California Bar Members Propose Guidance on 'Secured by Real Property' Requirement

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In recent years, the commercial real estate industry has witnessed an explosion in the use of innovative new approaches such as multi-party and/or multi-tiered debt financing arrangements. A great deal of uncertainty exists regarding whether and how the income exclusion under Section 108 applies to these transactions. Specifically, there is a lack of regulation or other guidance addressing the extent to which the requirement that a debt is "secured by real property" may apply to these hybrid financing arrangements.

This Taxation Section paper (this "Paper") will review the current state of applicable law, summarize the nature of recent financing innovations in the marketplace, and speculate how the current law might apply in the contemporary market. Finally, this Paper will suggest the form that practical guidance on this issue might take.

The cancellation, or discharge, of indebtedness generally gives rise to gross income to the borrower to the extent the lender forgives the debt or the borrower repays or repurchases the debt at a discount.³

Until the Tax Reform Act of 1986, the Internal Revenue Code ("IRC" or the "Code") provided for an elective exception for the discharge of qualified business indebtedness, defined as indebtedness incurred or assumed by an individual in connection with property used in his trade or business. The excludable amount was limited to the basis of the taxpayer's depreciable property, and the excludable amount was applied to reduce the basis of the taxpayer's depreciable property. If the amount of discharge income exceeded the basis of depreciable property, the excess was included in gross income for the year of discharge. This exception was repealed by the Tax Reform Act of 1986.

In the early 1990s, the U.S. real estate market suffered major declines in valuation. Indeed, in many parts of the country, including California, this period is typically referred to as a real estate market crash, with many local markets suffering price drops of fifty percent (50%) or more. One result of this crash was the potential for borrowers attempting to restructure their debt to face cancellation of indebtedness income ("CODI") on property that had declined substantially in value. In order to ameliorate the financial impact to such taxpayers and other potentially far-reaching effects on the real estate market, Congress enacted Omnibus Budget Reconciliation Act of 1993⁴, which amended IRC § 108 to provide, in certain circumstances, that the gross income of a taxpayer does not include income from the discharge of qualified real property business indebtedness ("QRPBI").⁵

B. IRC § 108

Assuming that a taxpayer has CODI, IRC § 108(a)(1) provides five instances where CODI is excluded from the taxpayer's gross income:

C. Recent Developments in Real Estate and Related Debt Workouts

In the 1980s and early 1990s, it was common for real estate investors to finance the acquisition, construction or improvement of real estate with loans in the amount of 80 % to 90 % of the value of the subject property. This is known as the Loan-to-Value ("LTV") ratio -- the amount of debt expressed as a percentage of the appraised value of the security collateralizing that debt. Major credit rating agencies generally require a specific industry-accepted LTV ratio when grading debt in order to leave a "cushion" for depreciation in the value of the property; the higher the LTV ratio the riskier the debt, and the lower the grade given the debt by the credit rating agency. An LTV ratio analysis consists of analyzing all loans encumbering a given asset, including subordinate financing.

The real estate crash of the early 1990s revealed the consequences of such high LTV ratios. When the value of a property fell beyond a certain level, the security of the loan (the encumbered property) could not support the loan itself. Debt workouts between borrowers and lenders became necessary in order to prevent massive numbers of foreclosures across the commercial real estate market. Of course, generally, a debt workout produces unattractive tax consequences -- namely, CODI for borrowers.

In response to the significant economic threat facing the commercial real estate market, Congress enacted the Omnibus Budget Reconciliation Act of 1993, and the amendment to IRC § 108. The Congressional committee report issued pursuant thereto acknowledged the threats facing the commercial real estate market, and explained the rationale for deferral of CODI generated by debt workouts:

As real estate values began to recover, investors searched for the means to increase their equity leverage. In light of the credit rating agencies' distaste for allowing higher LTV ratios, hybrid financing emerged as a vehicle by which investors could obtain additional capital without raising the LTV ratio of the property. Although hybrid financing was in no way a new concept, the inability to obtain "hard" debt against the property in excess of the acceptable LTV ratio led, at least in part, to its increased popularity.

The LTV ratio analysis accounts for subordinate financing encumbering the underlying asset. Accordingly, these new hybrid financing techniques were constructed with an eye to allowing for additional financing without affecting the LTV ratio of the underlying property. The most common forms of these new hybrid financing structures include the following: second mortgages, A/B notes, mezzanine loans and preferred equity. A brief description of each is provided below.

In Private Letter Ruling 200953005 (the "PLR"), the Internal Revenue Service ("IRS") was asked to rule on the proper treatment of income arising from the cancellation of indebtedness under Section 108. The ruling is based on the following general facts: in year 1, Borrower, through its subsidiary Owner LLC, acquired Property for use in a trade or business. Borrower financed the acquisition with funds from several sources, including equity contributions from owners of Borrower, including Taxpayer, and funds borrowed by Owner LLC from third party lenders (the "Original Debt"). The Original Debt was secured by a mortgage on the Property, as well as other collateral.

In year 2, Borrower refinanced the Original Debt with funds from several other sources, including a mezzanine loan secured by a 100% ownership interest in Owner LLC, the 100% direct owner of the Property. Refinancing proceeds were used to repay the Original Debt, for improvements to and operations of the Property, and for a distribution to the beneficial owner of Borrower.

The loan agreements restricted the use of funds and the transfer and issuance of ownership interests in the pledged entities. Certain springing guarantors guaranteed to pay for losses incurred by the mezzanine lender if any other entities whose ownership interests are pledged file for bankruptcy or a similar legal procedure before the lender can foreclose on the ownership interests assigned as collateral for the mezzanine loan. In the event of a default on the mezzanine loan, the mezzanine lender can step into the shoes of the borrower on a pre-agreed basis.

Taxpayer was negotiating a refinance of the mezzanine loan. Economic conditions had a significant adverse impact on the value of the Property, and Taxpayer's ability to secure financing. Taxpayer anticipated that future refinancing would result in a discharge of some of the mezzanine debt.

Taxpayer requested a ruling that indebtedness collateralized by an ownership interest in an entity owning real property -- the mezzanine debt -- was "secured by real property" within the meaning of Section 108(c)(3). IRS ultimately ruled that Taxpayer's mezzanine debt was secured by the Property.

B. Factors Identified by PLR 200953005

The PLR identified several factors relevant to determine whether a debt is "secured by the real property." The PLR explains,

• What other assets, if any, are held by the owner of the property? If no other assets are held (or only other related personal property), the debt may be secured by the real property.

• Upon default of the debt, who acquires control of the property? If the creditor steps into the shoes of the owner, the debt may be secured by the real property.

• Upon foreclosure of the debt, what is transferred to the creditor? If the entire interest is transferred -- even an equity interest in the intermediary owner entity -- leaving no minority interest, the debt may be secured by the real property.

It is reasonably clear that both second mortgages and A/B notes are secured by real property for purposes of IRC § 108(c)(3). Both financing arrangements involve notes that are literally secured by the encumbered property; the creditor would acquire control of the encumbered property upon default and ownership upon foreclosure.

It seems equally clear that preferred equity is not so secured. The investor does not retain rights of control upon default or ownership upon foreclosure; rather, the investor receives preferential rights of cash distributions, plus agreed upon returns. Such rights do not appear to approach that of "secured by the real property" for purposes of IRC § 108(c)(3).

In the case of mezzanine debt, it is unclear whether the debt is secured by real property for purposes of IRC § 108(c)(3). In the facts provided in the PLR, and as is typical in mezzanine debt arrangements, the mezzanine borrower pledges direct or indirect equity interests in the mortgage borrower (the actual owner of the real property) as collateral for the mezzanine loan.

Under such circumstances, the PLR argues the debt was secured by the real property because: (1) upon default, the mezzanine lender acquires "control" of the real property; (2) upon foreclosure, the entire equity interest is transferred to the mezzanine lender; and (3) for federal income tax purposes the mezzanine borrower owns the real property and incurred the debt because the true owner (a subsidiary of the mezzanine borrower) was a special purpose, disregarded entity.

The PLR also notes that the legislative history behind IRC § 108(c)(3) was intended to apply to junior debt that becomes undersecured due to declining property values and which the parties wish to renegotiate, which was the case in the facts presented by the taxpayer. Finally, the PLR adds that the term "secured by real property" should be viewed more broadly than simple mortgages, since Congress knowingly used the more general term "secured by."

Viewed literally, however, mezzanine debt arrangements do not satisfy IRC § 108(c)(3) because the mezzanine loan is not (directly) secured by the encumbered real estate. This is confirmed by the fact that mezzanine debt so arranged does not increase the LTV ratio of the mortgage loan; indeed, that is the very reason why mezzanine debt is utilized in such instances. If the mezzanine borrower defaults, the lender may foreclose on its collateral -- the pledged equity interest, which results in the change of ownership in the related borrower: the mezzanine lender becomes the borrower of the mortgage loan. However, the real property itself does not change ownership. Indeed, in a special report issued by Moody's Investors Services, one of the major credit rating agencies, the collateral of a mezzanine loan was described as follows:

As real estate values appreciated at unprecedented rates during the early to mid-2000s, history was bound to repeat itself. In 2008, with the fall of Lehman Brothers Holdings, Inc., the U.S. real estate bubble finally burst. Much of the commercial real estate industry now finds itself desperately in need of debt workouts to take into account the declines in commercial real estate values and to prevent massive numbers of foreclosures.

However, it is not clear how IRC § 108 applies to CODI tax obligations resulting from debt workouts of these widely used hybrid arrangements -- particularly mezzanine debt. Moreover, there is little guidance in this area, and what guidance exists lacks clear and formal criteria for the many taxpayers facing the dilemma of debt workouts. Indeed, the only meaningful discussion addressing the definition and parameters of "secured by real property" under IRC § 108(c)(3) appears to be Private Letter Ruling 200953005 which, as discussed above, leaves many questions unanswered as to the application of IRC § 108(c)(3) to hybrid financing arrangements such as mezzanine debt.

B. Proposed Guidance

The authors propose that IRS and Treasury provide guidance -- in the form of regulations under Section 108 or a Revenue Ruling -- to clarify the definition and scope of "secured by real property" for purposes of Section 108(c)(3).

The authors recommend that the meaning and scope of "secured by real property" should reflect the economic reality of the debt arrangement or financial instrument. As such, the regulation should employ factors utilized by the commercial real estate market when analyzing debt. Primarily, if a financial arrangement has no impact on a property's LTV ratio, such lack of impact is indicative of the debt's unsecured status (or at least unsecured by that particular piece of real property). Such an approach is in concert with the Congressional intent behind Section 108(c)(3), whereby Congress expressed its desire to limit the exclusion to circumstances where the reduction in property value impacts the debt itself (and accordingly impacts the LTV ratio).

The regulation may employ other secondary factors to determine whether a debt is secured by the real property. Such factors include: (1) to what property is the lien (if any) attached; (2) what collateral is transferred to the lender upon foreclosure; (3) if the real property forecloses, where does the lender in question fall within the priority hierarchy (e.g., with respect to unsecured creditors); and (4) whether the lender requires personal guarantees from the borrower.

Nevertheless, the authors recognize the government may prefer a more expansive view of the definition and scope of secured by real property for purposes of Section 108(c)(3). Such a definition may include debt arrangements such as the mezzanine debt described in the PLR (whereby the debt would not otherwise qualify as secured by real property under our proposed guidance) within the exclusion from CODI provided by Section 108. In such case, the authors believe IRS and Treasury should still provide guidance to clarify the meaning and scope of secured by real property for taxpayers who acquired, constructed or improved real property with structured finance vehicles such as mezzanine debt.

² Although the participants on the project might have clients affected by the rules applicable to the subject matter of this Paper and have advised such clients on applicable law, no such participant has been specifically engaged by a client to participate in this project.

³ IRC §§ 61, 108, 1001.

⁴ Pub.L. 103-66.

⁵ IRC § 108(a)(1)(C).

⁶ IRC § 108(c)(3)(C); 108(c)(1)(A).

⁷ H.R. REP. NO. 103-111, at 622 (1993).

⁸ Daniel B. Rubock, US CMBS and CRE CDO: Moody's Approach to Rating Commercial Real Estate Mezzanine Loans, Moody's Investors Services Structured Finance Special Report, March 29, 2007.