Attorney Thanks Treasury for Meeting on New Legislation
Attorney Thanks Treasury for Meeting on New Legislation
- AuthorsBlanchard, Kimberly S.
- Institutional AuthorsHaythe & Curley
- Subject Area/Tax Topics
- Index Termslow-income housingHUDdebt, restructuring
- Jurisdictions
- LanguageEnglish
- Tax Analysts Document NumberDoc 98-13568 (16 pages)
- Tax Analysts Electronic Citation98 TNT 83-30
Kimberly S. Blanchard of Haythe & Curley, New York, has thanked Treasury for meeting with her to discuss proposed guidance under the Multifamily Assisted Housing Reform and Affordability Act of 1997. At the same time, Blanchard also forwarded a memorandum, prepared by her firm, summarizing the significant issues left unresolved under the legislation. In the memo, the firm also addresses the Act's tax consequences, including the treatment of a second mortgage as true debt; a debt-for-debt exchange analysis; and a below-market loan analysis.
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April 13, 1998
Paul Crispino, Esq.
Attorney-Advisor
Tax Legislative Counsel
1500 Pennsylvania Avenue
Washington, D.C. 20220
Re: Section 8 Debt Restructuring Guidance
Dear Mr. Crispino:
[1] Thank you for taking the time to speak with me on March 30, 1998 regarding the item on Treasury's 1998 business plan relating to the new HUD section 8 debt restructuring legislation.
[2] As I indicated, I an enclosing a copy of a memorandum prepared by my firm summarizing what we believe to be the significant unresolved issues under the legislation. The tax discussion is contained in part II,C of the memorandum.
[3] Since we spoke, I have been in touch with an accountant who sent a ruling request to the IRS on this issue. I assume that request may find its way to your desk. I would be most interested in speaking with you again after you have had the chance to study this issue further. In the meantime, if you have any comments or questions relating to the enclosed memorandum, please do not hesitate to call me at the number shown above.
Sincerely,
Kimberly Blanchard
Haythe & Curley
New York, New York
Enclosure
April 14, 1998
REENGINEERING LEGISLATION: SUMMARY AND ANALYSIS
PART I SUMMARY OF ACT
A. INTRODUCTION.
[4] On October 27, 1997, the President signed the Multifamily Assisted Housing Reform and Affordability Act of 1997 (the "Act") into law. The Act will take effect on October 1 of this year and terminate on October 1, 2002, unless extended. It is designed to decrease the projected costs to the Department of Housing and Urban Development ("HUD") of renewing Section 8 project-based rental assistance to certain multifamily housing projects.
[5] The Section 8 program was created in 1974 and provides for assistance to "low income" (defined as income of less than 80% of the median income in the area as determined by HUD) and "very low income" (defined as income of less than 50% of the median income of the area) individuals or families. Section 8 subsidies come in two forms: tenant-based through the issuance of vouchers directly to the persons seeking housing, and project-based, through the provision of subsidies to the owners of low-income projects. Both programs are administered by local and state housing agencies. Between 1974 and 1983 (when the project-based program was discontinued), HUD entered into thousands of long-term contracts to provide these subsidies. Most of these contracts will expire in the next few years and will be subject to renewal.
[6] The Act (generally referred to as the "reengineering legislation") was necessary because the federal subsidies provided in Section 8 contracts which are expiring and subject to renewal were projected to grow from $1.2 billion in fiscal year 1997 to almost $7.4 billion in fiscal year 2006. The Act reduces the rents HUD will have to pay under extended Section 8 contracts. However, decreasing rents, while reducing HUD's costs, could also serve to prompt massive defaults on the mortgages encumbering the projects. While the Section 8 contracts were generally for a term of 20 years, the mortgage loans insured by the Federal Housing Administration ("FHA") which financed the projects were generally for a term of 40 years. To avoid defaults, therefore, the Act provides for debt-restructuring mechanisms.
[7] The purpose of this memorandum is to summarize the Act and to examine the likely impact of the Act on the refinancing and restructuring of debt which financed FHA-insured Section 8 assisted projects. The Act itself raises many questions. While Part I merely summarizes the Act, Part II of this memorandum discusses and analyzes uncertainties and issues raised by the Act.
B. ELIGIBILITY.
[8] A project is eligible to participate in the reengineering program if (i) its rents exceed the rent of comparable properties determined in accordance with guidelines to be established by HUD, (ii) its mortgage is FHA-insured, and (iii) it has contracted for project-based assistance under one of the following Section 8 programs: new construction or substantial rehabilitation, property disposition, moderate rehabilitation, loan management set aside, displacement assistance and rent supplement. It is important to emphasize that properties secured by mortgages not insured by FHA are excluded from participation in the reengineering program.
[9] In addition, as the Act is currently written, bond- financed projects may be excluded from participation in restructuring. This was not the intent of the Act and, consequently, corrective legislation is anticipated prior to the 1999 fiscal year. We have been informed in informal discussions with Congressional staff that such legislation is expected either this spring in supplemental spending legislation or this fall in the HUD appropriations act.
C. THE RESTRUCTURING PLAN.
[10] The Act provides that a participating administrative entity ("PAE") shall cooperate with the owner of a project and any servicer of the existing mortgage to develop a mortgage restructuring and rental assistance sufficiency plan (a "Plan"). Each Plan is submitted to HUD. A Plan governs each project and addresses, among other things, the restructuring of the project's rents. the rehabilitation needs of the project, necessary reserves and similar matters. The Plan also establishes minimum thirty-year use restrictions on each project.
[11] The PAE will be a public housing agency (an *Agency') or an Agency and a private entity (for-profit or not-for-profit) or an Agency and a consortium of two or more private entities, approved by HUD. The PAE acts as the liaison between HUD and the owner by developing the Plan with the owner on the one hand, and entering into a portfolio restructuring agreement (a "PRA") with HUD on the other hand. A PRA may govern more than one project, and it identifies HUD's responsibilities and the responsibilities of the PAE in implementing the Plan.
D. RENT REDUCTIONS.
[12] A major feature of the Act is the reduction in the rents that HUD will pay to the owners. The new rents either (a) must be similar to rents on comparable properties, if the PAE makes the rent comparison within a reasonable time and if the new rent is based on at least two comparable properties, or (b) if such comparable property rents cannot be determined, must be 90% of the fair market rents for the area as determined by HUD. A "comparable property" is one that is similar to the project based on a list of characteristics (e.g., neighborhood, age, property size, apartment mix, etc.), yet which does not receive project-based assistance.
[13] The Act allows for exceptions to the rent reduction requirements described above in recognition of the fact that in certain markets and for certain projects such reductions would be catastrophic. Twenty percent (20%) of all units subject to restructured mortgages in any fiscal year may allow for rents based on the project's budget not to exceed 120% of the fair market rent for the market area. These budget-based rents would be set at a level sufficient in the judgment of the PAE to support (i) debt service on the project, (ii) operating expenses including contributions to reserves and costs of rehabilitation, (iii) an adequate allowance for potential operating losses due to vacancies and failure to collect rents, (iv) a reasonable rate of return and (v) other expenses determined to be necessary by the PAE. HUD may waive (i) the 120% of fair market rent cap for not more than 5% of all units subject to restructured mortgages in any fiscal year and (ii) the 20% annual cap, in each case based on a finding of special need.
[14] The Plan will provide for rent adjustments for future years which will be determined by applying an "operating cost adjustment factor," as such term will be defined under regulations forthcoming from HUD.
E. RESTRUCTURED DEBT: CREATION OF TWO MORTGAGES.
[15] The method set forth in the Act to restructure the eligible FHA-insured mortgages is to bifurcate the current outstanding debt on each project into a first mortgage which is sustainable by the new rents, and a "soft" second mortgage whose term may be no longer than the term of the first mortgage. The second mortgage amount will equal no more than the difference between the existing debt and the restructured or new first mortgage. However, HUD or the PAE must determine that the second mortgage is in an amount which can reasonably be expected to be repaid.
[16] The second mortgage may bear interest at a rate not in excess of the applicable Federal rate and payments on that second mortgage must be deferred until the first mortgage is paid in full, except to the extent there is excess project income remaining after payment of all reasonable and necessary operating expenses (including deposits in a reserve for replacement), debt service on the first mortgage and any other expenditures approved by HUD. If there is excess income, at least 75% of it must go to payments on the second mortgage, and up to 25% may be paid to the owner if HUD or the PAE determines that the owner meets benchmarks for project management and housing quality.
[17] The second mortgage must be paid in full when (a) the first mortgage is terminated or paid in full (except as otherwise agreed to by the holder of the second mortgage), (b) the project is sold and the new owner assumes the second mortgage in violation of HUD guidelines; or (c) the owner receives notice from HUD that the owner has failed materially to comply with the Act or the United States Housing Act of 1937.
F. RESTRUCTURING TOOLS.
[18] Various restructuring tools are set forth in the Act to facilitate the creation of the bifurcated mortgaged structure. The Plan may include any of the following: (a) payment of a claim under the FHA insurance absent a default and without prior approval of the mortgagee; (b) the arrangement for other FHA mortgage insurance, reinsurance or other credit enhancement programs, including multifamily risk-sharing mortgage programs; (c) credit enhancement or risk-sharing arrangements on the restructured first mortgage established with state or local authorities, the Federal Housing Finance Board, Fannie Mae, or the Federal Home Loan Mortgage Corporation; and (d) applying any residual receipts, replacement reserves and other project accounts for the maintenance of long-term affordability and/or the rehabilitation of the project.
G. PROJECT-BASED VERSUS TENANT-BASED ASSISTANCE.
[19] Projects may be restructured with project-based rental assistance or with tenant-based assistance. HUD must renew the Section 8 contracts with project-based assistance in certain situations: (i) in tight rental markets; (ii) if the project's population is mostly elderly or disabled; or (iii) if the owner is a nonprofit housing cooperative organization. If the extension of project-based assistance is not mandatory, the PAE, upon consultation with the owner, must develop a rental assistance assessment plan as part of the Plan to determine whether project-based or tenant-based assistance is better for the project's restructuring.
[20] Each rental assistance assessment plan needs to include an analysis of the following factors upon determining whether to convert to tenant-based assistance or to extend project-based assistance: (i) The tenants' ability to find other affordable housing; (ii) What types of tenants live in the project (the elderly, large families, etc.); (iii) Local housing needs identified in the comprehensive housing affordability strategy, and local market vacancy trends; (iv) The costs of assistance using the new rent levels; (v) The long-term financial stability of the project; (vi) Residents' ability to make reasonable choices about their living situations; (vii) The quality of the neighborhood; and (viii) The project's ability to compete in the marketplace.
H. OWNERS EXCLUDED FROM RESTRUCTURING.
[21] If HUD or a PAE determines either that an owner has committed one or more specified bad acts or that a project can be rehabilitated in a cost effective manner, an owner can be denied access to the mortgage restructuring opportunities. An owner's bad acts are material adverse financial or managerial actions or omissions with regard to the project or any other project that is federally assisted or financed with a loan from, or mortgage issued or guaranteed by, a federal agency, or material failure by the owner to follow the requirements of the Act, after notice and an opportunity to cure.
[22] An owner has an opportunity to dispute a determination of ineligibility. If a project is ultimately excluded from the restructuring program, HUD will help the owner sell or transfer the property to another party, preferably to a nonprofit tenant organization.
PART II. ANALYSIS OF ACT
A. INTRODUCTION.
[23] This part of the memorandum analyzes issues raised by the Act relating to how financings will be structured and the tax consequences of such financings. In light of uncertainties surrounding these financing and tax issues. the memorandum explores options for owners who decide not to restructure under the Act. New HUD regulations, tax guidance and, perhaps, new tax legislation will ultimately determine whether the Act succeeds in restructuring and refinancing the debt which financed FHA-insured Section 8 assisted multifamily housing.
B. FINANCING ISSUES.
1. RESTRUCTURING OR REFINANCING EXISTING MORTGAGE.
[24] The Act provides owners who participate in the reengineering process with two basic options. One option ("Option 1") is to use the proceeds of a second mortgage loan, in most or all cases from HUD, to pre-pay a portion of the existing debt and to restructure and modify the terms thereof as a first mortgage in accordance with a Plan. The second option ("Option 2") is to refinance the existing mortgage with the proceeds of a new first mortgage loan and the HUD second mortgage loan.
[25] In a tax-exempt financing, both options would result in a redemption of bonds. Option 1 would result in a redemption of bonds to the extent of the principal prepayment of the existing mortgage. Option 2 would result in a redemption of all outstanding bonds and a new bond issuance in the amount of the first mortgage.
[26] A major obstacle to implementing both Options will be the preclusion of redemptions in the governing bond documents. Most multifamily housing bonds may not be redeemed for ten years after issuance and call premiums are required for a few years thereafter. Most lock-outs have expired for Section 8 bond issuances, except for refundings within the past ten years. Owners of projects with such lock-out requirements will not be able to participate in restructuring unless and until a default has occurred allowing for an acceleration of bonds. A "fabricated" default could result in a lawsuit from bondholders. However, without a restructuring, "genuine" defaults will in most cases eventually occur.
[27] In taxable financings, Option 1 is the more likely option and the most cost effective. The lender, HUD and the borrower would agree on the terms of a work-out and restructure the existing mortgage.
[28] Option 2 is a more likely scenario in tax-exempt financed transactions. The owners and HUD have an interest in extending the term of the current mortgage and lowering its interest rate. These steps would lower debt service requirements, allow for a smaller second mortgage and increase the likelihood of payment of the second mortgage. Bondholder consent, typically by 100% of all bondholders, would be required to re-negotiate the provisions of the existing debt. This would not be practical in almost all cases. Therefore, Option 1 would not be a realistic alternative. These objectives should be able to be achieved, however, in an Option 2 refinancing, especially in the current interest rate environment.
2. SIZING OF THE BIFURCATED MORTGAGES AND REASONABLE
EXPECTATION OF PAYMENT.
a. OVERVIEW
[29] A central requirement of the Act is that the second mortgage in any Plan shall be in an amount that the PAE determines can reasonably be expected to be repaid. If such a determination cannot be made, the second mortgage structure cannot be utilized, thereby preventing the adoption of a Plan. Therefore, the method used by the PAE to determine the size of the bifurcated mortgages is crucial. The Act does not specify the method to be used in such determination and presumably forthcoming HUD regulations will do so. The three likely sources of repayment are (i) excess cash flow, (ii) sale proceeds or (iii) a loan at the maturity of the mortgages to refinance the second mortgage.
[30] The first mortgage will be sized based on the level of debt service which can be supported by projected revenues at rent levels required by the Act. The second mortgage will be in an amount equal to no more than the difference between the restructured or new first mortgage and the mortgage existing prior to restructuring. It follows that the larger a first mortgage a project can support, the smaller the second mortgage needs to be. HUD and the owner have a common interest in sizing the mortgages to maximize repayment of the first mortgage and to meet the "reasonable expectation of repayment" test for the second mortgage.
b. EXCESS CASH FLOW
[31] Three basic variables, i.e., interest rate, term and required debt service coverage ratio, will affect the size of the first mortgage: (i) the lower the interest rate, the larger the mortgage: (ii) the longer the term, the larger the mortgage; and (iii) the lower the ratio, the larger the mortgage. Interest rates will be a function of market conditions and term, in tax-exempt financed transactions, will be a function of bond counsel's calculation of the useful life of the project.
[32] After the interest rate and term are determined, to the extent that the second mortgage is expected to be paid from excess cash flow, the critical variable is the required debt service coverage ratio. It is the cushion of the coverage ratio above 1.00 which provides excess revenue to pay debt service on the second mortgage.
[33] The level of the ratio will be determined by the credit enhancer of the first mortgage. Coverage ratio requirements of FHA- insured mortgages are generally lower than those required by private credit enhancers. However, if the reasonable expectation of repayment of the second mortgage is dependent on excess cash flow, it may be that in many cases a higher ratio may be necessary to demonstrate sufficient excess cash flow to make sufficient payments on the second mortgage.
c. SALE PROCEEDS AND REFINANCING AT MATURITY.
[34] The two other sources of repayment are (i) sales proceeds and (ii) a refinancing loan at maturity. The PAE will have to access whether it is reasonable to expect such sources to be available to pay the second mortgage. This assessment will be based on projections and numerous assumptions. Forthcoming HUD regulations should provide guidance on whether these methods of repayment are acceptable for purposes of determining a reasonable expectation of repayment.
d. LOW INTEREST RATE ON SECOND MORTGAGE.
[35] Another useful and anticipated tool to make the second mortgage structure viable is to have a very low interest rate on the second mortgage. This will increase the likelihood of repayment by significantly lowering debt service payments on the second mortgage.
e. CANCELLATION OF DEBT.
[36] Notwithstanding the above, in some cases, in order to be able to make a determination that the second mortgage will be reasonably expected to be repaid, a portion of the existing debt may have to be forgiven and cancelled. Any such cancellation will create cancellation of debt ("COD") income to the owner. See Part II Subsection C below for further discussion of COD income.
3. FEATURES OF ACT IMPACTING ON PROJECT CASH FLOW.
a. TERM OF THE NEW SECTION 8 CONTRACT
[37] The Act makes the initial renewal of expiring Section 8 contracts subject to the availability of amounts provided in advance in Congressional appropriations acts. It is expected that the term of new contracts will be limited to one year based on an annual appropriation for such purpose because fiscal and political realities will restrict the availability of amounts to a one year period. Although it is unlikely, HUD may choose to use other previously appropriated and available moneys to fund longer-term contracts. One year Section 8 contracts would be a fundamental departure from the past. Nonetheless, 30 year affordability and use restrictions on the project contained in recorded documents are required. In addition, the owner must accept each offer to renew a contract during the 30 year restricted period, if the offer is on terms specified in the Plan.
[38] The Act therefore presents two risks for owners and lenders. One risk is that HUD will not renew contracts on which the owner is relying to pay debt service on its mortgage loans. Such non- renewal could be as a result of new legislation or new policies adopted by HUD. Another risk is that Congress will fail to appropriate monies in a fiscal year, resulting in HUD's inability to renew contracts.
[39] These risks cast a cloud of uncertainty over the refinancings and may discourage owners or lenders from participating in the program or may discourage credit enhancers (other than FHA) from agreeing to enhance the first mortgages. In all likelihood, especially in the initial years of reengineering, many private credit enhancers will not participate and first mortgages will be insured almost exclusively by FHA or through FHA's risk sharing program. For those private credit enhancers that do agree to enhance first mortgages, these risks will undoubtedly affect pricing.
[40] One alternative which may be required by lenders and/or credit enhancers is for the first mortgage to be sized assuming the non-renewal of Section 8 contracts. This would result in a smaller first mortgage and a larger second mortgage. Another alternative may be an agreement that if a Section 8 contract is not renewed, the owner will receive other benefits which will strengthen the gross income of the project. For example, the 30 year rental restrictions could be automatically modified in the event a Section 8 contract is not renewed by HUD.
b. TENANT-BASED OR PROJECT-BASED ASSISTANCE.
[41] The determination of whether a project receives project- based or tenant-based assistance will have a significant impact on the financial stability of the project. Conversion to tenant-based assistance will create significant uncertainty, since the rent subsidy follows any departing tenant and does not remain as a subsidy for the project. Therefore, if a Plan provides for tenant-based assistance, the projection of cash flow to support debt service on the mortgage loans will be more speculative. Such uncertainty will make it more difficult to size the mortgage loans and to determine that there is a reasonable expectation of repayment of the second mortgage. In addition, such uncertainty will discourage credit enhancers (other than FHA) from enhancing the first mortgages and will certainly increase the price owners will have to pay for such enhancement.
[42] As explained above in Part I Subsection G., projects (i) in tight rental markets, (ii) which are occupied by predominately elderly or disabled families or (iii) which are owned by a nonprofit housing cooperative organization, must receive project-based assistance. The manner in which forthcoming HUD regulations define whether a project meets these criteria will determine the parameters of mandated project-assistance renewal. /1/
[43] Whether a project which is not eligible for mandated project renewal will receive project-based or tenant-based assistance will be determined by the PAE. This determination will be based on the eight factors described above in Part I Subsection G.
C. TAX CONSEQUENCES OF THE ACT
1. COD INCOME WHERE A PORTION OF EXISTING DEBT IS
CANCELLED.
[44] Prior to the passage of the Act, concerns were expressed by many owners that its debt restructuring provisions would cause them to be taxed on COD income. Congress attempted to prevent the appearance of debt cancellation by adopting a model where, in most cases, the sum of the principal amount of the first and second mortgages will equal the unpaid principal amount of the existing debt. However, where the principal amount of the second mortgage that can reasonably be expected to be repaid is less than the amount needed to repay the remaining portion of any existing debt, the Act contemplates that the shortfall can be cancelled. Unavoidably, any such cancellation will create COD income to the owner/borrower.
[45] Congress was concerned that the tax on COD income would prevent a sufficient number of owners from participating in reengineering, and suggested that tax legislation might be needed to solve the problem. The Conference Report relating to the Act urges Congress to consider necessary legislation to ensure that "the housing policy represented by th[e] Act is not thwarted by owner concerns about tax liability." No such legislation has been proposed as of the date of this writing. Presumably, any such tax legislation would either exempt from tax COD income arising by reason of reengineering under the Act, or would allow owners an extension of time to pay any resulting tax (as had been proposed in 1997). /2/
2. TREATMENT OF THE SECOND MORTGAGE AS TRUE DEBT.
[46] Some commentators (including the former head of the Joint Committee on Taxation, Kenneth Kies, who testified before Congress concerning these issues last September) appear to be concerned that given the "soft" nature of the second mortgage (e.g.. as a cash-flow mortgage), the second mortgage might not be treated for tax purposes as bona fide debt of the owner. If a second mortgage were treated as other than debt, the owner could realize COD income. For example, if the second mortgage were treated as the issuance of an equity participation to HUD in exchange for HUD's assumption or payment of debt, the owner could realize COD income to the extent that the value of the equity participation were less than the amount of the debt cancelled.
[47] The factors distinguishing debt from equity for tax purposes are notoriously subjective, and the IRS is notoriously reluctant to issue guidance in this area. Nevertheless, we would expect that a second mortgage made pursuant to the Act would be treated as true debt for tax purposes. The Act is explicit in requiring a reasonable expectation that the second mortgage be repayable in full. The Act also requires that the second mortgage be a feature of any mortgage reengineering plan. Moreover, there is ample precedent in the industry for structuring similar soft arrangements involving private lenders, HUD and other governmental or quasi-governmental agencies. We are aware of no instance in which the IRS has taken the position that such arrangements are not debt for tax purposes.
3. THE DEBT-FOR-DEBT EXCHANGE ANALYSIS.
[48] Assuming that the second mortgage will be treated as true debt for tax purposes, there are two separate and distinct ways in which the reengineering contemplated by the Act could be analyzed for tax purposes. First, a reengineering could be treated as an exchange (including by way of modification) of old debt for new debt. Second, it could be treated as if the owner/borrower simply borrowed new money from new lenders and used the proceeds of the new loans to repay the existing debt in full.
[49] If any portion of a restructuring were treated as an exchange, then under certain circumstances the owner could recognize COD income. In that scenario the old debt would be treated as having been satisfied in exchange for a new debt, the "issue price" (principal amount) of which, in most cases, would be treated as reduced to the extent the new debt did not bear adequate stated interest, defined by reference to the IRS published applicable federal rate. Since it is anticipated that most second mortgages will bear interest at a very low rate, the result of applying the exchange analysis to the second mortgage would be to create COD income in an amount equal to the difference between the face amount of the debt replaced and the imputed issue price of the second mortgage. /3/
[50] In any restructuring under Option 1, there will be an exchange of a portion of existing debt for a restructured first mortgage. However, it is not expected that the restructured first mortgage will bear interest at less than the applicable federal rate. Therefore, such an exchange should create no COD income. In any restructuring under Options 1 or 2, HUD is expected to advance the second mortgage which is applied to repay a portion of the existing debt. Therefore, unless HUD itself is the holder of the existing debt, the restructuring involving the second mortgage will not be an exchange. Accordingly, the exchange analysis should be of no real concern to most owners contemplating a reengineering.
4. THE BELOW-MARKET LOAN ANALYSIS.
[51] The second mortgage will in almost all cases bear interest at below-market rates. The second mortgage will be a new borrowing used to repay a portion of the existing debt. In such a situation it is clear that the owner cannot recognize COD income, since there is no debt being cancelled.
[52] Some commentators, including Kenneth Kies, have suggested that the below-market loan rules of Code section 7872 could apply to the second mortgage. We believe it is clear, however, that section 7872 will not apply to debt restructurings under the Act.
[53] Section 7872 applies only to specified types of below- market loans: gift (family) loans, compensation-related (employee) loans, shareholder loans, tax avoidance loans and loans that the IRS designates in regulations as having a "significant effect" on the tax liability of the borrower. Where section 7872 applies, the lender is deemed to have made an imputed transfer of cash to the borrower in an amount equal to the foregone interest represented by the below- market interest on the loan. Section 7872 characterizes the imputed transfer of cash from the lender to the borrower in accordance with the overall substance of the relationship between the parties. For example, if the lender is a member of the borrower's family, the transfer would be treated as a gift. If instead, the lender is the borrower's employee, the transfer would be treated as compensation for services. If section 7872 applied to the second mortgage contemplated by the Act, the deemed transfer from HUD to the borrower could be treated as a government subsidy, which might or might not be taxable to the owner.
[54] Section 7872 could apply to a second mortgage under the Act only if such mortgage loan could be characterized as a tax avoidance loan or is otherwise described in regulations as having a significant tax effect. Given the fact that the Act was passed by Congress and that it specifically contemplates a second mortgage at below-market interest rates to achieve a stated legislative purpose, we believe it is inconceivable that the IRS or the Treasury Department could take the position that a loan extended pursuant to the Act could be treated as a tax avoidance loan within the meaning of section 7872. Moreover, no regulations have been proposed relating to other "significant effect" loans and nothing in the regulations under section 7872 suggests that the second mortgage loan could be treated as having such an effect. To the contrary, several exceptions set forth in the regulations promulgated pursuant to section 7872 appear designed to exclude governmental loans from the scope of that section. Below-market loan programs have been used by the federal government and its agencies for many years as a means to subsidize private investment in low-income housing. /4/ To our knowledge, the IRS has never suggested that any of these below-market loans were subject to section 7872.
5. CONCLUSION.
[55] It appears that the tax consequences of debt restructurings contemplated by the Act will not be as adverse as has generally been portrayed. Nevertheless, there are too many issues that are fact-sensitive to warrant a conclusion that there will be no tax risks involved. Many believe that, unless these issues are addressed by new tax legislation, or at least by Treasury of IRS guidance, owners will choose not to participate in the reengineering program.
[56] The Treasury Department/IRS 1998 business plan contemplates that guidance will be issued this year in connection with the tax ramifications of the Act. We understand that such guidance will take the form of a revenue ruling to be issued by this summer. Unfortunately, it appears that such guidance may be limited to addressing the potential application of section 7872 of the Code. In informal discussions with Treasury representatives, we are discussing the need for broader guidance concerning the tax effects of debt restructuring under the Act.
D. SCENARIOS FOR OWNERS WHO DECIDE NOT TO RESTRUCTURE UNDER THE
ACT.
[57] As a result of the uncertainties described in this memorandum, especially the tax uncertainties, many owners may decide to opt out of the Section 8 program and pursue one of the following options.
1. CONVERSION TO MARKET RATE PROPERTY
[58] The owners of the better-performing projects may decide not to renew expiring Section 8 contracts but rather to convert their projects to market rate properties without income restrictions. If an owner does not agree to a contract extension, not less than twelve months prior to terminating the contract, the owner must provide a written notice to HUD and tenants, and HUD must make tenant-based assistance available to tenants residing in units assisted under the expiring contract at the time of expiration. Such tenants may or may not leave the project, but presumably these stronger projects will be able to replace tenants who leave and continue to perform their obligations under debt instruments.
2. ABANDONMENT AND DEFAULT
[59] Many owners of the worst-performing properties may not be able to restructure without realizing significant COD income. Such owners may decide to abandon their projects, which means that tenants in assisted units will receive tenant-based assistance as described above. Widespread defaults on the debt which financed such projects will inevitably take place causing acceleration and prepayments of debt, significant losses for the federal government and a further deterioration of low and moderate income housing.
3. SALE OF PROPERTY
[60] Owners may decide to sell their projects either to a for- profit entity, a not-for-profit organization or a public (governmental) entity. In addition, for-profit entities could form partnerships or joint ventures with not-for-profits to buy projects.
[61] An owner that sells its project will recognize gain, generally taxable as capital gain, to the extent that the amount realized exceeds its basis in the project. Since the amount realized includes the full amount of the existing mortgage debt assumed by the buyer, even if the debt exceeds the value of the property, a selling owner will often realize gain far in excess of any cash proceeds of sale. Moreover, because such gain is not characterized as COD income, it cannot be excluded from the seller's income under any of the COD- based exemptions.
[62] Some owners may nevertheless prefer to sell their Section 8 property, recognizing capital gain, than to risk recognizing COD income. This could be true, for example, where the owner is a partnership comprised of individuals who are taxable at a maximum rate of 20% (25% to the extent the gain is attributable to depreciation recapture) on capital gain but who would be taxable on COD income at the maximum ordinary income rate of 39.6 percent. In other cases, albeit rarely, the owner may have a high basis and thus a built-in loss on the property that could reduce the tax liability on a sale as opposed to a refinancing.
[63] Few buyers, of course, will be willing to purchase property subject to a mortgage debt that exceeds the property's fair market value. Among other concerns, the buyer runs the risk that a subsequent refinancing down to fair market value would result in the buyer realizing COD income. Current tax law is notably unclear on the point. The unsettled state of the law gives an advantage to a not- for-profit, tax-exempt buyer. Assuming that any phantom COD income would not be taxable as income from "debt-financed" property (an issue that can usually be resolved favorably), a tax-exempt buyer would be indifferent to the tax risks that a taxable buyer could not ignore.
a. SALE TO A FOR-PROFIT ENTITY
[64] A for-profit entity may be willing to assume the existing debt and take the risks under reengineering that an existing owner is unwilling to take. If a project is sold and the existing debt is assumed by the new owner and if the project had been financed with tax-exempt debt, the new owner would have to wait six months before utilizing a tax-exempt bond issue to refinance the debt on the most favorable terms. Alternatively, the new owner may purchase the property using the proceeds of a tax-exempt bond issue or of taxable debt. A Plan could contemplate such a sale and provide for a new contract and a restructuring of the debt.
[65] Any new tax-exempt bond issue would have to meet certain requirements of the Code. The owner would have to obtain a private activity volume allocation, comply with agreed upon 20/50 or 40/60 set aside requirements, and comply with the 15% rehabilitation requirement.
b. SALE TO A NOT-FOR-PROFIT ORGANIZATION
[66] Sales to not-for-profit organizations may be the most prevalent exit strategy used by current Section 8 housing owners. As discussed above, a not-for-profit organization will not have the same tax concerns as a for-profit entity. A not-for-profit organization could assume the existing debt or purchase the property using taxable debt or new money tax-exempt bonds issued under section 145 of the Code. Neither the volume cap allocation nor the 15% rehabilitation requirement apply under section 145.
c. SALES TO PUBLIC ENTITIES
[67] Sales to public entities may also become a widely-used exit strategy. A housing authority or other authorized public entity could either agree to assume existing debt or to refinance the debt. Whether public entities will purchase projects will be dependent on public policy decisions and statutory authorization.
[68] New money "essential function bonds" under Section 103 of the Code could be issued. No volume cap, 15% rehabilitation requirement or tenant set-aside limitations would be necessary.
E. CONCLUSION
[69] The Act creates the potential to allow for a massive restructuring of HUD's multi-billion dollar FHA-insured Section 8 portfolio. Owner participation in reengineering will be greatly enhanced and the goals of reengineering are more likely to be accomplished if the uncertainties discussed in this memorandum are addressed by Congressional legislation, by HUD regulations and by Treasury Department guidance. In particular, if these issues are decisively resolved, refinancings by owners may predominate. Not-for- profits and public entities may also have unique opportunities to purchase projects as a result of the Act. In addition, the selection and performance of the PAE in a State will have a profound impact on the success or failure of reengineering in that State.
[70] The next significant events which will determine the implementation of the Act are (i) the publication of HUD regulations, and (ii) the issuance of guidance by the Treasury Department. Based on informal discussions with HUD staff, we do not anticipate the initial publication of HUD regulations until the summer at the earliest. We expect that guidance from the Treasury Department may be forthcoming at about the same time. We await these developments and how to report to you on them.
* * * * *
[71] Haythe & Curley Memoranda provide brief comments on legal developments and issues of interest to our clients and friends. These memoranda do not provide exhaustive treatment of the subjects covered and are not intended to provide legal advice. Readers should seek specific legal advice before taking any actions with respect to the matters covered.
[72] If you have any questions regarding this memorandum, please contact David L. Dubrow at (212) 880-6115.
FOOTNOTES
/1/ The Conference Report relating to the Act expresses the belief that in defining a tight rental vacancy market a six percent vacancy rate is reasonable. The Report states that "it is most likely that metropolitan areas such as New York City, Boston, Salt Lake City and the San Francisco Bay area will he considered to be tight rental markets . . . . and, therefore, covered under the mandatory renewal provisions".
/2/ Notwithstanding Congress's concern, current tax laws already exempt COD income from tax in a variety of circumstances, including where the debt cancelled is "qualified real property business indebtedness." Some owner/borrowers may therefore be entitled to exclude COD income from gross income under current law. Although the qualified real property business indebtedness exclusion from COD income applies only to the extent that the owner had basis in the property prior to the cancellation, in many cases the owner of Section 8 housing will still have basis attributable to the original mortgage debt.
/3/ In the exchange scenario, the owner would eventually recover the amount of COD income recognized in the year of refinancing in the form of increased deductions for original issue discount ("OID") over the remaining term of the new debt. The owner would be entitled to interest deductions pursuant to the OID rules in excess of the amount of interest actually paid. While the overall result would be a wash from the owner's perspective, this could still be disadvantageous since the income would be recognized up front in the year of refinancing and backed out of income only over time as OID.
/4/ See Norogradac and Company LLP, Low-Income Housing Tax Credit Handbook (1997 ed.) at section 6.01[2][a] (reviewing six different below-market loan programs).
END OF FOOTNOTES
- AuthorsBlanchard, Kimberly S.
- Institutional AuthorsHaythe & Curley
- Subject Area/Tax Topics
- Index Termslow-income housingHUDdebt, restructuring
- Jurisdictions
- LanguageEnglish
- Tax Analysts Document NumberDoc 98-13568 (16 pages)
- Tax Analysts Electronic Citation98 TNT 83-30