Restructuring real estate debt Featured

7:00pm EDT December 26, 2008

Downsized operations or a scarcity of tenants has temporarily left many business partnerships with too much real estate and too much debt. Refinancing is often the solution of choice, but doing so isn’t always viable. Owners may owe more than the property’s current value, or they face a maze of lenders and servicing agents behind highly securitized notes, making it nearly impossible to identify the lender, let alone build a relationship that would favor loan renegotiation. Even if selling the property were an option, partners want to be positioned to resume expansion plans and occupy the space when the economy rebounds.

“Down the road, these businesses will benefit from owning the facilities, but they have to survive in the short term,” says Tom O’Rourke, tax partner with Haskell & White LLP. “Raising capital is tough, so restructuring the debt may be the best option. But there are pluses and minuses to each alternative, so partners should consider each one carefully before proceeding.”

Smart Business asked O’Rourke what partners should know when evaluating options for restructuring real estate debt.

Why is renegotiating the debt terms the best option?

If possible, lengthening the debt terms would be the most expedient solution, because it will reduce the payments now, while giving owners the opportunity to recoup value and utilize the property down the road. But partners must use caution, because what appears to be a simple modification could end up generating forgiveness of debt income, which creates tax implications. The workout needs to be accomplished so that the modified debt issue price is not less than the old debt, which can be a complex calculation. Partners can research the tax impact under the original issue discount calculation provision provided for in IRC §1273 and §1274.

Is raising capital to pay down the debt still possible?

Bringing in a partner who will provide the cash to pay down the instrument or help fund the difference between the original note and the property’s current value for refinancing purposes is an option. Many traditional sources of cash have dried up, so partners will have to be creative and look to institutional investors, pension funds, life insurance companies, and even friends and family who might want to invest. Be aware that infusing capital into an existing partnership may create a step-down in basis under new mandatory basis adjustment rules that are just now having an impact, given the recent losses in real estate values. So model your new structure and plan to protect tax attributes.

Have some owners successfully converted lenders to partners?

If you have a relationship with the lender, selling him or her the debt in exchange for an equity stake in the business is another possibility. Be aware, however, that forgiving debt or cancelling debt is usually treated as income to the partners, unless there’s an exception. The American Jobs Creation Act eliminated the exception of using partnership equity to cancel indebtedness income. Under the revision, the partnership is treated as paying off the debt in exchange for the fair market value of the interest transferred, and the excess principal is forgiven, which creates tax consequences at the partner level. Under some circumstances, where the partnership agreement requires a deficit obligation restoration or guarantee, these gains can be mitigated, but both come with onerous economic considerations. It’s not that bringing in a lender as a partner isn’t plausible; it’s just not a slam-dunk solution because of the tax implications, especially for tax-paying partners.

Should owners consider the option of fore-closure or filing for bankruptcy protection?

Both foreclosure and bankruptcy are options. However, the decision often hinges upon whether the indebtedness was secured through partners’ personal guarantees. When liabilities are reduced or are deemed to be distributions, partners can be charged with the gains, and they’ll have to come up with the cash to pay the additional tax, unless they can find an appropriate exclusion.

What’s most important is that partners consider all options and the consequences of each choice, while considering the long-term business impacts. Though short-term business survival and debt reduction may be the current focus, eventually the economy will turn and partners want to be ready to capitalize on the rebounding market.

TOM O’ROURKE is a tax partner with Haskell & White LLP. Reach him at (949) 450-6358 or TORourke@hwcpa.com.