New Tax Laws Impact COD Income and Budget Proposals Target "Carried Interests" Issued to Fund Sponsors

20 March 2009 Publication
Author(s): Van A. Tengberg

Legal News Alert: Real Estate Tax Strategies

President Barack H. Obama has had a very busy past few months. During February, 2009, the president signed into law the American Recovery and Reinvestment Act of 2009 (ARRA) and also submitted to Congress his administration’s proposed budget for 2010. These actions contained many changes (or proposed changes) to the tax laws that could significantly impact the taxation of real estate investment funds and their sponsors, including those relating to cancelation of indebtedness income and the tax treatment of so-called “carried interests” that are issued to real estate fund sponsors.

Temporary Tax Relief for Debt Discharges
On February 17, 2009, President Obama signed the ARRA into law. This new law contained a number of new tax law changes, including a special rule that is designed to provide temporary tax relief to struggling operating businesses (including real estate investment trusts (REITs)) by facilitating their ability to restructure their existing debt on a tax deferred basis.

General Background. In general, under current tax laws, if a borrower is relieved, or discharged from, the obligation to repay borrowed funds, then, subject to certain exceptions, the borrower generally recognizes “cancellation of indebtedness” (or COD) income, which is taxable at ordinary income rates.

For a distressed borrower seeking to restructure debt, the requirement to recognize and pay income tax on COD income can, in and of itself, defeat the purposes of the workout. The tax law recognizes this and over the years a number of exceptions and special rules have been created in order to provide tax relief in certain types of situations. For example, under one set of special rules, bankrupt or insolvent borrowers can often qualify to exempt their COD income from tax. As a trade-off for this tax-exemption, the bankrupt or insolvent borrower must then reduce the amount of its tax “attributes” (such as net operating losses (NOLs), tax basis, etc.) by an equal amount.

Another set of special rules applies to “underwater” real estate that is utilized in the borrower’s trade or business (i.e., amount of secured debt exceeds the fair market value (FMV) of the collateral). Under this set of rules, a borrower can enter into an agreement with the lender to write down the debt to the current FMV of the assets and then elect (subject to some limits) to exclude the resulting COD income from taxation, again, with the trade off that the borrower must then reduce its tax basis in depreciable real estate by an equal amount, thereby reducing depreciation deductions going forward.

Finally, another set of special rules applies to purchase-money debt (i.e. seller “carryback” notes that are issued by the buyer of property to the seller in connection with the sale of property). In general, if the seller/lender and the buyer/borrower agree to reduce the purchase money debt, the reduction can be characterized as a tax-free purchase price reduction (which in turn, requires the buyer/borrower to reduce its tax basis in the property) rather than taxable COD income.

The New Law. In the wake of recent economic events, the ARRA adds yet another set of special rules to the tax law relating to COD income. These new rules, which are set forth in new Section 108(i) of the Internal Revenue Code, are designed to provide temporary tax relief to struggling operating businesses (including REITs) by facilitating their ability to restructure or repurchase their existing debt on a tax-deferred basis.

These new rules are temporary in that they permit borrowers to elect to defer the payment of taxes from COD income recognized as a result of certain types “reacquisitions” of “applicable debt instruments” that occur during the 2009 and 2010 calendar years. If a borrower qualifies and files an election under this new law, instead of being required to pay income tax on the COD income entirely in the year of the discharge, the borrower will be permitted to defer and report the COD income ratably over a five-year period beginning in 2014 and extending through 2018. Given that there are no “interest” charges on this deferral, this new provision could offer significant time value of money benefits to borrowers who are otherwise faced with currently taxable COD income.

For this purpose, a reacquisition is defined to include cash repurchases of debt, exchanges (including “deemed” exchanges) of a new debt for the old debt, equity-debt exchanges as well as a complete1 forgiveness of the debt by the note holder. The term “applicable debt instrument” means any debt instrument issued by a C corporation, or, for non-C corporate borrowers, any debt instrument issued in connection with the conduct of a “trade or business.” Although REITs are generally viewed as “C corporations” for this purpose, an operating partnership of a REIT that utilizes an UP-REIT structure is not a C corporation. Generally, most types of equity REITs (including their affiliated operating partnerships) conduct enough activities, even with the constraints of the REIT tax rules, to qualify as being in a trade or business for this purpose. Nevertheless, this is an issue (among others) that should be carefully analyzed in connection with any workouts of REIT and/or other real estate fund debt.

Tax Strategies. In today’s economic environment, investors who own or manage distressed real estate are faced with even more tax planning opportunities (and pitfalls), especially in situations where lenders are amenable to either discounting or extending the current debt arrangements, or perhaps selling the notes to investors at a discount. The range of tax planning opportunities include (a) structuring to avoid current taxation of COD income altogether if the investor is bankrupt/insolvent or if the real estate is underwater, in either case with the trade off being a reduction in tax attributes or tax basis, or (b) alternatively, perhaps taking advantage of the temporary provisions of new tax code Section 108(i) to defer the recognition of COD income ratably over the five-year period beginning in 2014 and ending in 2018. Furthermore, for purchase-money debt, taxpayers who are able to secure a reduction in principal may qualify to avoid completely the recognition of COD income under the purchase price reduction exception.

Property owners should carefully consider their own particular tax consequences when planning any debt workouts as taking advantage of the new deferral elections for COD income under Section 108(i) may not always be the preferable course of action. For example, in the year of discharge, the taxpayer might otherwise qualify for an existing exclusion such as the “qualified real property business” exception, or the bankruptcy or insolvency exceptions described above. The new Section 108(i) states that if a taxpayer elects deferral under the new rules, none of these other exceptions or exclusions will be available in years 2014 – 2018. Similarly, a taxpayer who has tax losses (including NOLs) in the year of the debt discharge might consider whether it is preferable to forego this new election and instead shelter the COD income with currently available losses (or NOLs) that might not otherwise be available in 2014-2018 (i.e. when the “good times” return).

Borrowers who are organized as “partnerships” — including most real estate funds as well as any operating partnerships that are part of an UP-REIT structure — will face additional complications in analyzing the impact of these new rules. Many of the existing exclusions for COD income (including the bankruptcy, insolvency, and real estate exclusions described above) are applied at the partner level. In other words, although the partnership recognizes the COD income, each partner takes into account his/her own allocable shares of that COD income and, to the extent such partner is bankrupt or insolvent, that partner might or might not qualify for tax exemption with respect to that portion of the COD income. Similarly, if the discharged debt otherwise qualifies for the existing real estate exclusion described above, each partner can elect (or not elect) to exclude from taxation his/her share of that COD income under those rules. However, the new Section 108(i) election is made at the partnership level. Thus, conflicts could arise as a partnership’s election under Section 108(i) to defer until 2014 – 2018 would make the partners ineligible to utilize any of these other exclusions that otherwise might be beneficial to them, based on their own tax positions.

President Obama’s Proposed Budget Targets “Promoted” Real Estate Funds
On February 26, 2009, President Obama submitted his fiscal year 2010 budget proposal to Congress. This proposal includes a provision that would tax “carried interests” as ordinary income beginning in 2011. Although this type of provision has been proposed since 2007, many private equity fund managers were caught somewhat by surprise by this development as some were anticipating (or perhaps hoping) that the continuing economic crisis might place these types of tax increases on the “back burner.”

Background. Most private investment funds (including real estate funds and joint ventures) that are sponsored by U.S. promoters are organized as partnerships or limited liability corporations (LLCs) that are taxed as partnerships. The U.S.-based sponsors of these vehicles often receive at least two forms of compensation from the fund. The first is a fixed management fee that is generally taxable as ordinary income to the sponsor. The second is a “carried interest” pursuant to which the sponsor is entitled to some designated share of the profits of the fund (20 percent or so is not uncommon), usually calculated after the investors of the fund have received a return of their capital plus a certain return thereon.

Under current law, the carried interest has a number of very beneficial tax benefits for the sponsor. For one thing, even though the carried interest certainly has value, there is generally no taxable income required to be reported by the sponsor at the time the carried interest is issued. Moreover, the sponsor does not have to recognize taxable income unless and until the fund recognizes taxable gains or profits and allocates those to the sponsor as part of the sponsor’s share. Last, but certainly not least, to the extent the fund’s gains are capital gains (which, in the case of many real estate funds, would be the case upon sale of assets), the sponsor is entitled to report its share of those gains as preferential capital gains as well. In short, the sponsor not only receives maximum deferral, but also potentially is taxable on a large portion of its compensation as favorable capital gains.2

Any tax law changes targeted at carried interests could seek to address one, two, or perhaps all three of these potential tax benefits to the sponsor. The proposals by Congress since 2007 have, thus far, focused only on the third; i.e., taxing the ultimate allocations of income or gains from the fund to the sponsor as ordinary income rather than capital gains.

President Obama’s Proposal. As indicated above, the president’s 2010 budget proposal calls for new tax legislation to tax carried interests as ordinary income beginning in 2011. The budget proposal contains no further details regarding the scope or application of any such new legislation. Therefore, it is far too early to speculate on the exact form that this proposal may take, let alone to undertake any significant structural changes in anticipation of any such future legislation. However, if it turns out that the Obama administration’s proposals ultimately become law, and if those proposals at all resemble those which have been previously proposed by Congress since 2007, the scope and application of any such new rules could be quite broad and would significantly impact almost all U.S.-based private equity funds and hedge funds as well as most private real estate funds and promoted joint ventures.3

Tax Strategies. The following additional points are worth mentioning even at this very preliminary stage:

  • REIT Issues. Although the congressional proposals would tax a sponsor’s carried interest as compensation income for services rendered, each of these prior proposals also contained a provision that indicated that the income would not necessarily be considered to be “bad” income for REITs. In other words, for a REIT that earns income from a carried interest in a joint venture or other real estate fund, the carried interest would be taxable at ordinary income rates but would not be considered bad compensation income under the REIT tax rules (assuming, of course, that the underlying income of the fund or joint venture is not bad income).
  • Management Fee Waivers/“Cashless Capital Contributions.” Many real estate fund terms require the sponsor to make capital contributions to the fund based on some percentage of the capital invested by the investors in the fund (so called “skin in the game”). Many real estate fund terms also provide that the sponsor can elect to waive some or its entire management fee and, in lieu thereof, receive a priority allocation of future appreciation in the fund’s assets as a method of satisfying its capital contribution obligations (so-called “cashless capital contributions”). Fund sponsors should consider whether exercise of this cashless capital contribution feature might convert what otherwise would have been invested capital in the fund (and thus potentially escape the reaches of the new rules) into an interest that gives rise to ordinary income under any subsequent new laws.

As also indicated above, President Obama’s proposal states that it would not be effective until 2011 at the earliest. Thus, it likely is too early for real estate fund sponsors to make any drastic structural modifications to existing or new funds. However, stay tuned for further developments on this important topic.

1 This raises the question of whether “partial” forgiveness of a debt is eligible for relief under the new law.

2 Long-term capital gains are currently taxable to individuals at maximum federal rates of 15 percent, as opposed to 35 percent rates applicable to ordinary income.

3 Interestingly, the congressional proposals to date would not apply to oil and gas funds.

Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues.

If you have any questions about this alert or would like to discuss the topic further, please contact your Foley attorney or the following individual:

Peter J. Elias
San Diego, California

Van A. Tengberg
San Diego, California

Adam B. O’Farrell
San Diego, California

Internal Revenue Service regulations generally require that, for purposes of avoiding United States federal tax penalties, a taxpayer may only rely on formal written opinions meeting specific requirements described in those regulations. This newsletter does not meet those requirements. To the extent this newsletter contains written information relating to United States federal tax issues, the written information is not intended or written to be used, and a taxpayer cannot use it, for the purpose of avoiding United States federal tax penalties, and it was not written to support the promotion or marketing of any transaction or matter discussed in the newsletter.

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