Tax Aspects of Distressed Property (transcript from 16 Sept 2011 presentation)
by Roger Royse
Carol: Roger are you with us?
Roger: Yes I am. Thank you Carol.
Carol: Hi! Good Morning.
Roger: Good morning and thank you all for attending. My name is Roger Royse. I am the founder of the Royse Law Firm. It is a business, tax and corporate law firm with offices in Northern and Southern California. I’m speaking to you from Palo Alto today but we also have offices in San Francisco and Los Angeles.
Today we are going to take a little bit of a different tact to some of the presentations and address the tax aspects of acquisitions or sales of distressed assets or the paper. We’re just going to focus on the tax issues that arise in some of the workouts and some of the underwater property transactions that you might get involved in.
I’m going to follow a PowerPoint slide show that should be up on your screen and if you’d like a copy of the slideshow it will be available on our website at www.RoyseUniversity.com. If you can go to that website after the webinar it should be available shortly thereafter.
To continue, we’re going to talk today about a handful of different topics and I categorize them as issues for buyers, sellers and then some entity issues. I’d like to address some of the issues that arise with respect to the owners of the distressed property, the underwater asset. By underwater asset, of course, I mean an asset that has more debt than value because that is usually where we start when we’re about to work something out. That is most of what we’ll talk about today. It has to do with the tax issues that relate to people who sell those properties as well as the owners who do the workouts.
We also want to address some of the issues that have come up with respect to buyers of the property, investors or creditors for that matter. Because most of these transactions tend to occur in a partnership environment we do want to talk about partnership workouts because there are special issues with regard to partnerships that can be very complex and counter intuitive.
I would like to address some of the tax issues that come up in bankruptcy and of course an update on some of the things that we are seeing most recently.
To start, the biggest issue, of course, whenever we have workouts or transactions in distressed debt is COD or cancellation of debt income. And so, taking a step back for a minute, the concept is that when debt is forgiven, the debtor has an accretion to wealth and that accretion to wealth is taxable. It is taxable as ordinary income. It is cancellation of debt income.
Our goal with respect to debt in a lot of workouts is to avoid current tax to avoid COD income, but sometimes, and I will show you this in a minute, it is to our advantage to actually trigger COD income. It is important to have a little bit of an understanding of what that is and how that works.
In the typical transaction, and here is the easiest scenario and the most obvious scenario, is that the debtor goes to the creditor and asks for a reduction in the debt. We just reduced the principle of principal balance. That is pretty clearly, absent an exception, cancellation of debt income.
Another scenario is where the property is transferred back to the creditor in exchange for the debt. Here is where it starts to get a little bit tricky. In that case, if the debt is recourse debt, and just so we are all on the same page, what I mean by “recourse” debt is debt that the debtor is personally liable for. In other words, the creditor can sue that debtor and has access to all of his personal assets for satisfaction of the debt.
If the debt is recourse debt and we have a transfer of property for debt, we could trigger cancellation of debt income to the extent that the debt exceeds the fair market value of the property.
Okay, let me say that again. We could have cancellation of debt income to the extent that the debt exceeds the fair market value of the property.
For example, if the property is worth a million dollars and the debt is 1.2 million and we transfer the debt in exchange, we have $200,000 of cancellation of debt income.
That is significant because COD income is taxed at ordinary rates as ordinary income, whereas, of course, gain from a sale or exchange of a capital asset is taxed at capital gain rates, 15 percent federally.
We have cancellation of debt income to the extent of the delta. However, because it is a transfer, it is a sale or exchange, we potentially have capital gain or loss up to the fair market value, and that is to the extent that the fair market value of the property exceeds the adjusted basis.
In my example, if our debtor purchased a property for 800,000, it is now worth a million and there is a debt of 1.2 because they financed it and took money out or something like that. We have 200 of COD income. We have another 200,000. That is a difference of 1 million minus 800,000 equals $200,000 of potential capital gain, depending on holding period and capital asset status, etc.
Remember, in the case of non-recourse debt, however, we do not have this bifurcation. It if is non-recourse debt, we would not have cancellation of debt income. In my example, it would all be capital gain. It is very important to distinguish whether we have recourse or non-recourse debt. That is usually the first question in these sorts of scenarios, and by non-recourse debt, what I mean is a debt that the creditor may only satisfy from the property that secures the debt. There is no personal recourse to the debtor.
Given the example that I just gave you, you might say, “Well, gee. Don’t you always want to have capital gain treatment, don’t you always want to have sale or exchange treatment?”
And the answer is “Not necessarily.” Sometimes, subject to very careful planning and many caveats, we might be able to plan into a result pre-transaction, if we are smart about it and think about and know these rules, we might be able to plan into whether we are going to have cancellation of debt income or capital gain income.
And the reason that I say not necessarily is that remember what I said about COD income being taxed at ordinary income rates, that is true, but we might be able to fit within an exception from COD income.
For example, in the case of a contested debt, typically the relief of that sort of debt does not give rise to COD income. That is not the big exception we typically rely on. The big exceptions are primarily the insolvency exception, which I am going to get to in a minute. Bankruptcy, which we will talk about.
A big one is a purchase price adjustment. In other words, if it is debt held by a seller, so we have seller financing and we have a reduction of that debt, we have an exclusion from COD income in that case.
Here is a big one. If there is no economic benefit. For example, if we have a cash basis taxpayer and there is accrued interest, the forgiveness of the interest would not typically give rise to COD income because that would be a deductible item. That is probably more a rule of convenience than anything else because if you had COD income for the forgiven interest, you would then have a corresponding interest deduction. It is a wash, no economic benefit, no COD income.
Bankruptcy, any cancellation of debt income in bankruptcy is excluded.
Insolvency, this is the one where we typically have some issues and we typically have some planning opportunities potentially.
COD income is excluded from income. Cancellation of debt is excluded from income to the extent of the debtor’s insolvency. And
insolvency is exactly what you might expect and subject of course to lots of rules as to what a debt is, but typically insolvency means the excess of the debt over the fair market value of the assets.
If we do rely on this insolvency exception, of course, there is a cost to that, and the cost is that we really getting in essence the full amount of complete exclusion from tax because we have to reduce what they call tax attributes. A tax attribute is something like a net operating loss, a tax credit, a capital loss carry-forward, or importantly basis.
There is an election to decrease basis in the taxpayer’s other assets rather than go through the scheme that I just described of net operating losses, credits, capital loss carry-forwards.
In the example, if we were to have COD income by an insolvent debtor, and the debtor say, “Well, I’m not going to pick this up into income because I’m insolvent,” that is fine, but then if they have net operating losses, those get reduced and they would not be able to use the amount of the reduced net operating losses in the future.
Same with credits at the rate of 33 1/3 cents on the dollar; same with capital losses, and then we go to basis, and just reduce basis in the taxpayer’s other assets.
You see that there is a future cost to use of the insolvency exception, but a tax deferred is sometimes a tax avoided.
Before I actually get to related party acquisitions, I want to talk about one more exclusion from cancellation of debt income and this is an important one for real estate transactions and real estate professionals. That is the concept of qualified real property indebtedness. It is one that we look at a lot. And the concept is that the debt that is relieved is not COD income up to the fair market value of the property. If the debt exceeds the fair market value of the property, that delta is excluded from COD income if it is qualified real property indebtedness that is being reduced.
C Corporations cannot use this exception. Individuals can as corporations can, partners can. It is applied at the S Corporation level in an S Corp and at the partner level in a partnership, and I will talk more about what that means in a later slide. The debt must be secured. The debt must be incurred to acquire, construct, improve or refinance property and must be business real property.
If we do fit within this exception and manage to run a gauntlet of all these requirements, and we can exclude the amount of debt forgiveness from COD income as qualified real property indebtedness, the cost of that is that we have to reduce tax basis in other depreciable real property of the taxpayer, and we can only reduce to zero. So, that means that the exclusion itself is limited to the amount of other depreciable business property, which could include depreciable real property of the taxpayer.
And just a couple of more quick exceptions that we oftentimes take a look at when we are dealing with entities or as a stock for debt exception. In other words, if a corporation satisfied its debt or stock, that is not COD income to the extent of the fair market value of the stock, it is to the extent that we exceed that fair market value, and we have a similar rule with partnership that I will talk about later because oftentimes, this is how this comes up, the contributors contributing the debt to a partnership in exchange for a partnership interest.
Related Party Acquisitions
This is sort of a trap, but let me give you the trap. Let me give you how it comes up by giving you the extreme example.
Suppose that I am a debtor. I owe creditor a lot of money. Creditor is willing to write that down. I do not fit with any exceptions. I do not want to have COD income, so instead we have the debt transferred to a related party and the related party does not write down the debt, but we have this agreement, we control both end of these. We know the related party is not going to enforce the debt. The transfer, of course, happens at a discount. That is what makes it all work.
By related party, I mean commonly controlled entities, 50 percent common control.
That is the extreme example we are playing a game here to basically get the debtor out of some of these debt without picking up the income, and unfortunately, it does not work. Not only does it not work in the obvious case, it does not work in cases that tend to be traps and tend to catch people.
The rule is, if there is a related party acquisition of a debt at a discount, that creates COD income.
For example, if a related party of one of the debtor’s commonly controlled companies comes along and buys the debt from the creditor at a discount from face, that itself creates COD income. It is a little bit of a trap, so we need to be careful of it. It comes up sometimes in some of these complicated multi-party partnership workouts and acquisitions.
Debt Modifications – This is probably the single most important thing to keep in mind in this area because that is a real “gotcha,” and the concept here is that, remember what I said about the debt being reduced, the debt being acquired by a related party, the debt being worked out, well, a significant debt modification is treated for tax purposes as a deemed exchange of the debt.
If we modify the debt, that may be treated as if we replaced it with a different debt, and if the issue price of the new debt that we replaced it with is less than the issue price of the old debt that was replaced, we have cancellation of debt income.
It is very important to avoid this significant modification and I say “significant,” but it may not be as significant as you would expect. Obviously, a reduction in principal debt is a significant modification.
There are some other modifications that may be significant.
A change in the collateral. If we substitute collateral, we might have a significant modification of the debt. Then we have to test it and determine what is the issue price of the debt, what is the face amount, do we have cancellation of debt income?
A change in the interest rate could be a significant modification. Changing it from recourse to non-recourse. Remember what I said about recourse and non-recourse? That itself might be a significant modification, and the release of a guarantor could be.
Now, this is a facts and circumstances test and the factors that I have laid out for you or set forth in IRS regulations, but ultimately, we look at facts and circumstances to determine whether it is a significant modification. Nevertheless, we need to be very sensitive to this issue because if we do have that significant modification, we have the potential of triggering gain, and again, the amount of the COD income we trigger is going to be based on the difference between the face of the debt and the value of the debt at the time of the modification.
Let us shift gears here for a minute and talk a little bit about the creditor side of the equation.
Typically with the creditor, what I am mostly concerned about are the people who are out in the market who are acquiring the property or acquiring a paper. Let us talk a little bit about people who acquire the paper first of all.
We will call him a lender. There is paper. It is secured by distressed property or maybe the debtor is in trouble, the property is purchased at a discount, and you might think, “Well, that certainly does not create any tax problems for me. I’m a buyer of the paper. I actually paid some money.”
That would not be entirely accurate because what we have done is we have created something we call market discount, and you see the letters on your screen that say “OID.” That stands for original issue discount, and we could talk for hours, maybe for days, about original issue discount, but suffice it to say for purposes of this transaction, the OID rules require that the discount in an instrument be taken into account as interest under economic accrual principles over the term of the loan.
Now, I know I just said a mouthful, so let me go back and parse it a little bit.
Creditor buys a note in the market. The face of the note is, say, a million dollars. Creditor pays 900,000 because it is a distressed property. We now have $100,000 of market discount. That market discount is going to get picked up in the creditor’s income as interest income ratably under economic accrual principles over the life of that instrument.
It is a surprise to a lot of people when they find that that has happened and it is a real “gotcha.” It is the one biggest thing that creditor or the lender or the purchaser of the paper has to be concerned about on the front end.
We have already talked about related party acquisitions. I mentioned it because it could trigger market discount as well, but let us use another example that is even, I guess, a little more pernicious. That is the modification after acquisition.
Suppose our creditor says, “Well, alright. I’ll accept that. I’m going to have original issue discount. It’s not a big deal. It’s not a big amount of discount. I’ll spread it over several years. That’s life.”
So they acquire the instrument at a discount and then, remember what I said about significant modifications triggering COD income, well, the flipside works as well. It also triggers an exchange from the creditor’s standpoint for tax purposes. So, we acquire the note, then we go negotiate with the debtor, we modify the note. Now, we have just modified it. We have a deemed exchange and we could potentially trigger gain.
In my example, we buy the note for 900,000. It has a $1 million face. One hundred thousand dollars difference. We do not have gain on acquisition of that note but we do have market discount. Then we modify the instrument. Now, we pick up $100,000 of gain because we are deemed to have exchanged our $900,000 note for $1 million note.
That is not the end of the world. There is a potential for deferring that gain under installment reporting. In fact, installment reporting is the default under installment tax reporting. What that means is that you do not typically take amounts into income until you actually receive them, which is on the cash basis for that purpose.
That is the “out” in this case. However, to peel the onion a little bit more, not everything qualifies for installment reporting. So, this is something that requires a little bit of thought and analysis and possibly some research.
Similarly, the creditor who picked up the gain might be able to get a bad debt deduction that washes out the amount of that gain. I will talk a little bit more about what it takes to qualify for that, but suffice it to say, not everybody can get that deduction for a partially worthless debt. So again, it requires a little bit of thought and planning.
Similarly, we might have a capital loss. I have showed you the gain issue when the issue price exceeds the purchase price, 1 million versus 900,000. But let us suppose that the face is greater than the issue price after the modification. So, in other words, it is a million-dollar note, but because of the way these rules work, you end up with an issue price of more than that. Well, you could have a capital loss just like you had a capital gain.
And you might say, “Well, that’s good. Our creditor gets the loss. They modified it and the note they paid 900 for is now only worth 800, so we get a capital loss of 100,000. Well, that is fine, but now you have OID potential. You have got more market discount that I just described because it is like you bought that 900,000 note for 800. So, even though you trigger a capital loss on a front end, you got to pick up OID (original issue discount) going forward.
Why is that bad?
There are two big reasons. Number one, there is a rate difference. The OID is taxable at ordinary rates up to 35 percent federally, whereas, capital gains are 15.
Secondly, capital loss has a very limited deductibility for an individual. Corporations do not have a special capital gain or loss rate. Individuals do have, but they are limited to $3,000 per year plus capital gains.
Typically what happens – because everybody I know has plenty of extra capital losses lying around and not a lot of extra capital gains – is that the capital loss is simply non-deductible. We have managed to pick up income on the one side at ordinary rates and have a non-deductible capital loss on the other side.
I promised I would talk about bad debts. Remember what I said how maybe the creditor can get some relief here by using bad debts by taking a bad debt deduction. Here are the rules. Keep in mind that there are two types of bad debts. There are business bad debts and non-business bad debts.
If it is a business bad debt, a creditor can take an ordinary deduction against ordinary income for either a wholly worthless debt or a partially worthless debt. There is such a thing as a partial bad debt deduction if it is a business bad debt.
If it is a non-business bad debt, it is only deductible to the extent that it is wholly worthless and is only deductible as a short-term capital loss.
I just explained the capital loss rules and how unhelpful they can be.
You can see there is a lot of pressure on whether we have business or non-business bad debts, and the test here is whether somebody is actually in the business of making these loans.
In my experiences, not a lot of people who get involved in these transactions can qualify for a business bad debt. Certainly, a bank could. A commercial lender could. Somebody in that business could, but otherwise, probably not.
So, the other things to keep in mind for investors, buyers of underwater asset or distressed debt is oftentimes, maybe always, these transactions occur through entities. It is pretty clear to know what tax liabilities you are picking up if you are buying the property itself – you, the creditor or buyer, if you are buying the paper, because you can search the record and determine what liens are out there.
When you are getting into an entity itself, there is a whole additional level of due diligence that needs to be undertaken. This is why it is important for those of you who are lenders and creditors to understand what is going on with the debtor side of the equation because the transaction in which you acquire an interest in the property may be the transaction that results in a huge tax liability to the entity that you are acquiring an interest in.
It is important to understand the rules on the debtor’s side as well as the creditor’s side and its important to diligence these items and find out where the skeletons are and what taxes are being triggered by the transaction itself.
I want to mention that 382 does not come up that much here in the real estate world, but I would feel bad if I did not say 382 whenever we are talking about operating losses. This is something that only applies when there is a change of ownership, meaning more than 50 percentage points of a C corporation over a period of three years. And if we do have that change in ownership of the corporation, what that means is that the corporation is limited in the amount of pre-change net operating losses that it can use to offset post-change income. It is a very, very small amount right now because the amount that the company can use is the applicable federal rate times the value of the corporation at the time of the change. The applicable federal rate (AFR) is about as low as I have ever seen it now. It is less than 1 percent.
As a practical matter, what 382 does is that it pretty much bars a post-change company from using a pre-change net operating loss against its post-change operating income.
Before I leave this I want to tell you how it comes up. It comes up when you have a corporation that has lots of losses and it may have as one of its assets a big tax NOL that it is going to use to offset its income often into the future for a long time. The investor comes along and says, “Well, that’s great. I’m looking at your numbers. I see you’re after tax return is pretty good since you’re not going to pay tax for a long time.” Investor makes the investment, we then trigger a 382 change and those net operating loss just go away. That is how it comes up.
And, by the way, this is more subtle in terms of knowing when you have had a change of ownership than you might expect because it is done on a three-year rolling basis. We need not have to have one transaction of more than 50 percentage points. You could have a lot of transactions that accumulatively add up to 50. You could have one transaction for 5 percent of the company that pushes you over that 50 percent number. Now, we have a 382 limitation and the NOLs have gone away.
If you are involved in this sort of transaction in a corporation context, not a partnership but a corporation context, this is something to be very aware of.
Okay, maybe a little more relevant to the group are withholding tax issues. And specifically, I want to mention FIRPTA because it is important that everybody who gets involved in this area have an understanding of FIRPTA and at least know what it is and how it works and where it comes up and I expect that most of the people on the call do, but let us refresh anyway.
The concept behind FIRPTA is that a buyer of a U.S. real estate, if it is foreign owned, must withhold 10 percent of the purchase price. The idea is that the foreigners are outside the U.S. taxing jurisdiction. They are not filing U.S. tax returns, so this is the government’s last chance to collect tax on the sale – 10 percent withholding on a transfer of foreign-owned real estate.
Where this comes up often is that most foreigners traditionally in the conventional wisdom should own U.S. real estate through a corporation, and there are reasons for that I will get into in the next slide.
Typically it would not be a transfer by the corporation of the real estate, it might be just a transfer of the stock of the corporation by the foreigner. The trouble is that if that corporation itself is a U.S. real property holding company, meaning more than 50 percent of the value of its assets consist of real estate, withholding is required on the foreigner’s sale of the stock of that company to the U.S. person. The U.S. person has to withhold 10 percent federally.
By the way, California also has its own FIRPTA counterpart of 3 1/3 percent of the estimated gain.
Keep in mind that we have FIRPTA withholding on sales of real property by foreigners, and sales of
real property in holding companies by foreigners. I am pausing on this because here in this new world of short sales, where property gets sold and no cash changes hands, it sometimes surprises people when they end up with a withholding tax obligation even though there was no cash because this withholding does apply even on a short sale scenario or even in a sale with no cash.
Always, as you folks probably know, we have exemption certificates where seller certifies that we do not have a FIRPTA interest that is being transferred. Keep in mind that in the foreign context it is a special consideration. That is the withholding tax issue that I wanted to mention.
Alright. Now, let us talk about some really cool stuff. Partnership workouts.
Everything I said about COD income applies in the partnership scenarios – COD income and exclusions. The partnership has the same sorts of issues.
A couple of things I want to mention about that.
Number one, partnerships are not taxpaying entities, and by partnership, I mean a limited liability company that is taxed as a partnership, which almost all of them are – an LLC or a partnership.
First rule is that if the LLC has COD income because it entered into a workout, it is not a tax-paying entity, it is a tax reporting entity, and it must allocate that income to its partners or its members if it is an LLC. There are rules in the Internal Revenue Code on how that income is to be allocated and we, again, could talk for days about the rules for allocating debt and allocating debt-related income and non-recourse deductions under the minimum gain chargeback rules, but for now, just suffice it to say that the Internal Revenue Code is going to pretty much specify how COD income gets allocated. It is going to get allocated back to the partners who got the deductions that ended up and giving rise to the COD income.
As an example, assume we have a property. We buy it for a million. It depreciated. We got lots of deductions from the depreciation, but the debt stayed at a million. Now, we negotiate the debt down. We trigger COD income. That COD income is going to go right back to the partners who got the depreciation deductions. That is a special rule to keep in mind here.
The second thing to keep in mind, and this comes up often in these transactions, is the COD exclusions that I talked about 30 minutes ago. Remember that there was a bankruptcy exclusion. There was the insolvency exception. Those exclusions apply at the partner level so, if the partnership negotiates and works out some debt and triggers COD income, we do not look at and determine whether the partnership is solvent or insolvent when we figure out whether to exclude it. We have to look at each individual partner who has been allocated the income, and if the partner is insolvent, then they can exclude their share of the income to the extent of the insolvency.
This is true of qualified real property indebtedness as well. We look at this at the partner level. It is not true of an exception that I should have talked about, which is the purchase money debt exception. This applies at the partnership level. This is the scenario where a partnership used seller financing to acquire the property, and then turned around and negotiated the debt down.
That is a lot like they just bought the property for less money, right? The tax allows you to avoid COD income and just treat it as though it is an adjustment of the purchase price. Instead of a million you paid $800,000 for the property. That applies at the partnership level, of course. You can see why it really has to. It is an issue that comes up whenever we have workouts.
Now, let us talk about some things that are a little bit more subtle. There is this concept of liability shifting or in tax talk we call them 752 deemed distributions.
In the partnership world, partners are allocated a share of the debt of the partnership for basis purposes. If you are a members of an LLC, if you – member or partner – have an interest in a partnership or LLC, and the partnership or LLC has debt, we allocate that debt under fairly extensive rules to each member or partner and you get basis for that tax basis. Basis is important for lots of reasons. One of which is that it is a cap on how much can be deducted by the partner.
Whenever a partnership incurs debt, that debt has to be allocated to the partners, and somebody is going to get additional basis. And whenever that debt goes away, that is treated as a distribution and somebody is going to lose basis.
In a partnership workout where we reduce the amount of debt, maybe we feel very clever about fitting within a COD income exclusion and avoiding COD income, but now we have to look at this deemed distribution idea, and if we have a deemed distribution in excess of basis, we end up with taxable gain at the partner level even though we have avoided COD income.
It is a little bit of a trap, so keep in mind that COD income is not the end of the inquiry when you have a partnership workout.
To put it in more concrete and less abstract terms, the way I would like to think about it is if somebody has a negative capital account, we have a potential problem. The way that it would work is that the partnership buys property. Let us suppose it is 100% financed, to make it simple, so it is debt, we have property, the partners do not put any cash, it is all debt financed, but we have debt at the partnership level. We have basis allocated to the partners. Now we depreciate the property. We have deductions. They get allocated back to the partners. They get to take those deductions subject to other limitations, but not subject to the basis limitation because they get allocated basis. They are happy. They put up no cash and they got a tax deduction.
We are not going to repay the debt so we negotiate the debt down. Now, we have COD income, but we are very clever, we have avoided income under one of the COD exclusions because we are insolvent or whatever it is. Now we go to the next inquiry. We reduced that debt and treat it as a deemed distribution and now our partner has a distribution in excess of basis.
In that scenario, the accountants in the group will tell you that when we allocated the depreciation deductions, we created negative capital account because the partners started with a capital account of zero, were allocated some loss, and they went negative. When the loss has been restored, they have to pick up income on that. That is an example of a deemed distribution concept.
To make this even more subtle, there is a scenario where creditors of the partnership become partners. In other words, it is not a third-party lender that we negotiate the debt with, we negotiate it with a third-party lender. A third-party lender that now becomes a partner. They contribute the debt to the partnership and they exchange the debt for a partnership interest.
Just like in the corporate world, there is such a thing as a debt for equity concept. In the partnership world, of course, we compare the value or usually, just as a short-hand method, you will find tax lawyers using capital accounts as a proxy for value, versus the face of the debt that has been forgiven.
In other words, it is a lot like the creditor contributes cash to the partnership and partnership turns around and uses the cash to pay the debt and everything is in balance and the world works out and we are all happy. However, we still have this 752 liability shift issue to consider. So, when a new partner comes in with his debt and contributes the debt, some of that debt now has gone away. We have 752 shift. And if the new creditor partner was not a partner before contributing the debt, they are not being allocated any of that.
If they were a partner, which often happens because creditors want to take warrants when they make loans or they want to have a percentage interest or some sort of participation, they may be ending up triggering COD or 752 income to themselves in these transactions. Even creditors have to be cautious in entering this area.
Bad Debt, Worthless Security Loss
We have talked about bad debts. We know what a business bad debt is. We know that it is deductible partially or wholly deductible at ordinary rates and that a non-business bad debt is deductible as a short-term capital loss only if it is wholly worthless.
The reason I mention it here is because oftentimes in the partnership world, the partner or the lender is looking for a way of just getting an immediate deduction. What I really would like to talk about is abandonment because this is the more interesting issue.
Consider this scenario. Lender makes a loan. The loan goes bad. Lender contributes the loan to the capital of the partnership, and now they are a partner. The partnership still goes bad. It turns out it is just never going to be worth anything again. Maybe for whatever reason, the lender is not able to take a worthless security loss because they cannot prove that it is worthless, plus a worthless security loss is a capital loss. So instead, they come up with the idea of abandoning the interest.
Here are the tax stakes.
An abandonment loss is an ordinary loss. It is deductible against ordinary income. A worthless security loss, which is the loss somebody can take when a security becomes worthless, is usually a capital loss.
Remember what I said about bad debt – if it is a bad debt loss that is a capital loss. The partner says I’m going to abandon the interest and trigger an abandonment loss, and sometimes that works. It is important to script it properly and to establish an intention to abandon the interest in an actual abandonment in which it has actually been surrendered.
Unfortunately, there is one more level of inquiry and that is that we do not have an abandonment loss if we have a sale or exchange, and if there is debt allocated back to the partner that is abandoning, and if they are actually getting it out from under that share of debt that has been allocated to them either on a actual basis because of release of guarantees or on a deemed basis because they are no longer a partner, we have a deemed distribution. That deemed distribution converts this entire abandonment transaction into a capital transaction, and we do not get ordinary deductions, we get a non-deductible capital loss.
Okay. Let me say that again. If we have a partnership that has debt, an abandonment strategy might not get you to an ordinary loss position, which is usually the end game. Again, this is something that has to be considered fairly carefully.
If it is worthless, if we are looking to get a worthless security deduction, that could be capital or ordinary as I said depending on the nature of the interest in the hands of the holder because it is a capital asset. It is not an ordinary asset. For most investors, it will be a capital asset thereby triggering capital loss. We also need some sort of identifiable event establishing worthlessness and there is also a timing issue in that we need to take it in the earliest year that we can.
Bankruptcy – What I would like to mention about bankruptcy is that there is a cancellation of debt income exception for bankruptcy. In other words, debt that gets discharged in a bankruptcy proceeding under a Title 11 case we call it – that is bankruptcy – is exempted from income. We do not have these problems of making sure we fit within the exclusion for a bankrupt party. It is probably not a good enough reason to become bankrupt, but it is one of the benefits of COD income in bankruptcy.
The 382 limitation, I talked about earlier. It does not apply in a Chapter 11 case. The bankrupt estate or company can use those NOLs going forward. In the case of a transfer to a bankrupt, we also could have a discharge treated as a purchase price adjustment. You remember the purchase price adjustment that I mentioned earlier. It could also be excluded under that basis.
What I really want to mention with respect to bankruptcy is the dischargeability of claims because only certain tax claims are discharged in bankruptcy, not all them.
For example, claims from non-filing of a tax return would not be discharged. A claim from a fraudulent tax return would not be dischargeable. If the taxpayer is guilty of tax evasion – not dischargeable. Here is the big one, if the liability or the tax return to which the obligation relates is relatively new, it is not dischargeable. By new, I mean a return filed in the last three years, or with respect to which an assessment is less than 240 days old.
In other words, you do not get out of the last three years worth of taxes by filing bankruptcy and you only discharge the old tax claims. This is in a typical business bankruptcy.
Income taxes may be dischargeable subject to these exceptions I just gave you, but other types of taxes are not. For example, payroll taxes are not going to be dischargeable plus there is responsible person liability for officers, which is a whole other discussion. And even if the tax itself is dischargeable, if there is a lien filed on a property, that lien is not necessarily discharged. We have to go through the procedures for dealing with tax liens. The taxpayer essentially has to pay the lien to sell the property.
I did want to pause on bankruptcy to let you know there are some advantages because of the COD exception, but it is not a complete get-out-of jail card.
And we are all the way down to our update slide.
With respect to updates, I am not sure if anybody is able to stay awake through the description of the one-year extension of bonus depreciation. What is more interesting in terms of an update, to me anyway, has to do with a dispute between the California tax authorities and the IRS.
The Internal Revenue Service has made a request on the State of California basically, a summons – what they call a John Doe summons – to obtain property tax records.
Why do they want property tax records?
Because they are looking for transfers of real property for gift tax purposes, in other words, transfers without adequate consideration so they can impose a gift tax. The federal court recently refused to enforce the summons and allowed the state to avoid giving those records to the IRS. So, stay tuned.
The significance for me is that the Service has taken a very aggressive approach on a estate and gift tax and they are investigating property tax records and are not getting a whole lot of cooperation from the state.
The other thing I want to mention has to do with California’s goofy NOL carry-forward rules and carry-back rules. As a revenue measure raising measure, the NOL carry-forward has been suspended in 2010 and 2011 for certain taxpayers with adjusted gross income of 300,000 or more. There is a proposed and upcoming two-year net operating loss carry-back, but that has been delayed another year.
In other words, losses from prior years are not going to be deductible in 2011. Hopefully, they will be in 2012. The losses from this year will not be carried back until 2013.
With that I would like to open this up to some questions and I believe that you can type them in and send them to me
Woman: Roger, that was a great presentation. Thank you so very much. I just had a couple of questions on what kind of entity should I use to acquire and hold real estate?
Roger: Yeah, thank you. That is a great question, and this is something that comes up quite a bit. The entity of choice by far these days for domestic real estate is the limited liability company. Once in a while, you will see a partnership. Once in a while, a limited partnership, but most often it is an LLC and the reason why – let us pause a little bit on choice of entity.
If you are an investor in real estate or you are going to acquire real estate, even if it’s owner-occupied, you want an entity to protect you from liabilities associated with the real estate. There might be CERCLA claims. There might be tort liability. There might be contractual type claims arising out of the business. Something like that so we need some sort of entity. I typically advise it.
Now, granted you can insure against a lot of claims, but you can’t insure against everything, so I always advise to use entities for holding real estate except in the very smallest transactions that just do not justify the transaction cost.
In terms of type of entity, once we have decided we need an entity, then tax issues become paramount, and the tax issue is that we do not want to increase our tax burden if we do not have to by holding real estate through an entity. If we hold real estate in a C Corporation, that is about the worst possible thing that you can do for a U.S. person because the C Corporation is taxed on its income at a 35 percent maximum federal rate. And when it distributes its earning, it does not get a deduction for the distribution and the share holders of the corporation pay tax on receipt of the earnings and another 15 percent rate that is bound to go up.
Then we have a state tax overlay on top of all of that. It is two levels of tax. It is very high. With an LLC or a partnership, we have one level of tax and it could be at capital rates when we have an exit of a property. LLC or partnership are the preferred vehicles and an LLC is preferred over a partnership because the members have limited liability, whereas in a general partnership they do not. An LLC has come to be preferred over a limited partnership because in a limited partnership, there must be at least one general partner who has unlimited liability, whereas in LLC we do not have that problem.
Woman: Great. And the other question I have, if I am a foreign investor, a non-U.S. person, should I form a corporation or an LLC to invest in U.S. real estate?
Roger: Yeah, and this is a great follow-up and segue from the last one. Everything I just said applies to domestic investors and you can pretty much forget about it with foreign investors. That is the conventional wisdom. I am going to give you a little trick and an update and new planning technique in a minute. Foreigners are only taxed in the U.S. on their effectively connected income. That is income effectively connected with a U.S. trade or business and real estate income is most often deemed to be effectively connected. The result is that foreigners are subject to tax on rental type income, etc., from real estate that they own in the U.S.
Most foreigners that I know do not want to be in the U.S. tax net. They do not want to file returns. They do not want to do any of that stuff. To avoid that result, they will form – remember what I said about never ever use a C Corporation? Well, this is a case where you may use a C Corporation. A foreigner will form a C corporation to own the property, in that way they do not have to file here.
There is an estate and gift tax advantage as well because if the foreigner dies owning U.S. real estate that U.S. real estate is going to be subject to estate tax. If they die owning stock in the U.S. company that owns U.S. real estate, the stock will not be subject to estate tax. If they die owning an interest in an LLC, then that is a little bit of an ambiguous, uncertain area and it is one of those places where you need to call a tax lawyer.
Here is a technique that I want to give you. What I just told you is all conventional wisdom. However, let us think about this a little bit.
Most real estate investments that I know of generate not so much income but a lot of loss, at least early on. There is interest. There is depreciation because they are almost always leveraged and they are almost always depreciable real property. So, they trigger losses to the investors.
Remember what I said about the foreigner not wanting to get into the U.S. net. Well, one thought is why do they care? They are not going to pay tax anyway. It is all loss. There is of course the hassle of having to get a tax ID number and file U.S. returns, but they are not going to pay any U.S. tax, so maybe they just want to invest through an LLC like everybody else, or directly.
Why would they want to do that? Well, because 10 years down the road or 20 or whatever, when they sell the property, if the foreigner owns it through an LLC, it is going to be a capital gain transaction taxable at currently 15 percent, and yes, the foreigner will pay tax, but they will pay at 15 percent.
If instead we use that favorite conventional wisdom C Corporation structure, if the C Corporation sells the property 10 years down the road, it pays tax at a much higher rate. The foreigner, just like domestic people, can reduce their tax burden by using the LLC even though it is much more of a hassle for them.
That is a very complicated question. It really kind of depends on the tax appetite aspects of the foreigner.
Woman: Thank you for that. And then, Ray had sent in a question for everybody. I am going to read it off.
I heard that there are some structural ways to be able to purchase a note at a discount than renegotiate with the existing owner and avoid or extend the tax when making a deal with the owner. Can you tell us the best way to do this?
Roger: This question looks like it is actually asking a question from the standpoint of the buyer.
So, yeah, you can do this. Remember what I said, the purchase of the note at a discount by itself is not a taxable transaction to the buyer of the note, however, they do end up with original issue discount and that gets taken into account ratably on economic accrual basis over the term of the note. The challenge here is that if we have a modification after that happens, what we have basically done is triggered a deemed exchange and that deemed exchange could trigger a gain to the buyer.
If you are saying what is the strategy for deferring and avoiding that, the strategy is to not buy and then modify. It is to buy the note as modified or to engage in modifications that are not significant modifications. In other words, if the note that the buyer picks up does not get modified after purchase, all the bells and whistles they want are included as of the date of purchase, that might be a strategy to avoid this later modification issue.
Woman: Thank you for that. I do not have any other questions at this time unless there is anybody in the audience if you have any questions, please send them in using your chat question dialog box and we can send those over to Roger really quick before we close.
Roger, any closing comments while we are waiting on that?
Roger: Yes, I have one and this is not tax. It is just since I am talking to business people and professionals, I will tell you that from my standpoint, I certainly see lots and lots of transactions both in the real estate world and the corporate world and it has been a busy and turbulent time. Fortunately, tax lawyers are somewhat recession proof. As long as something is going on, we stay pretty busy. I have a feeling that we are hitting a whole new wave. I think the summer of 2011 is going to be remembered as a start of another downturn and maybe a significant one just from the frontlines here. So, these issues that I have talked about I think are going to become very relevant in the foreseeable future.
I want to thank you for hosting this and for allowing me to be a speaker again. I would like to tell people they can download these slides as well as some detailed information on everything that I have just said at www.royseuniversity.com.
For additional information on legal issues, contact Roger Royse.
Please see www.RroyseLaw.com or contact Royse Law Firm, PC at firstname.lastname@example.org for additional information.
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