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Owners Who Negotiate Debt Reductions Could Face Tax Hits

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Mar 2, 2010 - CRE News
With property values well below where they were three years ago, borrowers are increasingly trying to negotiate reductions in their loan balances.

But doing so could trigger a substantial tax hit on any forgiveness of debt.

The tax-liability issue became fodder for headlines in recent weeks when the owner of Manhattan's Stuyvesant Town/Peter Cooper Village offered to turn the property over in a deed-in-lieu of foreclosure. Its lenders subsequently filed to foreclose.

The property's owner, a group led by Tishman Speyer Properties, won't face a tax liability on any forgiveness of debt because its cost basis in the property of roughly $5.4 billion, less any possible depreciation and capital improvements, is far greater than the $3 billion of senior debt owed. Another $1.4 billion of mezzanine debt is secured by ownership interests in the entity that owns the property. But the transfer of ownership, either through a deed-in-lieu or an actual foreclosure would trigger New York's onerous transfer tax. That tax is assessed at the rate of 3.025% of the mortgage's face value.

The transfer tax liability - it would likely be borne by the property's lenders in the event of a deed-in-lieu or a foreclosure, both of which assume the property lacks the resources to pay the tax - would total $90.75 million. But it could be reduced if the entity that owns the property, as opposed to the property itself, is transferred, according to Harvey Berenson, managing director and member of the general tax group of FTI Schonbraun McCann Group, a New York advisory firm.

In that case, the value of the underlying property determines the amount of the transfer tax. Given that StuyTown's value is said to be roughly $2 billion, the transfer tax would be about $60.5 million.

Meanwhile, given the decline in property values and the volume of debt that was written at or near the market's peak, the number of loan workouts and debt restructurings is expected to explode.

"This is happening all over the country," said Maury Golbert, tax partner at Berdon LLP, a New York tax adviser.

Most properties purchased at or near the market's peak with high-leverage financing "that's coming due now are underwater," he explained.

If the amount of debt is greater than the property's basis, or cost, the borrower would face a tax hit if any of the debt is forgiven or cancelled. And that tax would be assessed at the ordinary income level of 35%, as opposed to the 15% rate on capital gains.

So say an investor bought a property in 2003 for $50 million and because of the run-up in values was able to borrow $70 million at the market's peak in 2007. If the property is now underwater, meaning it's unable to stay current, the owner could try to negotiate a reduction in the property's debt. If successful, the property would face a tax on the amount of debt forgiven.

"If you bought in 2007 and the cost basis is big, that won't be a terrible tax result," Golbert said. But a number of long-time property investors had taken advantage of the flood of capital during the market's peak to take cash out of their properties with hefty mortgages. If those get written down, "you're looking at a more difficult tax situation," he said.

Meanwhile, owners who live in New York City would face an additional 9% hit. After federal income tax offsets are taken into account, the total tax hit could be roughly 42% on the amount of debt forgiven.

"The basic rule is if debt is forgiven, the reduction is treated as taxable income in the year it happens," Berenson explained.

But property owners facing large tax hits can defer their payments. They can, for instance, reduce the tax basis instead of recognizing income from the property whose debt has been in part forgiven. Taxing authorities are also allowing liabilities to be deferred for five years. After that, 20% of the total tax liability is due annually until it's repaid, Berenson explained.

"Lenders can foreclose, or work something out," Golbert added. In either case, depending on where the property is located, potential tax issues arise. "If you work it out, and some debt goes away," you could see a tax hit if the property's cost basis is low enough, he said.

Golbert noted that property owners facing such tax liabilities could, at least in theory, defer them by structuring tax-deferred exchanges. The problem, he said, is that such deals are difficult to structure today. They require equity and debt. If a property owner was hit by a foreclosure, chances are slim that he has sufficient equity to structure such a transaction, and "it's tough to borrow" for such exchange transactions.

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