Tough Times for Lenders : Financial Services Lawyer & Attorney : Winstead Law Firm : Finance, Banking, Bankruptcy

As I've commented previously, Congress has been contemplating imposing a stiff tax increase on the "carried interest" or a developer's "promote" in real estate deals; and a long, long list of commercial real estate industry organizations have been fighting to stop the tax increase.

This tax would be a real hardship on commercial real estate, and consequently would result in even more tough times for lenders.  (And of course, Congress is looking for ways to raise money in order to combat the deficit.)

Here's some good news in troubled times for commercial real estate: the tax increase on carried interest is dead (for the immediate future).

Recall that the House passed its version of the tax increase (H.R. 4123; The American Jobs and Closing Tax Loopholes Act ) in late May.  Here is the summary of the House bill by the Mortgage Bankers Association:

"Under the House-passed bill, 50 percent of any carried interest that does not reflect a return on investment capital would be taxed at the significantly higher income tax rate (up to 35 percent), instead of as long-term capital gains, which are taxed at 15 percent. In 2013, the portion of carried interest taxed at the higher rate would climb to 75 percent. The Joint Economic Committee has found that this provision would raise taxes by $18.7 billion over the next 10 years."

Distressed borrowers and lenders alike now can sigh a (small) sigh of relief . . .  because on last Thursday (June 24), the Senate failed for a third time (it was try, try and try again) to persuade 60 Senators to support the bill.  Here is the summary and announcement from the National Multi Housing Council:

". . . Senator Max Baucus (D-MT) twice modified the carried interest proposal to try to make it more palatable to real estate partnerships. 

The latest iteration would have taxed 75% of a carried interest at ordinary income rates and 25% at capital gains rates as of 2011. A carried interest attributable to assets held for at least five years would have been taxed at a 50-50 split. The language was also modified to exempt family partnerships who allocate carried interests on a pro-rata basis from the tax law change. Those partnerships would have continued to be taxed at capital gains levels. 

While the most immediate threat appears to have passed, NAA/NMHC remain vigilant as the Senate could take up the extenders bill again in the fall, and carried interest remains a possible "pay for" for other forthcoming legislation."

I know that this is this is the "tough times" blog, where things are always suppose to be dark and . . . hopeless - or at least coated in a thick layer of winter gray.  But, this is good news . . . .

It is nice to have some good news.

And kudos to Steve Church of JLL for bringing this "news" to my attention.

If you have any comments or other perspectives on this, please post a comment.

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While the nature of the collateral securing a loan may change, while the local market may change, while the number and nature of the lenders in the credit stack may change, while "X" (you fill in the  "X") may change, ONE thing never changes . . . . 

. . . income taxes.

And I suspect that the impact of debt restructures (and foreclosures) on income taxes will become more and more important in the future.  But let's not overlook the importance of this topic today.

In prior postings, we've touched on the importance of income tax issues, including cancellation of debt income and other "bad" consequences [2nd of two postings].

Below is a list furnished by a partner of mine, Julie Sassenrath.  Julie has in-depth knowledge of the tax code, case law and IRS rulings, and has a very, very practical bent.  She uses variations of this list as a starting point to assess the tax consequences of a specific workout or foreclosure.

Collecting this information often is a key element in any debt restructuring plan, whether you are the key principal behind the borrower, or the asset manager pursuing the recovery of the Lender's investment.

Here is Julie's quick list:

• Amount of debt (principal and accrued but unpaid interest)
• Has accrued but unpaid interest been deducted?
• Recourse v. non-recourse nature of the debt
• Guarantors or other persons liable for debt (and relationship to partners), and nature of liability
• Basis of the property (collateral)
• Basis of partnership interests of the partners
• How has the debt been allocated among the partners for tax/basis purposes?
• Identity of the partners (and their partners if a partnership) and ownership interests
• Financial status of each partner (solvent, insolvent, bankrupt, etc.)
• Tax attributes of each partner (NOLs, passive losses, capital losses, etc.) and overall tax picture of each partner
• Other real estate interests held by each partner
• Other assets held by the partnership
• Fair market value of the property (collateral)

If and when you focus on income taxes in a plan, be sure to contact an experienced adviser.

Frankly, I am NOT familiar with this topic.  When faced with this topic, I quickly reach out to Julie or another tax lawyer at my law firm for help.

If you have information or questions to add to this list, please post a comment below.

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Guest Writer - Mike Cook, Winstead PC

2nd in a series of 2 postings
(Part 1: The Insolvency Exclusion to Cancellation of Debt (COD) Income;
The Effect of Exempt Assets Under the Carlson Rule)

The Court, having determined that the use of “assets” was ambiguous, pointed out that “[t]he stated purpose of the 1980 Bankruptcy Tax Act was to ‘accommodate bankruptcy policy and tax policy.’” Both Senate and House reports indicate that the proposed insolvency exception in Section 108(a)(1)(B) was intended to ensure that an insolvent debtor outside of bankruptcy (like a debtor coming out of bankruptcy who is accorded a ‘fresh start’ under Federal bankruptcy laws) is not to be burdened with an immediate tax liability.

The Tax Court, however, concluded that although an asset of a debtor may be exempt from the claims of creditors under applicable law, if that asset and the debtor’s other assets exceed the debtor’s liabilities, the debtor has the ability to pay an immediate tax on income from discharged indebtedness. By implication, therefore, the same Congress that decided that it was in the public interest that exempt assets be removed from the reach of creditors so that debtors could obtain a fresh start intended, nevertheless, to impose an income tax on the value of those assets in the event that a taxpayer negotiated a debt settlement with creditors outside of bankruptcy. In effect, the Carlson Court concluded that Congress intended to impose a penalty on taxpayers that handled their financial problems without resorting to the bankruptcy court.

Under the Carlson rule, an individual with substantial exempt assets pays a high penalty for not filing bankruptcy. The opposite viewpoint, however, is that the reason the Tax Court has sided with the government is because the cases from the late 1980s showed the gross disparity in tax treatment that could occur from the differences in exempt assets allowed from state to state. In Texas, a person with substantial exempt assets could successfully take an insolvency position under the old law. It should be noted that only the Tax Court has addressed the issue, and if the economic conditions currently being experienced produce the same quantity of workouts from commercial debt (COD from residential loans is currently excluded from gross income) as occurred in the 1980s, the issue of whether exempt assets should be excluded from the insolvency calculation will surely reach several courts of appeal.
 

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Guest Writer - Mike Cook, Winstead PC

Part 1 of 2

During the current economic crisis, debtors will be negotiating workouts with lenders and if the debtors successfully obtain debt relief, they will also be seeking tax relief from the taxation of COD income. The ability to use the broadest exclusion from COD income, the insolvency exclusion, has been severely restricted in recent years. The relief from taxation of COD income by reason of insolvency of a taxpayer has a common law history, but it was codified in 1980 as Section 108(a)(1)(B) of the Internal Revenue Code. The legislative history of the Bankruptcy Tax Act of 1980 made it clear that a purpose of the statutory insolvency exclusion was to put insolvent taxpayers on the same footing as those who filed bankruptcy, which also excludes COD income from taxation. But recently the Tax Court has penalized taxpayers for not filing bankruptcy; the insolvency exclusion does not now produce the same tax results as does bankruptcy. So are debtors better off filing bankruptcy than entering into a debt settlement with lenders?

When an individual files bankruptcy and is relieved of personal liability, the debtor comes out of bankruptcy with his/her exempt assets and there is no taxation of the relief of liability because COD is not income pursuant to Section 108(a)(1)(A). In the late 1980s, when the banking and real estate industries collapsed in the southwest United States, taxpayers relied on old case law to the effect that their exempt assets were not included in the insolvency calculation. The IRS seemed to back away from its initial litigating position and agreed with the taxpayers’ exempt asset position, but in the 1990s the IRS put taxpayers on notice that its position was that the insolvency calculation should be calculated without inclusion of the exempt assets. The Tax Court subsequently addressed the issue in Carlson v Commissioner, 116 T.C. 87 (2001) and it adopted the IRS’ position.

The Carlson Court noted with some frustration that Congress did not define the word “insolvency” or “assets” as used in Section 108(a)(1)(B) and turned to several dictionaries to find the meaning of “asset.” The court noted three definitions: (i) the property of a deceased person subject by law to the payment of his or her debts and legacies; (ii) the entire property of a person, association, corporation, or estate applicable or subject to the payment of debts; and (iii) the items on a balance sheet showing the book value of property owned. The first two definitions support an exclusion of exempt assets while the third definition supports an inclusion.

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