Editor: Lori Anne Johnston, CPA, J.D.
The pandemic has had various effects on the real estate industry. Generally, the residential housing market has been strong, riding on the back of rock-bottom interest rates. In contrast, the commercial sector, particularly hotels and retail, has struggled during the ongoing pandemic. This item examines debt workouts involving commercial real estate.
At the beginning of the pandemic, lenders offered financially troubled commercial borrowers short-term solutions, such as deferred payments, but as those agreements have begun to expire, lenders find themselves at a crossroads. Many businesses with retail or other space continue to struggle to pay their debts. Some creditors therefore have begun to work with debtors to get the most out of their current situations. A lender may look to adjust the terms of the debt, reduce the principal of the debt, or take partial equity on top of refinancing, with the end goal of presenting a more equitable alternative to the business than forcing it into bankruptcy. Recent examples include:
- So-called loan-to-own transactions in which investors initially provide lending to a distressed borrower, with an eye toward later converting that instrument into equity (either by its terms or pursuant to a separate agreement);
- Assignment-for-the-benefit-of-creditors (ABC) transactions, which, in particular for smaller debtors who see the cash flow writing on the wall, acts like a pre-packaged bankruptcy without the stigma of "bankruptcy" following the debtor; and
- Converting insolvent partnerships into corporations in the hope that the taxpayer can then exclude cancellation-of-debt (COD) income. This issue is discussed in more detail below.
Capitol Hill update
In the case of debt restructuring or forgiveness, Sec. 61 and Regs. Sec. 1.61-12 create potential taxable COD income for the borrower. As of this writing, it is unclear whether Congress will provide borrowers, who are most likely suffering from real economic losses, relief from COD income. Currently there is no definitive plan to offer such relief, so any guess about what might occur is largely speculative. Congress could enact provisions similar to those in the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, which benefit employers that have Payroll Protection Program loans by providing that loan forgiveness does not result in COD income.
Another option would be a deferral of the COD income via taxpayer election to reduce the tax basis of their assets by the potential COD income. This would effectively defer the income recognition until the asset is sold or the property is foreclosed on. A third remedy would be a temporary COD deferral for a fixed period followed by an income recognition period, perhaps by refreshing Sec. 108(i), which was enacted in response to the Great Recession.
Because no such legislative action is currently on the horizon, advisers must seek other strategies to help clients avoid or reduce COD income from a debt workout.
Debt workouts and COD income
Because the real estate industry largely operates in passthrough entities, it is at a disadvantage when trying to use Sec. 108's provisions for excluding COD income. Under Sec. 108(a) the taxpayer has an option to exclude COD income if it meets certain criteria, such as a discharge within a Title 11 bankruptcy case or if the taxpayer is insolvent as of the time of the forgiveness. As the Code is currently written, however, the exclusion provisions of Sec. 108 cannot be applied by partnership entities themselves. Instead, the determination of insolvency and exclusion of COD income within Sec. 108 is applied at the partner level (Sec. 108(d)(6)).
For the real estate industry, this poses a problem. Many real estate assets are held through partnership entities, which are not eligible to take advantage of the Sec. 108 provisions. Currently, in situations where a complex flowthrough structure is in place, the debtor must look through multiple layers of partnerships to get to the individual level where insolvency is tested. In some cases where there are multiple flowthrough layers, this might be impractical; in other cases, when one of these layers includes a fund with hundreds, maybe even thousands, of partners, this exercise may be exceedingly impractical.
A potential strategy
One possible solution may be converting the debtor partnership into a corporation to take advantage of the Sec. 108 provisions for excluding COD income that are applicable to corporations and not partnerships. One way to incorporate a partnership currently organized as an LLC for legal purposes is to file an election to be treated as a corporation. Alternatively, the partnership could liquidate, and the partners could contribute their partnership interests into a newly formed corporation.
Another possible solution would be to have a partnership transfer all its assets into a corporation and distribute shares of the corporation back to its partners. Once the check-the-box election has been made and the partnership converts to a corporation, the debtor tests for insolvency at the new corporate level rather than tracing it through the partnership structure to the individual level. This may allow an insolvent partnership (provided the facts are right) to avail itself of the Sec. 108 exclusions.
However, to make this partnership-to-corporation conversion tax-free, the real estate entity must (arguably) prove that under Sec. 351 the conversion has a business purpose beyond the tax savings. Taxpayers have sometimes taken the position that depending on the planned use of cash (borrowed or generated) within the business, the difference in the cash tax burden for a corporation (based on a current 21% income tax rate) and that of a partnership (which often requires tax distributions as high as 50%) may ultimately support an overall argument that the former real estate partnership would be better off operating in corporate form from a cash flow perspective.
Converting to a real estate investment trust (REIT) may seem like a possible solution to avoid double taxation. A REIT does not pay corporate-level tax as long as it distributes current-year income to its owners. However, REITs are subject to prohibitive ownership rules that make it hard for closely held companies to invest using this structure. For example, to avoid being classified as closely held after attribution rules are applied, the top five shareholders in the REIT must hold less than 50% of the value of the REIT stock.
Some illustrations of debt workouts may be helpful here. One recent example involves the building that housed the space previously occupied by the department store Barneys in New York City. With Barneys filing for bankruptcy, the private landlord reached out to Wells Fargo to request an extension of the loan's maturity date. The bank agreed to modify the loan, extending the maturity date from July 2020 to January 2022. This extension gives the property owner 18 months to figure out a repayment plan.
Chuck E. Cheese filed for Chapter 11 bankruptcy over the summer and said in a news release that its goal was to complete a "restructuring that supports its re-opening and longer-term strategic plans." When CEC Entertainment LLC, the parent company of Chuck E. Cheese, emerged from Chapter 11, it had shed approximately $705 million of debt obligations.
Owners of malls across America were struggling before the pandemic hit, largely due to the prevalence of online shopping. With foot traffic halted due to COVID-19 precautions, revenues are down and mall owners are falling behind on their mortgage payments. Recently, Mall of America in Bloomington, Minn., entered into a forbearance agreement with a special servicer on its loan after falling behind on its mortgage payments.
PREIT, another owner of retail space, filed for bankruptcy. PREIT's restructuring offer includes a payment extension and securing of its debt while retaining equity for shareholders.
All these transactions likely have COD income consequences, whether it be from Barneys' landlord creating COD income through the modification of the debt instrument (applying the significant modification rules of Regs. Sec. 1.1001-3) or the COD income generated due to Chuck E. Cheese's debt forgiven in bankruptcy. The key is to find the most tax-advantageous way to minimize the ultimate tax bite.
As the short-term agreements that borrowers and creditors reached at the beginning of the pandemic start to expire, real estate companies and others will need to find long-term solutions to their insolvency problem. As debt workouts become more prevalent, companies will have to start thinking about how to deal with the potential COD income. Using Sec. 108 to exclude (or defer, if Congress takes meaningful action) COD income can be a strong tax planning tool, giving these companies a chance to solve their long-term cash planning issues while avoiding bankruptcy or foreclosure.
Lori Anne Johnston, CPA, J.D., is a manager, Washington National Tax for RSM US LLP.
Contributors are members of or associated with RSM US LLP.