LENDING AND DEBT ISSUES Todd Keator - PowerPoint Presentation

1. LENDING AND DEBT ISSUESTodd KeatorThompson & KnightDarryl SteinhauseDLA Piper LLPDerrick TharpeWells Fargo 1031 Exchange ServicesLou WellerWeller Partners LLPOctober 24-25, 2019

2. AgendaRQ Debt IssuesRP Debt Issues, including ReversesCash Out Loans Before or After ExchangePay-Down/Re-Advance Structures2

3. 3BOOT OFFSET RULESIRC 1031(b): Gain is taxed to the extent of money or the FMV of “other” property received in the exchange. also known as “Debt Boot” RQ cash is NOT offset by RP liability assumed. i.e. cannot take cash out and offset it by RP liability RQ liability relief IS offset by RP liabilities assumed (or taken “subject to”) Thus, distinction between RQ cash and debt boot is key

4. 4What’s a Liability under 1031?TAM 8328011 – “sums certain due at a fixed or determinable date of maturity”What about demand notes and other obligations w/o a maturity date? Contingent liabilities?Property Taxes?

5. RQ: Liability vs. Taxable CashRQ liability can be paid off at closing and not assumed and still be treated as debt relief and not cash boot receivedBarker: Taxpayer did not have unfettered use of cash. Taxpayer was merely a conduit for payment of liability by buyer Remember 1995 case of Wittig? 5

6. RQ: Liability vs. Taxable CashRQ liability, if secured by RQ, does not need to relate to the RQCCA 201325011. LOC used for general business purposes was liability for 1031 purposes IRS also cited Barker for premise that TP may receive cash if contractually obligated to use it to pay down RQ debt6

7. 7RQ: Liability vs. Taxable Cash If RQ debt is unsecured, IRS position seems to be that it must relate or be traced to the RQ, or it’s taxable cash bootWhat about IRC 1031(d) provision that buyer’s assumption of liabilities determined under IRC 357(d) is boot to TP? Recourse debt is assumed if transferee agrees to satisfy the liabilityBarker: TP should be contractually required to payoff debt : not have unfettered use of cash

8. RQ: Liability or Taxable Cash?Taxpayer has line of credit not secured by RQ. TP would like to pay down LOC with exchange proceeds and treat as repayment of loan (to be offset by RP liability), rather than as taxable cash payment that cannot be offset. Result?TP is a Pship and partner wants to pull out $$ on transfer of the RQ and treat as repayment of undocumented partner loan (to be offset by RP loan), rather than as taxable cash payment that cannot be offset. Result?8

9. RQ: DefeasanceRQ loan is securitized and cannot literally be repaid US gov’t securities are acquired as substitute collateral, then transferred to a 3rd party SPE and pledged to lender SPE assumes loan and makes loan payments. RQ and TP are released from loan9

10. 10 RQ: Defeasance Methods of defeasance and effect on 1031: Legal (taxpayer released) v. In Substance (taxpayer continues to own securities and is not released)Whose funds are used to acquire the securities? TP, prior to exchange, QI or Buyer?Is there an assumption for 1031 purposes?Is there taxable boot in a defeasance?

11. 11RQ: DefeasancePremium often will be paid to make up for the interest rate differential between loan and current market ratesRQ has a $20M securitized loan at 4%. Current market interest is 3.5%. Securities valued at just under $23M must be purchased to generate enough income to pay 4% interest Is the $3M premium deductible as interest?

12. Sec. 467 Loans Prepaid rent may result in deemed loan from tenant to landlord, known as “467 loan” Excess rent over prorated amount is a loan amortized over the term of the lease$10M prepaid rent for a 10 year lease$1M in rent in Yr 1 $9M is loan to landlord from tenant $1M per year is treated as rent for parties (i.e. deducted by tenant; income to landlord) 12

13. Sec. 467 Loans Transfer of RQ: TP, as landlord, has liability relief and Buyer has liability assumptionTP exchanges in Year 4, with 467 loan of $6M. TP does not transfer $6M rent to buyerPrice is discounted by $6M due to below market rentTP has debt relief of $6M. Buyer has debt assumption in the amount of $6M which is added to tax basis Buyer will report rental income of $1M per year under 467 loan. Any escape? 13

14. RQ: Liability vs. DeductionsCan accrued property taxes and interest on RQ can be both liability relief and deductible expense? If RQ buyer treated as assuming them, how can TP deduct them?What if accrual basis TP has already deducted them? 14

15. RQ Liability Relief TimingRQ transfers in Yr 1. RQ debt is paid off at closing and remaining proceeds go to QI. Exchange fails in Yr 2. Is RQ debt relief taxable in Yr 1 or Yr 2?Rev Proc. 2003-56 for partnerships treats as debt relief in Yr 1Payments held by QI are not treated as received until Yr 2. Other requirements of §453 apply. §1031 regsLiability paid off is payment in yr of sale; liability actually assumed by buyer is not payment in year of sale except for amount in excess of basis (contrast with meaning of “liability assumed” for 1031 purposes)15

16. RP: Liability vs. Cash Paid Pre-existing debt assumed or seller financing is liability assumedOpen issue if new third party debt is a liability assumed for 1031 purposes. If treated as cash paid, can receive non taxable excess loan proceeds at RP closing 16

17. RP Loan ExpensesLoan Fees: Open issue if taxable boot when paid from exchange proceeds. Cost of loan but still necessary to acquire RP. Are they a (g)(7) expense?Lender Expenses and Other Items:Reserves or other HoldbacksDoc fees & other administrative chargesThird party costs: attorneys, surveys, environmental reports, lender title insuranceCan these be paid from loan proceeds and does that help?Structuring a closing statement17

18. Issues and Risks for Construction Lenders in reverse improvement exchanges Bankruptcy of Exchange Accommodation Party (EAP, since not always an EAT) and/or its parent entity (“EAP Parent”)Ability of the Construction Lender to realize upon its collateral (the “Parked Property”) Timing concerns – when can the Construction Lender collapse the structure so EAP Parent is out of the picture18

19. Issues and Risks for Construction Lenders in reverse improvement exchanges Bankruptcy Concerns Bankruptcy of EAP or EAP Parent could subject the Construction Lender’s collateral (the Parked Property), to claims of creditors of the EAP or EAP’s Parent. Typically, EAP is a special-purpose entity of which EAP Parent is the sole member. The SPE is typically a limited liability company for state law purposes and a disregarded entity for federal income tax purposes. If EAP cannot borrow other than pursuant to the Construction Loan, the structure for the Equity Loan must have EAP Parent as the borrower.19

20. Issues and Risks for Construction Lenders in reverse improvement exchanges Bankruptcy Concerns Interjection of EAP as nominal borrower under the Construction Loan adds the bankruptcy risk and the risk of a “rogue accommodator” (either EAP or EAP Parent) who will not cooperate with completing the exchange and transferring the membership interests to the exchanger.  Making Exchanger a co-borrower is risky from a Section 1031 perspective. 20

21. Issues and Risks for Construction Lenders in reverse improvement exchanges Bankruptcy ConcernsConstruction Lender’s mitigation strategies: Obtain a full guaranty from the exchanger. Require that EAP have an independent non-member manager (possibly an affiliate of the exchanger) who will agree not to vote for bankruptcy. Any removal of the exchanger-affiliated manager should be an event of default under the Construction Loan.Require a non-consolidation opinion from EAP’s counsel that EAP will not be wrapped into a bankruptcy of EAP Parent.Also make EAP Parent a special-purpose entity. 21

22. Construction Lender’s Ability to Realize Upon CollateralConstruction Lender should obtain a direct note and mortgage from EAP for the Construction Loan Construction Lender might also take an interest in the Equity Loan through either (i) a collateral assignment of the security for the Equity Loan or (ii) an intercreditor agreement with the exchanger that prevents the exchanger from exercising its rights in the event of a default under the Equity Loan Construction Loan should be due when construction is completed. Extension rights should be personal to the exchanger. Termination of construction management agreement and default on the Equity Loan should be events of default22

23. Timing and non-bankruptcy Concerns To fit within the framework established in Bartell, 147 T.C. 140 (2016), the Construction Loan should become due if construction is not complete within 24 months or the exchanger has not exercised its option to purchase Exchanger should get Pre-approval of the transfer of membership interests in EAP from EAP Parent to the exchangerWill lender require Financial information regarding EAP and EAP Parent normally sought from Borrowers?23

24. 24Cashing Out w/o TaxRQ: $10M value with $4M debt and $6M equityRP: $10M value TP would like to only put $2.5M down (retaining $3.5M) and finance $7.5M What are TP’s options and how safe are they?

25. Pre Exchange Refinancing Garcia: pre-exchange equalizing of mortgages in 2 party exchange RQ: 100K mortgage; RP: 75K mortgageSeller increased RP mortgage by 25KLong: Pre-exchange reallocation of partnership liabilities to avoid mortgage relief in a pre-1984 partnership exchange Fredericks: TP refinanced RQ loan coming due and pulled out $2M equity after entering into sale contract Behrens: Dicta states OK to borrow pre or post exchange, just not during exchange25

26. Pre Exchange RefinancingIRS:1990 Prop. Regs: liabilities incurred “in anticipation of an exchange” would not offset RP liabilities PLRs: 8434015, 8248039 and 200019014. Focus on independent business reasonCCA 201325011. LOC drawn upon for business use is RQ liability26

27. Pre Exchange Refinancing: 1995 ABA Report Pre-exchange: should be independent of exchange, not conditioned on the completion of a relinquished property sale nor part of the same escrow or settlement process; lender should look to the credit of Taxpayer and not the credit of the buyer27

28. Post Exchange Refinancing Case Law: none IRS rulings: 200131014Dulles World Property withdrawnABA report: Not taxable boot because TP will remain responsible for repaying debt, unlike pre-exchange refinancing Nano Second Rule?28

29. Pay-down/Re-advance Structures “Zero Cash Flow” properties (aka a “Zero”) are marketed to 1031 investors. CTLs with little equity requirement (5-15%) plus depreciation deductionsProvide pay-down/re-advance structures for TPs with excess exchange equity29

30. Pay-down/Re-advance Structures TP needs $1M of RP with $500k of equity. Wants Zero RP with $100k equity (10%) and $900k down. QI pays $500K to seller who pays down debt to $500K and transfers to TP TP thereafter re-borrows $400K.Issues? Penalties?30

31. Wrap Notes TP needs $1M of RP with $500k of equity. Wants to acquire RP that is subject to $900K debt Can TP pay $500K down and issue a wrap note for only $500K to the seller ?When exchange is over, can seller pay TP $400K to assume full $900K of liability? 31

32. Multiple RP Issues TP sells RQ for $1.8M, paying off $800k loanQI holds all exchange funds TP acquires RP #1 for $1M, all equity Can TP refinance RP #1 and pull out $800K of equity prior to acquisition of RP #2?What if funds are used to acquire RP #2? Does this violate (g)(6)? 32

33. Combo Multiple RP and Buyer Note RQ consideration is $6M cash and $4M note. TP acquires RP #1 with $6M cash, then refinances RP #1 for $4M Purchases Buyer Note from QI for $4M TP thus has full basis in Buyer NoteQI then acquires RP #2 for $4M. Does this work? 33

34. Thank you!Views expressed in this presentation are those of the speakers and do not necessarily represent the views of any of their firms. This presentation is provided solely for the purpose of enhancing knowledge on tax and legal matters. It does not provide tax or legal advice to any taxpayer because it does not take into account any specific taxpayer’s facts and circumstances. These slides are for educational purposes only and are not intended, and should not be relied upon, as tax, legal or accounting advice.34