Document Sample
					                          TAX MANAGEMENT
                            REAL ESTATE
         a monthly professional review of current tax, legislative and economic developments

                                                               that lead an investor to become liable on a per-
‘‘I Personally                                                 sonal guaranty, the issues that need to be ad-
Guaranteed a Loan on a                                         dressed when dealing with and discussing op-
                                                               tions with the lender, the various legal and tax
Real Estate Deal That’s                                        considerations that come into play, and the
                                                               strategies that you should consider if you find
Gone Sour — Now What                                           yourself in this precarious position.
Do I Do?’’                                                     The Deal I Should Have Turned
by Kenneth W. Bosworth, Esq., Lawrence J. Feller,              Down
Esq.,                                                             There are many different ways a person may
Kenneth A. Goldstein, Esq., Kristin L. Dunlap, Esq.,           find himself or herself personally liable to a
and Kenneth Klassman, Esq.*                                    lender or the other investors/partners on a real
                                                               estate deal. The following is just one scenario
                                                               that is playing out for real estate investors all
   In today’s economy, more and more real es-                  over the country today.
tate investors are finding themselves in the situ-                 In 2006, a real estate entrepreneur identified
ation where they have personally guaranteed a                  a piece of commercial real estate in a second-
loan on a real estate deal that is not perform-                tier market that appeared to have the appropri-
ing. The investor is now faced with personal                   ate demographics to support the redevelopment
exposure to the lender and the other investors/                of the property into a higher performing center.
partners in the deal, often in an amount that                  The entrepreneur purchased the property at a
greatly exceeds the value of that investor’s as-               seven cap, which was, and still is, by general
sets. This article explores the circumstances                  standards, believed to be a fairly good deal in
                                                               the marketplace. The center was 30% vacant,
                                                               but the entrepreneur accepted that vacancy rate
     The co-authors are attorneys in the real estate group     because the intent was to re-tenant the center
and wealth protection planning group of Horwood Mar-           with higher paying, more creditworthy tenants,
cus & Berk Chartered (HMB). HMB’s real estate group            stabilize the center, and sell the property a few
provides the firm’s clients with depth and experience in a
broad range of real estate matters, both at a national and     years down the road at a five cap. The entre-
local level, including all aspects of acquisition and devel-   preneur was excited about the opportunity and
opment, financing, construction and ownership. We work          decided to invest his own capital and also to
in conjunction with our wealth protection planning attor-      bring in a few close friends and family mem-
neys to structure the most tax favorable acquisitions, joint   bers as investors. The entrepreneur and the in-
ventures and dispositions, while also providing alterna-
tives for proper risk allocation. More information about       vestors organized a limited liability company to
HMB and the coauthors’ biographies can be found at ww-         acquire the property. As part of the financing                                                  package, each of the investors was asked to

                                     TAX MANAGEMENT INC.
sign a personal guaranty, joint and several with each                        requests for information. The lender likely
other investor, in favor of the mortgage lender. Be-                         will want detailed information about the steps
lieving there was not any real risk that the guaranty                        that the operator is taking to improve the
would ever be triggered, each investor agreed to sign.                       value of the collateral so that it can assess
   At the time of acquisition, the LLC had borrowed                          whether its interests are best served by con-
$3,000,000 to acquire the property. Over the course of                       tinuing its relationship with the operator ver-
the next two years, as a result of renovations to the                        sus removing the operator and replacing the
property, the LLC had increased the debt to                                  operator with more qualified personnel, typi-
$5,000,000. In 2008, the commercial real estate mar-                         cally a third-party receiver.
ket stagnated, several tenants left the property, and
                                                                             In some cases, for liability purposes, a lender
then there was no market for replacement tenants,
                                                                             may hire independent consultants to advise it
leaving the center 50% vacant. The LLC owes the
                                                                             on how to handle a particular property and its
lender $5,000,000 in principal, which started accruing
                                                                             guarantor group. When the operator is inter-
interest at default interest rates since the LLC can no
                                                                             viewed by the lender or an independent con-
longer afford to keep current on the loan. The most
                                                                             sulting firm, the operator should be prepared
recent appraisal of the property estimates its value at
                                                                             to demonstrate why s/he is the best candidate
approximately $3,000,000. Accordingly, each investor
                                                                             to maintain and improve the value of the col-
faces joint and several liability of approximately
                                                                             lateral. This includes explaining, among other
$2,000,000 to the lender. The entrepreneur who put
                                                                             things: (i) the plan for the property, (ii) what
the deal together was also facing personal liability on
                                                                             facts and circumstances support the plan, (iii)
several other deals that have gone bad. Some of the
                                                                             the issues leading up to the current default
investors have liquid assets that would cover the en-
                                                                             status of the loan (presumably through no
tire $2,000,000 obligation, while others are teetering
                                                                             fault of the operator), (iv) the steps the opera-
on the edge of bankruptcy.
                                                                             tor is taking or will take to maintain and im-
                                                                             prove the property in accordance with the
What To Do Now — Understanding                                               plan, and (v) the new financial projections for
Your Position                                                                the property.
  The general rule that applies to this situation and                        The lender and the independent consulting
others like it is that there is no single solution. In or-                   firm also will want to understand: (i) the mar-
der to determine the best course of action once a guar-                      ketplace in which the property is located, (ii)
antor group realizes that it owns an asset that is worth                     the competition within the marketplace, (iii)
substantially less than the debt owed to the lender, the                     the competitive advantages and disadvantages
group needs to evaluate all factors relevant to the                          of the property, and (iv) how the operator is
group’s situation. This is exactly what the lender will                      marketing the property in order to ensure that
be doing, and if it is not, then this will allow the guar-                   the operator is maximizing the strengths and
antor group to be one step ahead of the lender.                              minimizing the weaknesses of the property.
                                                                             The goal in all of this is to show the lender
    The Property. One of the primary concerns of                             and the independent consulting firm that the
    the lender, if not the most significant concern,                          operator fully grasps the seriousness of the
    is evaluating whether the current owner/                                 situation that it is in, that the plan is well
    operator is the right person to carry out the                            thought out and well reasoned, and that the
    day-to-day operations at the property. If the                            plan has a realistic chance of success within a
    loan is in default, the lender has the right to                          time frame that is acceptable to the lender.
    foreclose on its mortgage and legally compel
    the removal of the operator or put a receiver                            The Loan Documents. Each guarantor should
    in its place. To the extent that the operator is                         review the loan documents, ideally with the
    also a guarantor, he or she has an interest in                           assistance of an attorney, to assess the nature
    retaining his or her position as the operator so                         and extent of the guarantor’s liability to the
    that s/he can maintain and improve the collat-                           lender. In particular, each guarantor should re-
    eral value of the property, thereby minimiz-                             view and confirm the terms of the guaranty
    ing, and, with any luck, avoiding, any liabil-                           document. For instance, the guarantor should
    ity under the guaranty. For this reason, it be-                          determine whether a guaranty is a guaranty of
    hooves the operator to stay in frequent contact                          payment and performance, or just a guaranty
    with his or her lender once a loan goes into                             of collection. Upon a default by the borrower,
    default, and to be responsive to the lender’s                            a guaranty of payment and performance cre-

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                                                          ISSN 8755-0628
ates an obligation on the part of the guarantor                           anties is, if multiple guaranties were delivered
regardless of whether the lender has pursued                              to the lender, it is possible that the action of a
collection from the borrower. A guaranty of                               co-guarantor or the borrower (which may not
collection binds the guarantor only after all                             be controlled by the guarantor) may cause a
attempts to obtain payment from the borrower                              guarantor to become liable under its guaranty,
have failed.                                                              including potentially becoming fully liable for
Each guarantor should also review its guar-                               the entire loan balance. These dynamics
anty document to determine the extent of the                              should be fully understood by the guarantor
liability to the other guarantors. For example,                           when deciding its next steps with respect to
a joint and several guaranty among all guar-                              the lender and the co-guarantors.
antors means that the lender can pursue any                               If a limitation does exist, the guarantor should
one or all of the guarantors for the full                                 determine the scope of the limitation, as it
amount owed to the lender. A guaranty that is                             most likely will play a role in determining the
several, but not joint, means the lender can                              guarantor’s strategy for dealing with the
pursue each guarantor for only its respective                             lender. For example, if a guaranty is limited
obligation. This is most common in syndi-                                 to a certain amount of principal plus corre-
cated or participant loans. A guaranty also                               sponding interest, plus any fees incurred by
may be limited in any number of ways, in-                                 the lender to collect such amounts, one strat-
cluding: (i) a maximum dollar amount, (ii) a                              egy may be for the guarantor to propose to
certain amount of time, (iii) a specified event,                           pay the limited portion of the principal
such as a threshold occupancy or percentage                               amount in full in exchange for complete for-
of the property sold, or (iv) certain ‘‘bad boy’’                         giveness of the interest and fees incurred by
acts of the guarantor, such as fraud, bank-                               the lender. Ultimately, the decision whether to
ruptcy, mishandling of project funds, or mis-                             remit payment to the lender depends upon a
representation concerning the loan (all of                                number of factors, including: (i) the value of
which are discussed in more detail below). In                             the collateral relative to the outstanding bal-
the absence of any limits, typically the guar-                            ance of the loan, (ii) the financial position of
anty is with full recourse to the guarantor                               the guarantor, (iii) the financial position of the
without exception. In addition, in many real                              other guarantors, and (iv) the existence or
estate deals, each guarantor will be held fully                           nonexistence of a contribution agreement.
responsible for environmental liabilities (no                             The lender’s financial position also plays a
matter the limitation of the guaranty), so the                            part in the guarantor’s strategy. In today’s en-
extent of this potential liability will need to be                        vironment, many financial institutions are tak-
fully evaluated if there are environmental                                ing their last gasps and trying to get as much
concerns with the property.                                               money in the door as they can as fast as they
When reviewing ‘‘bad boy’’ guaranties, it is                              can, which may put the guarantor group in a
important to understand fully the circum-                                 better position to minimize its risk.
stances that convert the obligation to a full re-                         Rights and Obligations Among Guarantors
course guaranty. For instance, a misrepresen-                             Under the Partnership Documents. In many
tation of the guarantor’s financial position                               cases, the guarantors will have entered into an
could trigger the guaranty to become full re-                             operating agreement or some other type of
course. If this is the case, the guarantor should                         partnership agreement, which sets forth vari-
be extremely careful to make sure that it is                              ous rights and obligations with respect to each
fully and accurately disclosing all of its assets                         other and will greatly affect the outcome of
and liabilities. To the extent the document                               the guarantors’ negotiations with the lender
holds the guarantor liable for items such as                              and with each other. For instance, the partner-
the return of security deposits to the lender,                            ship documents might specifically address the
prepaid rent, real estate taxes, and insurance                            circumstance in which the guarantors become
proceeds, the guarantor should make sure that                             personally liable to the entity’s lender. If this
it adheres to the strict requirements of the                              is the case, the partnership documents might
guaranty and that appropriate procedures ex-                              identify the responsibility of each guarantor
ist to ensure that the party responsible for                              as to the other guarantors and the penalties for
handling the cash for the operator does not                               not complying with such obligations. The
create liability for the guarantor. Another is-                           guarantor obviously needs to be aware of the
sue that arises with ‘‘bad boy’’ limited guar-                            consequences of not complying with the

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                                                       ISSN 8755-0628
    terms of the partnership documents. It is also                           decision-making authority on behalf of the
    important for the guarantor to understand that,                          borrowing entity. Sometimes the partnership
    subject to any legal limitations that might ap-                          documents permit the removal of a decision
    ply by operation of law, the partnership docu-                           maker. If such a provision exists, it should be
    ments govern the rights and obligations                                  carefully reviewed and evaluated by each
    among the guarantors themselves, but not the                             guarantor before negotiations with the lender.
    relationship between the guarantors and the                              It may become readily apparent that interest
    lender. Accordingly, the guarantors must keep                            of the decision maker of the borrowing entity
    in mind both the rights and obligations pro-                             is not necessarily aligned with the interest of
    vided for in the partnership documents and                               the guarantor group as a whole. One example
    how those rights and obligations come into                               is where the decision maker happens to be an
    play in light of any action the lender may take                          individual who has little or no personal assets
    against the guarantor group. For instance, the                           but is entitled to tremendous gain if the
    partnership documents may provide that each                              project can be repositioned. This decision
    guarantor is responsible for a share of the ul-                          maker has incentive to take greater risks to
    timate liability to the lender consistent with                           position the project, such as incurring addi-
    its investment interest in the entity. However,                          tional indebtedness on behalf of the borrow-
    if the guarantors have executed joint and sev-                           ing entity, on the premise that he or she has
    eral guaranties with the lender, the lender will                         nothing to lose. This places the other guaran-
    likely pursue all guarantors and seek payment                            tors in a dangerous position. Even if the oper-
    from any guarantor that has the financial ca-                             ating agreement does not provide for the re-
    pacity to make the lender whole, in which                                moval of the decision maker, it may be appro-
    case the rights and obligations of each                                  priate for the guarantor group to discuss an
    member/guarantor under the partnership                                   amendment to the operating agreement that
    documents come into play only after the                                  will allow for greater participation by the
    lender has collected all of the indebtedness                             guarantor group as a whole in decision-
    owed to it.                                                              making.
    Another issue that is likely to be addressed in
    the partnership documents is who controls the                            Contribution Rights Under Common Law.
    decision-making of the borrowing entity. This                            Carefully drafted partnership documents are
    is particularly relevant because, in a typical                           also important with respect to the rights and
    real estate transaction, each guarantor is re-                           obligations a co-guarantor may have against
    quired to be responsible for the obligations in-                         the other co-guarantors so as to not leave the
    curred by the borrowing entity, no matter                                remedies up to the courts. Even if the guaran-
    whether that guarantor participated in the cre-                          tors have not entered into an express agree-
    ation or modification of those obligations. For                           ment setting forth their respective responsibil-
    instance, the borrowing entity is the party                              ity for a jointly and severally guaranteed debt,
    that, with the lender’s consent, has the right to                        the law (at least in Illinois) provides a com-
    extend the loan, increase the indebtedness in-                           mon law right of contribution. Under this
    curred by the borrowing entity, make day-to-                             right, the co-guarantors become liable to con-
    day decisions concerning the property such as                            tribute their proportionate share of the amount
    whether or not to pursue a particular tenant at                          paid, provided a co-guarantor is not insolvent,
    the property, and if so, on what terms, and                              in which case the insolvent co-guarantor is
    whether or not to sell the property, potentially                         not included in determining the proportions.
    for an amount less than the indebtedness                                 As a general rule, the right to contribution
    owed to the lender. All of these events can                              does not arise unless and until there is a de-
    greatly impact the liability of each individual                          fault (as determined by the underlying loan
    guarantor. A properly drafted guaranty would                             documents). When given the choice, a guar-
    not allow a guarantor to escape liability sim-                           antor should always try to control the situa-
    ply because the guarantor did not participate                            tion itself, rather than leaving the outcome to
    in a particular decision of the borrowing en-                            the discretion of a judge.
    tity or perhaps was unaware that the decision
    was even made, and in most cases will ex-                           Discussions with the Lender
    pressly disclaim these types of defenses. Ac-                         Once they understand their position, the guarantors
    cordingly, in many regards, the guarantor be-                       need to consider how best to approach the lender.
    comes beholden to the parties who have                              What can you say to a lender? When and how do you

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                                                          ISSN 8755-0628
get your attorney involved? Does each guarantor need                       Contractual rights to indemnification also
his/her own counsel? These are very important ques-                        may dictate a particular guarantor’s interest in
tions that can have a huge impact on the discussions                       how it addresses the default status of the loan.
among the guarantors themselves and ultimately with                        For instance, the lender may be willing to
the lender.                                                                agree to lend additional money to the project
    What can you say to a lender? Best practices                           to perhaps fund tenant improvements, bro-
                                                                           ker’s commissions, and other necessary oper-
    dictate that you mark any written communica-
                                                                           ating costs, on the condition that the guaran-
    tion to the lender with ‘‘For Settlement Dis-
                                                                           tors provide a certain amount of capital to-
    cussion Purposes Only.’’ Although offers of
                                                                           ward the project or provide additional
    settlement or compromise generally are not
                                                                           collateral. A contribution agreement among
    admissible at trial to prove liability, such of-                       the guarantors may require one guarantor to
    fers can be admissible if the statements made                          be responsible for only a small fraction of the
    by a party during settlement negotiations are                          amount of the total capital required by the
    inconsistent with that party’s position during                         guarantors as a whole, whereas the same con-
    the trial, or if the statements are being used to                      tribution agreement may require a substantial
    prove the existence of a binding settlement                            contribution by another guarantor. The guar-
    agreement. Furthermore, to the extent that a                           antor who is required to contribute only a
    statement made during settlement negotia-                              small portion of any required capital from the
    tions is used to show something other than li-                         lender may be best served by funding his
    ability, such as witness bias, the statements                          share and advocating that the other guarantors
    would be admissible within the discretion of                           fund their respective shares, on the premise
    the judge.                                                             that his interests are best served if the project
   When and how do you get your attorney in-                               is recapitalized by the guarantors collectively
   volved? The decision to engage an attorney to                           and he is responsible only for a smaller por-
   represent the guarantor group in its interac-                           tion of such recapitalization. On the other
   tions with the lender once the loan is in de-                           hand, a guarantor who, pursuant to the contri-
   fault is also more complicated than one might                           bution agreement, is responsible to fund the
   think. This decision gives rise to the question                         significant portion of such recapitalization
   of whom that attorney is representing when                              may view the lender’s request for additional
   the attorney is engaged by the group. Al-                               capital or collateral as throwing good money
   though the guarantor group has a common in-                             after bad, particularly if such guarantor has
   terest in navigating its way out of a defaulted                         limited liquid funds, and, therefore, he or she
   loan and minimizing its group liability to the                          may prefer to resist the lender’s request for
   lender, the guarantors may have different                               additional capital or collateral.
   agendas with respect to that process, and there                         Accordingly, even when one might think that
   also may be legal conflicts of interest among                            the guarantors’ interests are aligned, there are
   the guarantors. For example, similar to the is-                         several circumstances in which the interest of
   sues related to the decision maker discussed                            the guarantors and how they may want to
   above, one or more guarantors with little or                            handle a particular demand may differ. This
   no assets may wish to negotiate an extension                            issue highlights the importance of the
   of the loan and incur additional indebtedness                           decision-making on behalf of the borrowing
   on the basis that they can still realize an up-                         entity. If decision-making is based on a ma-
   side in the property even if their equity is                            jority of ownership, and ownership of the en-
   worthless. Conversely, a few guarantors may                             tity was consistent with the sharing percent-
   desire to turn the keys of the property over to                         ages set forth in the contribution agreement,
   the lender because they don’t believe there is                          the guarantor who is responsible for the most
   any upside that warrants their continued in-                            significant portion of the recapitalization
   volvement. Other guarantors with assets may                             might be able to dictate that the borrowing
   not want to increase their liability, especially                        entity would not agree to any such amend-
   if they have lost confidence in the property or                          ments. While it is important to point out that
   its operator. Such guarantors may be inclined                           decision-makers in the borrowing entity likely
   to continue to work with the lender, rather                             have a fiduciary duty to the borrowing entity
   than lose considerable sums under the guaran-                           and its owners, which requires that the deci-
   ties, because they know they cannot collect                             sions makers make decisions in the best inter-
   against their co-guarantors.                                            est of the borrowing entity and its owners,

                                             Tax Management Real Estate Journal
                             2009 Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.                    5
                                                        ISSN 8755-0628
    that decision-making authority likely would                               er’s promise to make certain discreet loan ad-
    be protected by the business judgment rule.                               vances toward the property.
    As long as such decisions are premised on                                 When a guarantor is asked to update his or
    valid business reasons, which typically are                               her personal financial statement with the
    not difficult to establish, the decision-maker                            lender, the guarantor needs to be very careful.
    will be protected.                                                        The act of delivering financial information to
    Does each guarantor need its own counsel?                                 the lender, in and of itself, creates liability on
    Given the conflicts that can arise among the                               the part of the guarantor to the lender. For in-
    guarantors as a whole, it may be prudent for                              stance, to the extent that the guarantor pro-
    each guarantor to retain separate counsel to                              vides inaccurate or incomplete information to
    make sure that individual best interests are                              the lender, it may be liable to the lender or
    being served. This counsel not only can ad-                               fraud or misrepresentation. The guarantor
    vise the guarantor on its rights with respect to                          should be particularly concerned about being
    each of the guarantors, but also can assist the                           accused of committing fraud and causing the
    guarantor on more personal matters, such as                               lender to incur additional debt on the basis of
    asset protection planning. Any asset protec-                              fraud, which may preclude the guarantor from
    tion that would take place in light of liability                          obtaining a discharge in a later filed personal
    posed by the guarantor’s guaranty to the                                  bankruptcy. In addition to common law theo-
    lender must be conducted subject to appli-                                ries of fraud and misrepresentation, the guar-
    cable fraudulent conveyance laws. To the ex-                              antor needs to be mindful of the representa-
    tent the guarantor has assets that exceed the                             tions, warranties, and covenants set forth in
    guarantor’s contingent liabilities, there is still                        the form of personal financial statement itself.
    an opportunity to protect those assets. The                               Almost every form of personal financial state-
    guarantor’s counsel can also assist the guaran-                           ment contains representations and warranties,
    tor in determining whether or not to submit an                            such as a guarantor’s warranty that all infor-
    updated personal financial statement to the                                mation provided is true and complete.
    lender, which is worth discussing in more de-                             One particularly important item disclosed in
    tail.                                                                     the personal financial statement is the manner
    Updating Your Personal Financial State-                                   in which the guarantor’s assets are titled. The
    ment. Once a loan goes into default, a lender                             guarantor should clearly identify how assets
    will want to evaluate all information relevant                            are titled, such as whether assets are titled in
    to the loan, including the creditworthiness of                            LLCs or other entities. For example, a lender
    the guarantors. Accordingly, the lender likely                            will attribute more value to an asset that is
    will ask the guarantor group to provide up-                               titled in a guarantor’s name than to an asset
    dated financial statements and each individu-                              that is titled in an LLC owned by the guaran-
    al’s most recently filed tax return. One impor-                            tor. If the asset were titled in the individual’s
    tant factor that will dictate how a lender will                           name, the lender could seize upon the asset
    handle a particular defaulted loan is the cred-                           once it obtains a judgment against the guaran-
    itworthiness of the guarantor group as a                                  tor. If the asset is held through an LLC, gen-
    whole. If, for instance, the lender were to de-                           erally the lender can obtain only a ‘‘charging
    termine that the guarantors had little or no as-                          order’’ against the guarantor’s economic inter-
    sets for the lender to pursue, the lender might                           est in the LLC, unless the LLC is a single
    be less inclined to try to exact any type of                              member LLC, in which case some courts
    specific performance from the guarantor                                    have allowed the lender to seize all of the
    group on the basis that guarantors may rea-                               guarantor’s membership interests of the LLC
    sonably believe that there is little downside to                          and in turn the assets of the LLC. A charging
    not complying with the lender’s demands. If,                              order entitles the lender to payment of its
    on the other hand, the lender believes that the                           claim out of distributions otherwise payable
    guarantors have significant assets from which                              to the guarantor/member; however, it does not
    to recover all or a portion of the guaranteed                             entitle the lender to any other rights of a
    indebtedness, the lender is more likely to use                            member, such as the right to force a distribu-
    that leverage to compel certain performance                               tion or liquidation. Further complicating a
    by the guarantor group, including recapitaliz-                            lender’s position is the position that a charg-
    ing the property or providing additional col-                             ing order requires the lender to reflect the
    lateral to the lender in exchange for the lend-                           member’s share of LLC income, if any, on the

                                                Tax Management Real Estate Journal
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                                                           ISSN 8755-0628
    lender’s tax return. If this position is held to                   come tax effect. However, the payment will increase
    be valid, the lender may be required to recog-                     the guarantor’s basis in his or her interest in the bor-
    nize income as a result of the charging order,                     rower. If the payment is deductible by the guarantor
    without the ability to force a cash distribution                   as a bad debt, the character of the deduction will de-
    to cover such tax liability. In a closely held                     pend on whether the bad debt is treated as a business
    company, generally it is not difficult for the                     bad debt or a nonbusiness bad debt. A business bad
    manager or member, as applicable, to with-                         debt is deductible against ordinary income whether or
    hold distributions or at least minimize LLC                        not the debt is totally or partially worthless. A non-
    distributions while a lender holds a charging                      business bad debt is deducted as a short-term capital
    order. This affords the guarantor/member sig-                      loss and must be totally worthless. The character of
    nificant leverage in negotiating with the                           the bad debt deduction as a business bad debt or a
    lender compared to the situation where the                         nonbusiness bad debt will depend on whether or not
    guarantor owns the asset in its own name. Ac-                      the obligation was made in connection with the guar-
    cordingly, the guarantor should be careful to                      antor’s trade or business. This determination is highly
    make sure it is disclosing assets held in LLCs,                    dependent on the particular facts and circumstances.
    because such disclosure can significantly af-                       However, if the main purpose of the guaranty was to
    fect the lender’s evaluation of the guarantor’s                    protect or increase the guarantor’s investment in the
    creditworthiness. Given the potential liability                    borrower, the bad debt will be considered a nonbusi-
    created by the delivery of the personal finan-                      ness bad debt. In any event, to the extent that there is
    cial statement itself and the important role                       a right of subrogation against other guarantors, the
    that the personal financial statement may play                      bad debt deduction may not be taken until such right
    in dictating the lender’s decision to extend the                   becomes worthless.
    loan, on the one hand, or call the loan, on the                       Regardless of whether the borrower transfers the
    other hand, the guarantor should consult with                      property to the lender by giving the lender a deed in
    an attorney when completing the personal fi-                        lieu of foreclosure or the lender forecloses on the
    nancial statement and should confirm, in con-                       property, the transfer of the property to the lender is
    sultation with an attorney, that, from a strate-                   treated for tax purposes as a sale of the property to the
    gic standpoint, it makes sense to deliver a per-                   lender, and the borrower will recognize income or loss
    sonal financial statement.                                          to the extent that the outstanding balance of the debt
                                                                       exceeds the borrower’s basis in the property. How-
Tax Considerations                                                     ever, if the debt is considered recourse debt as a result
                                                                       of the guaranty, the borrower may recognize COD in-
   Further complicating the negotiations with the
                                                                       come (unless one of the exceptions applies) equal to
lender are the tax effects of any proposed modifica-
                                                                       the difference between the principal amount of the
tions to (or cancellation of) the loan documents. The
                                                                       debt and the fair market value of the property. In such
tax concepts surrounding this type of default scenario
                                                                       a case, the borrower would also recognize gain or loss
are complex and vary greatly depending on the facts.
                                                                       equal to the difference between the fair market value
Another issue also may need to be determined on an
                                                                       of the property and the borrower’s basis in the prop-
individual basis. However, the following summarizes
                                                                       erty. If this transaction results in a capital loss to the
the basic tax concepts involved.
                                                                       borrower, and the borrower does not have sufficient
   If the lender agrees to reduce the principal balance                capital gains to offset this capital loss, this could re-
of the loan, this principal reduction will result in the               sult in the borrower paying income tax on the ordi-
recognition of cancellation of debt (COD) income to                    nary COD income and leaving the borrower with a
the borrower, such income taxable as ordinary income                   currently nondeductible capital loss.
in an amount of the principal reduction, unless one of
the exceptions applies. The exceptions that are most
likely to apply are the bankruptcy, insolvency, or                     Conclusion
qualified real property business indebtedness excep-                       Unfortunately, it seems that every day, another real
tions. Note that if the borrower is a partnership or an                estate deal goes bad. Every investor hopes that it is
LLC taxable as a partnership, insolvency is tested at                  not their deal that does, but if so, there are steps that
the partner or member level.                                           an investor can take to minimize the damage. Al-
   The amount paid by the guarantor on its guaranty                    though the facts of every deal are different, the key is
either will be treated as a capital contribution by the                to apply to those facts the legal and tax considerations
guarantor to the borrower, or will be deductible by the                that are addressed in this article with respect to the
guarantor as a bad debt. If the payment is treated as a                lender and the other guarantors, so that the best pos-
capital contribution, the payment will not have any in-                sible strategy can be determined and the precarious

                                              Tax Management Real Estate Journal
                              2009 Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.                   7
                                                         ISSN 8755-0628
situation in which an investor may find itself can be
resolved in a manner that is beneficial to all parties.

                                             Tax Management Real Estate Journal
8                            2009 Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.
                                                        ISSN 8755-0628