As the coronavirus lockdown drags on, nearly every kind of commercial real estate except for warehouses and distribution centers is a short. We previously reported that Carl Icahn was shorting CMBX 6, a commercial mortgage bond derivative contract that tracks a lot of malls. Savvy investors are now looking at CMBX 9, which tracks a variety of commercial mortgage bonds, including issues with hotels and apartments as collateral.
CMBX indexes are naked credit default swaps for commercial real estate mortgage bonds. These IHS Markit products allow investors to track various tranches of 25 issues of mortgage-backed securities in each index. Short investors can buy protection by paying premiums, while long investors pay no premiums but promise to insure that protection. And yes, the lowest tranches of some CMBX indexes have incurred total losses. CMBX 9 is regarded as a hotel bet because hotels comprise 17 percent of the collateral for the bonds it tracks. The index includes bonds backed by the Starwood Extended Stay portfolio.
Starwood was recently acquired by Marriott International, the world’s largest hotel chain. Marriott CEO Arne Sorenson believes that April was the trough in hotel occupancy, but said a small uptick in leisure travelers driving to close destinations is not enough to bank a recovery on. Marriott just permanently closed its brand-new Times Square Edition hotel — right across the street from another large Marriott property that is a popular conference and tourist facility. Analysts expect about 20 percent of New York hotel capacity to be permanently removed and converted to other uses.
Hotel occupancy is currently 40 percent — just breaking even for higher-end lodgings. Business travel is done. The videoconferencing capability that should have killed it off years ago is now in wide use. Many companies that don’t have to sell products in person will never return to big travel budgets. Our readers know this because they’re grounded, their conferences were canceled, and they’re looking at this article in between Zoom meetings and GoToWebinars. Some readers don’t ever want to go back to their downtown offices. So what do the owners of those underwater properties do with them?
Like-kind exchanges are a time-honored way for real estate owners to defer gain on dispositions of commercial properties. But this tax benefit is not just for properties with old-fashioned capital appreciation. Some planners find a way to use it when the disposition consists of throwing the keys to the lender. That was the subject of discussion led by Brian O’Connor of Venable at the recent 2020 Federal Real Estate and Partnerships Tax Webinar hosted by the NYU School of Professional Studies Division of Programs in Business.
Background
A like-kind exchange has straightforward requirements that are not easy for owners of underwater properties to meet. There has to be an exchange, the transferred property must be qualifying real property, the replacement property must be of like kind, and both the transferred and replacement property must be held for use in a trade or business or for investment (section 1031(a)). When the transferred property is underwater, the qualifying property and exchange elements are the most difficult to meet.
Boot on the exchange is taxable (section 1031(b)). Net relief from liabilities is taxable as boot (reg. section 1.1031(d)-2). The basis of the replacement property equals that of the transferred property, increased by liabilities assumed, gain recognized, or cash paid (section 1031(d)). If the transferor’s basis in the underwater property is greater than fair market value, it will have to do something to equalize the values in the exchange; otherwise it will have to recognize boot.
Like-kind exchanges have been turbocharged by statutory permission to use deferred exchanges, intermediaries, and cash escrow (section 1031(a)(3)). A replacement property is not going to be easy to find for an owner wanting to dispose of a property with a billion-dollar mortgage on it. In a big-money deal, there is usually a deferred exchange handled by a qualified intermediary (reg. section 1.1031(k)-1(g)(4)).
Property being property, there would be recording and transfer tax issues on an outright transfer to the intermediary. So when a qualified intermediary is used, the transferor usually makes an assignment of all of its rights in the proceeds of a sale contract to the intermediary, with notice to affected parties, rather than making a formal conveyance of the property itself to the intermediary (reg. section 1.1031(k)-1(c)(4)(v)). Taxpayers typically assign contracts to the intermediary, which closes on the contracts and transfers the properties to the buyer and seller, which complete the title transfers. Participants speak in terms of sale and purchase prices.
When a property is worth less than loan principal, and the loan is nonrecourse, tossing the keys back to the lender will result in capital gain to the borrower. When there is a foreclosure or a deed in lieu of foreclosure, the difference between the loan principal amount and the FMV of the property is capital gain (Commissioner v. Tufts, 461 U.S. 300 (1983)). That’s the gain that owners of underwater property hope to avoid by using a like-kind exchange.
If the debt were recourse, the difference between the FMV of the property and the loan principal amount would be COD income, which could be sheltered by an exception (section 108). Nonrecourse real estate loans typically have covenants that, when violated, cause the loan to be converted to recourse status. Called “bad boy” covenants, these provisions cover acts like bankruptcy of the owner and nonpayment of real estate taxes. Bad-boy covenants can be viewed as contingent liabilities. So the recourse nature of the converted loan may not be recognized for tax purposes until the lender seeks to enforce the loan as recourse. That is, just breaching a bad-boy covenant may not be enough.
What Equity?
Does the transferor own anything? Is whatever the transferor owns considered qualifying property? This was the question posed at the NYU conference. The transferor clearly has no equity in the property.
Practitioners have advanced theories about what the taxpayer might own. Richard Lipton of Baker McKenzie theorized that the taxpayer might be transferring its right to the phantom gain on the underwater property. After all, in Tufts, the taxpayer had a big gain despite having no equity in the property. Section 1031 requires an exchange; it doesn’t require proceeds or equity. Lipton suggested that a carefully planned like-kind exchange should involve the lender giving a peppercorn of consideration to the borrower, so that the latter could transfer the right to that consideration to the qualified intermediary (Lipton, “Are Underwater Like-Kind Exchanges the Answer?” 115 J. Taxation 253 (Nov. 2011)).
However, Lipton and the NYU panelists noted the analogy to basis in tax-free reorganizations. Is a like-kind exchange analogous to a reorganization? Yes. Structurally, the rules operate similarly. In the reorganization context, assumption of liabilities is boot, and by definition underwater property cannot sustain a basis that includes the debt on it. In a corporation formation, the amount of the contribution — and the transferor’s basis in shares received in exchange — is limited to the FMV of the property (section 357(c)). And debt assumed in a reorganization is limited to the FMV of property transferred (withdrawn prop. reg. section 1.368-1(f)). This analogy would dictate that gain recognition on an underwater transfer is inevitable.
The IRS seems to have answered the question whether underwater property can be the subject of a like-kind exchange in a letter ruling (LTR 201302009). In the ruling, the taxpayer, a partnership, held the property in a single-member LLC, which the tax law disregards (section 1031(e)). The taxpayer was preparing to transfer the underwater property to the lenders, subject to the nonrecourse loans on it, and had a contract to that effect. It assigned all its rights in the proceeds of that contract to the qualified intermediary, with notice to the lenders.
So the lenders would step into the shoes of the taxpayer and participate in the like-kind exchange, and the intermediary would transfer replacement property with a value equal to the remaining principal amount of the loans to the taxpayer. The taxpayer would enter into an acquisition contract for replacement property and assign its rights in that contract to the intermediary. Because the property was underwater, the taxpayer was expected to make up the difference in values with cash or debt.
The IRS ruled that the taxpayer’s assignment of its rights in the contract to the intermediary would be a transfer of relinquished property for purposes of determining whether there was an “exchange of property held for productive use in a trade or business or for investment” under section 1031(a), even though the FMV of property was less than the principal amount of the outstanding nonrecourse debt.
Implicit in the ruling is the IRS acknowledgment that underwater property can be exchanged, provided something else is acquired. The IRS expressed no opinion on whether the transfer otherwise qualified for like-kind exchange treatment.
What Boot?
Whether something has been exchanged is a different question than whether the transferor has to recognize boot on the exchange. The transferor wishing to avoid boot has to ensure that the purchase price of replacement property exceeds the sale price of transferred property and that all equity is rolled over, according to Lipton.
How can the transferor ensure that the basis taken in the replacement property will equal that of the transferred property? The transferor can’t be broke to obtain that result in a like-kind exchange because it will need to have cash or borrowing capacity to equalize the values of the two properties. There are flush property owners that have underwater properties, so it’s not impossible. But even they might not want to deploy large amounts of cash to defray taxes.
Well, what if the taxpayer doesn’t have the cash? The debt overhang on the transferred property can be matched with debt on the replacement property if there is no new cash. NYU panelists and Lipton suggested that the replacement property could be credit net lease property encumbered by debt equal to or exceeding the debt on the transferred property. Also called “zero cash flow” property or triple net lease property, the cash flows of such property are locked down and entirely devoted to debt service. Lenders like these arrangements, which is why such properties can carry enormous debt. The point of having credit net lease property as replacement property is that the debt would be included in basis. The lawyers cautioned that the lease terms should be reviewed carefully.
NYU panelists wondered whether lenders would cooperate with like-kind exchange planning involving qualified intermediaries. The usual drill for such an exchange involves a transfer of rights in a sale contract to the intermediary, rather than outright transfer of the property. But in the underwater situation, there may be a lender or servicer about to foreclose. In a normal foreclosure, there is no sales contract. The lender gets the property. Without the cooperation of the lender, there is no opportunity to set up a like-kind exchange if foreclosure occurs first. If the lender would accept a deed in lieu of foreclosure, the taxpayer could assign its obligations under the deed to the intermediary.
Well, what if the lender won’t take a deed in lieu of foreclosure? What if the original lender isn’t even in the picture and the institutional servicer has no power to accept a deed in lieu of foreclosure on behalf of bondholders? The borrowers on big securitized mortgages really have no good way of negotiating with servicers.
What if the taxpayer instead transferred the encumbered property directly to the intermediary, as the regulations permit? That transfer may breach a bad-boy covenant and convert the loan to a recourse loan if the lender enforces the loan as recourse. Or the transfer may be a prohibited assignment that would prevent the taxpayer from passing title to the intermediary. Lipton pointed out that if the intermediary received the encumbered property and the lender then foreclosed, the transaction would be treated as a sale for the amount of loan principal, assuming no recourse conversion of the loan.
NYU panelists wondered what the date of the transfer for federal income tax purposes would be. This isn’t a sale that occurs when the benefits and burdens of ownership pass. State law has a redemption period during which the foreclosure transaction can be reversed if the lender recovers the funds from the borrower, even if the property had been sold at auction. Case law says that the transfer occurs at the expiration of the redemption period. In a Depression-era case, the foreclosure sale occurred in late October, but the court sustained the IRS determination that the transfer took place three months later, into the following year, when the redemption period expired, regardless of whether the lender pursued the borrower (R. Odell & Sons Co. v. Commissioner, 169 F.2d 247 (3d Cir. 1948)).