Under the tax law, if the borrower and the lender agree to amend the terms of an outstanding debt instrument, and if those amendments are considered to be significant modifications, then the parties are treated for tax purposes as if the old debt instrument were exchanged for a new debt instrument.
Thus, the creditor, from its point of view, has exchanged one asset (the old debt) for a new asset (the new debt), and the borrower, for its part, has repaid the old debt by issuing a new debt. Each of these deemed transactions can trigger potentially adverse tax consequences to one or both of the parties, depending largely on whether the debt is considered to be publicly traded.
For nonpublicly traded debt, this deemed exchange will generally create taxable gain or loss to the creditor based on the difference between the face amount of the modified note and the creditor's tax basis in the original note.
This typically will not be a problem for the creditor who was the originator of the loan (or who previously purchased the debt for an amount equal to face) because that creditor's tax basis will typically equal or exceed the face amount of the modified debt. By contrast, the deemed exchange could pose a major tax problem for an investor who purchased the debt at a substantial discount to face.
This can perhaps best be illustrated by an example:
Assume that an investment fund purchases a nonpublicly traded debt instrument having a $50 million face amount for $30 million (i.e., at a $20 million discount) and then shortly thereafter enters into various modifications of the note with the borrower (perhaps extending the maturity, reducing interest, increase collateral, and so forth).
If these modifications are deemed to be significant, then the investment fund will be treated for tax purposes as having exchanged the original note for a brand-new note containing the modified terms.
The investment fund would then generally be required to recognize a short-term capital gain equal to $20 million in this example, which is measured by excess of the face amount of the so-called new note ($50 million) over the investment fund's tax basis in the so-called old note ($30 million).
This is pure phantom taxable income that certainly does not have any basis in economic reality, and often will come as quite a surprise to the note purchaser.
For publicly traded debt, the tax calculations are very different. Here, the old note will be deemed to have been exchanged for an amount equal to the fair market value of the modified debt (rather than the face amount). This can potentially fix the immediate phantom tax problem for the creditor (that is, because the fair market value of the debt likely is not materially higher than the creditor's tax basis in the purchased debt), but potentially creates an adverse phantom tax issue for the borrower.
This is because the fair market value of the debt, due to its distressed status, is presumably less than the face amount. Thus, the borrower in this situation is treated for tax purposes as having repaid the old debt for an amount less than the face amount of that old debt, thereby triggering taxable COD income to the borrower in an amount equal to the difference.
Again, the requirement that the borrower recognize COD income here can often come as quite a surprise, especially given that the full amount of the debt may nonetheless remain outstanding.
As can be seen, the determination of whether or not a debt instrument is considered to be publicly traded for this purpose has a significant impact, not only on whether adverse tax consequences will arise, but also on who bears the burden of those adverse consequences.
Prior to November 2012, the rules were such that, unless the debt instrument was actually traded on a securities exchange, it was relatively difficult for a debt instrument to be considered to be publicly traded for this purpose.
However, these rules were revised in the wake of the 2008-2009 financial crisis, applicable to debt instruments issued (or deemed issued) on or after Nov. 13, 2012. These revised rules in some cases make it easier to avoid publicly traded status, and in some cases harder.
On the easier side, the new rules provide that a debt instrument will not be considered publicly traded in any case where it is part of an issue whose outstanding principal amount (as of the time the determination is being made) does not exceed $100 million (the so-called small debt exception). Debt instruments fitting within the small debt exception would be treated as nonpublicly traded for all purposes of these rules (even where such a debt instrument is actually listed and traded on a securities exchange).
On the other hand, for debt instruments not fitting within the small debt exception, the new rules make it much harder to avoid publicly-traded status. Such a debt instrument will be treated as publicly traded for these purposes if, at any time during the 31 day period ending 15 days after the issue date (or deemed issue date), the debt instrument is listed on an exchange, has a firm quote for a sales price or has an indicative price quote.
The definitions of "firm" and "indicative" price quotes are very broad and thus are intended to capture more debt instruments as being considered to be publicly traded for these purposes.
The tax consequences outlined above for debt modifications only arise in cases where modifications to the terms of a debt instrument are considered to be significant. Fortunately, the tax rules have fairly objective rules which were adopted in mid to late 1990's, which it make it fairly easy for parties to determine whether or not any particular amendments, either by themselves or in conjunction with prior amendments, would be considered to be significant for these purposes.
Thus, in some cases, it may be possible for the parties to structure the modifications so they are not considered to be significant. For example, when it comes to deferrals of due dates or extensions of maturity dates, the rules contain safe harbors whereby the parties will not be viewed as having made significant modifications, so long as the deferral or extension do not exceed certain prescribed time periods.
If amendments to nonpublicly traded debt do constitute a significant modification, one method for a prospective purchaser of the debt to avoid the potential for phantom taxable gain described above would be to require that the seller of the debt instrument execute the amendments prior to the sale. Of course, that is not always possible.
A discount purchaser that recognizes this type of phantom taxable gain might be able to defer the resulting income tax liability through use of the installment method of reporting tax gains (although this method has limitations).
Alternatively, although many leveraged real estate projects are owned and operated by entities which are classified as partnerships for tax purposes, if the issuer of the debt happens to be an entity which is classified for tax purposes as a corporation, the holder of the debt instrument may qualify for tax-deferred treatment on the deemed exchange pursuant to the federal income tax rules applicable to tax-free corporate reorganizations.
If the modified debt instrument is considered to be publicly traded, then, as noted above, the debtor will likely have COD income as a result of a significant modification. In these cases, it will be important to determine whether the debtor can qualify for any of the exceptions in the tax law which may permit the exclusion or deferral of this phantom tax liability (the discussion of potential exceptions to COD income described in the preceding portion of the discussion, above, also applies here as well).
For investors who purchase debt instruments at a discount, the market discount rules come into play. In general, an ordinary-course purchase of debt in the secondary market for a price which is at a discount to face by a purchaser who is unrelated to the borrower (and without any significant modification) creates market discount in an amount equal to the discount.
For tax purposes, the market discount will accrue over the remaining term of the debt pursuant to a formula, and then is required to be recognized by the holder of the debt instrument as ordinary income (rather than capital gains) upon redemption or disposition of the note.
For example, if an investor purchases a $50 million face amount note in the secondary market for $30 million, then holds the note to maturity and collects the full $50 million, the $20 million of accrued market discount will be taxable as ordinary income rather than as capital gains.
Moreover, partial principal payments that are made prior to maturity can often accelerate the recognition of this ordinary income for the investor.
These market discount rules are very broad and apply to most types of discount debt transactions in the secondary market. However, for distressed debt that perhaps is even in default (and thus immediately due and payable) at the time of the investor's purchase in the secondary market, there are some arguments that the market discount rules of the tax code do not apply.
Accordingly, investors in these types of instruments — i.e., distressed, deeply discounted and/or perhaps in default — may have an argument to support a position that some or all of their gains from such transactions can be reported as capital gains. The strength of this position and/or advisability of taking such a position in any given transaction will depend on the exact facts and circumstances surrounding the investment.
Many investments in distressed debt are made by investors who have the intention of obtaining ownership of the collateral securing the loan. These types of so-called loan to own transactions also can give rise to phantom tax liabilities.
Very generally speaking, the investor will recognize taxable income to the extent that the fair market value of the collateral received in a foreclosure (or deed-in-lieu or similar transaction) exceeds the creditor's tax basis in the purchased debt instrument, and, alternatively, will recognize a taxable loss to the extent the value of such collateral is less than the creditor's tax basis in the debt.
In any event, the investor will take over ownership of the collateral with a tax basis that is equal to the fair market value of the property as of that time.
Careful tax planning is certainly important in most transactions, but it can arguably be even more important in certain types of transactions, such as those involving discount purchases of distressed debt instruments in the secondary markets.
This is attributable not only to the fact that the tax rules in this area are particularly complex, surprising and counterintuitive, but also because, as can be seen in the discussion above, many of the potential tax liabilities triggered by these transactions are of the phantom variety (i.e. income tax obligation triggered without concurrent receipt of cash proceeds to pay the tax).
We are still early in the development of the current financial crisis which has been brought on by the global COVID-19 pandemic. The long-term impact on real estate capital markets is not yet clear.
But if history is any guide, it is not out of the question that opportunities may arise for investors to purchase distressed real estate debt at attractive prices in the secondary markets. If so, it would behoove the participants in these transactions to consider the various tax consequences of these transactions, and to do so as early in the process as is possible.
Clarification: This article has been updated to clarify the scope of market discount and capital gains tax rules.
Peter J. Elias is a partner at Pillsbury Winthrop Shaw Pittman LLP.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
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