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Panel: Update on tax issues impacting private
equity real estate funds
Moderator: Harry Shannon, Tax Principal, Global
Real Estate Group, Ernst & Young LLP
Panel Members:
Erica Herberg, Principal, The Carlyle Group
David S. Miller, Partner, Cadwalader,
Wickersham & Taft LLP
Case Study
Managers Investors
Real Estate
U.S. Investors Offshore
Private Equity Fund
hedge
funds and
CLOs
• Assume that the
Mezz
mezzanine loan will soon Borrower Mezz Lenders
default and is probably LLC
Mezzanine
Loan
worth about $.50/$1.00
REMIC
• The PE fund would like to Property
Owner Senior Lenders
restructure the loan in a LLC
Mortgage
tax-efficient manner
USActive 17418885.1 Property
Tax Considerations
Tax Issues for the PE Fund and Its Investors
• Cancellation of Indebtedness (COD) Income if the Debt Is
Cancelled
• Gain Upon Foreclosure (Difference between Face Amount of
Debt and Basis in Property) if the Property is Foreclosed
Tax Issues for Offshore Hedge Fund and CLO Investors
• Trade or Business Issues if Debt Is Restructured
• FIRPTA, Trade or Business, and Withholding Issues if
Foreclosure
Tax Issues for the REMIC
• Ensuring that its mortgages remain “qualified mortgages”
Avoiding COD Income
Modify the Debt in a Manner that Does Not Give Rise to a
Taxable Exchange for Tax Purposes
• Temporary Forbearance
– Two years following the issuer’s initial failure to perform
– Any additional period during which the parties conduct good
faith negotiations or during which the Issuer is in a title 11 or
similar case
• Defer Payments; Extend Maturity
– Scheduled payments may be deferred for a period that begins on
the original due date and extends for a period equal to the lesser
of five years or 50% of the original term of the debt instrument
• Change the Yield
– The yield of the modified instrument may be changed so long as
it varies by no more than the greater of:
• ¼ of one percent (i.e., 25 basis points) or
• 5% of the annual yield (0.05 x annual yield)
Avoiding COD Income (cont’d)
• Change the Collateral
– Recourse loan: Collateral may be released, substituted,
added, or altered, or a guarantee or other credit
enhancement added, so long as the change does not
change payment expectations
– Nonrecourse loan: Cannot release, substitute, add or
otherwise alter a “substantial amount” of the collateral
for, or provide a guarantee or add credit enhancement, for
a nonrecourse loan. However, collateral may be
substituted if the collateral is fungible or otherwise of a
type where there particular units pledged are unimportant
Avoiding COD Income (cont’d)
Rely on the “Privately-Traded” Debt Rules
• If the debt is not publicly traded, modify the terms of debt (i.e.,
extend maturity, provide for PIK interest, reduce interest rate to AFR),
but do not change the principal amount
• To avoid being publicly traded, debt must not
– be listed on a national securities exchange,
– be listed on an “interdealer quotation system,”
– be listed on certain foreign exchanges or boards of exchange, or
– appear on a “system of general circulation” that provides a
reasonable basis to determine fair market value by
disseminating recent price quotations of one or more identified
brokers, dealers or traders or actual prices of recent sales
transactions
• Debt-for-tax issues
– If the modified loan does not constitute debt-for-tax purposes,
then COD income will arise
Avoiding COD Income (cont’d)
Have an “Unrelated Party” Acquire the Debt at a Discount
Managers Investors
Real Estate
Private Equity Fund
U.S. Investors Offshore
hedge
• If the PE Fund were to buy REIT funds and
the mezzanine loan for CLOs
$.50/$1.00, the REIT would Mezz
Borrower Mezz Lenders
realize COD income under LLC
Mezzanine
Loan
the “related party” rules of
section 108(e)(4) REMIC
Property
Owner Senior Lenders
LLC Mortgage
Property
Avoiding COD Income (cont’d)
Have an “Unrelated Party” Acquire the Debt at a Discount
Managers Investors
Real Estate
Private Equity Fund
• Two corporations are not Irish section
treated as “related parties” so 110 company REIT
long as five or fewer individuals
Interest
do not own 50% or more of the
value of each Mezz
Borrower
Mezzanine
• An Irish section 110 company Loan LLC
or Luxembourg securitization
company that qualifies for U.S. REMIC
treaty benefits is needed to Property
avoid 30% U.S. withholding tax Owner Senior Lenders
on interest. (The REIT and the LLC Mortgage
Irish/Lux company are related
for portfolio interest purposes.) Property
Avoiding COD Income (cont’d)
Have an Unrelated Party Acquire the Debt at a Discount and
Enter Into a Total Return Swap with the Owner of the Borrower
Managers Investors
Investment
Real Estate
Bank Total Return
Private Equity Fund
Swap
REIT
Mezz
Borrower
Mezzanine LLC
Loan
REMIC
Property
Owner Senior Lenders
• Risk that PE fund is treated as the “tax LLC Mortgage
owner” of the mezzanine loan (which would
cause the REIT to realized COD income). Property
Section 108(i)
• For debt cancelled in 2009 or 2010:
– COD income is deferred until 2014 and
– Then included ratably in each year from 2014 to 2018
Section 108(a)
• If a taxpayer is insolvent or bankrupt, COD is not
recognized, but tax attributes (NOLs, basis) are reduced on
a dollar-for-dollar basis. (But if a partnership is the
borrower, section 108(a) is applied at the partner level (i.e.,
the partners have to be insolvent or bankrupt).)
COD Versus Realization for
Nonrecourse Debt
• A foreclosure on nonrecourse debt is treated as a sale of the
property for the face amount of the debt.
• Assume that the debtor has $100 basis in property that is
subject to $90 of debt and the property is now worth $50
– If $40 of debt is cancelled, the taxpayer realizes $40 of
COD income
– If the creditor forecloses on the property, the taxpayer
has a $10 capital loss and no COD, even though the
foreclosure is the economic equivalent of the cancellation
of $40 of debt and a sale of the property for $50 (i.e., $40
COD and $50 capital loss)
Tax Issues For Offshore Hedge Funds and
CLOs
Workout Activity
• The IRS takes the position that origination activities cause an
offshore fund or CLO that has a U.S. manager to be engaged in
a “trade or business” in the United States and subject to U.S.
corporate income tax.
IRS Office of Chief Counsel Memorandum (September 22, 2009)
• A workout that gives rise to a taxable event under section 1001
is treated as a redemption of the original loan and an
origination of the modified loan.
• Working out a nonperforming loan will generally increase its
value; the increase in value is entirely attributable to services
performed in the United States (as opposed to changes in the
credit of the borrower or changes in market conditions).
Tax Issues For Offshore Hedge Funds and
CLOs (cont’d)
• Risk for offshore hedge fund or CLO
– Least risk if the fund purchased a performing loan that
was not expected to default, the debtor subsequently
defaulted, and the U.S. manager is negotiating or
agreeing to a workout to preserve its investment
– Most risk if the fund purchases the loan when it is
distressed in order to work it out and sell it at a profit.
Tax Issues For Offshore Funds and CLOs
Owning Real Estate
• Income from the real estate subject to a 30% withholding tax
or 35% net income tax
• Gain on the sale of the real estate (measured from its value
on the date of foreclosure) subject to 35% net income tax
• Many offshore funds are prohibited from directly owning real
estate
• If an offshore fund owns an interest in U.S. real estate, the
real estate will often be held in a U.S. “blocker” corporation
(and the fund may, in turn, hold this U.S. corporation through
a foreign “blocker” corporation)
Tax Issues For Offshore Funds and CLOs
Owning Real Estate (cont’d)
Foreign Fund
Cayman “blocker” corporation
U.S. “blocker”
corporation
Interest in
U.S. real property
Tax Issues For REMICs That Hold
Distressed Real Estate Loans
• If a REMIC agrees to a “significant modification” of a
mortgage loan when the loan is not in default or default is not
“reasonably foreseeable,” the mortgage may fail to be a
qualified mortgage, which could jeopardize the REMIC’s
status as a REMIC. A REMIC’s governing documents may
have other (non-tax) limitations on modifications.
– Revenue Procedure 2009-45 (September 15, 2009)
expands the definition of “reasonably foreseeable”
default and provides that a mortgage may be modified
without losing its status as a qualified mortgage if there is
a “significant risk of default” upon maturity or before
based on a “diligent contemporaneous determination
(including credible written representations from the
borrower).” The risk of default may be a year (or possibly
later) in the future.
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