tax notes federal
NEWS ANALYSIS
Underwater Like-Kind Exchanges
by Lee A. Sheppard
As the coronavirus lockdown drags on, nearly
every kind of commercial real estate except for
warehouses and distribution centers is a short. We
previously reported that Carl Icahn was shorting
CMBX 6, a commercial mortgage bond derivative
contract that tracks a lot of malls. Savvy investors
are now looking at CMBX 9, which tracks a variety
of commercial mortgage bonds, including issues
with hotels and apartments as collateral.
CMBX indexes are naked credit default swaps
for commercial real estate mortgage bonds. These
IHS Markit products allow investors to track
various tranches of 25 issues of mortgage-backed
securities in each index. Short investors can buy
protection by paying premiums, while long
investors pay no premiums but promise to insure
that protection. And yes, the lowest tranches of
some CMBX indexes have incurred total losses.
CMBX 9 is regarded as a hotel bet because hotels
comprise 17 percent of the collateral for the bonds
it tracks. The index includes bonds backed by the
Starwood Extended Stay portfolio.
Starwood was recently acquired by Marriott
International, the world’s largest hotel chain.
Marriott CEO Arne Sorenson believes that April
was the trough in hotel occupancy, but said a
small uptick in leisure travelers driving to close
destinations is not enough to bank a recovery on.
Marriott just permanently closed its brand-new
Times Square Edition hotel — right across the
street from another large Marriott property that is
a popular conference and tourist facility. Analysts
expect about 20 percent of New York hotel
capacity to be permanently removed and
converted to other uses.
Hotel occupancy is currently 40 percent — just
breaking even for higher-end lodgings. Business
travel is done. The videoconferencing capability
that should have killed it off years ago is now in
wide use. Many companies that don’t have to sell
products in person will never return to big travel
TAX NOTES FEDERAL, JULY 6, 2020
budgets. Our readers know this because they’re
grounded, their conferences were canceled, and
they’re looking at this article in between Zoom
meetings and GoToWebinars. Some readers don’t
ever want to go back to their downtown offices. So
what do the owners of those underwater
properties do with them?
Like-kind exchanges are a time-honored way
for real estate owners to defer gain on dispositions
of commercial properties. But this tax benefit is
not just for properties with old-fashioned capital
appreciation. Some planners find a way to use it
when the disposition consists of throwing the
keys to the lender. That was the subject of
discussion led by Brian O’Connor of Venable at
the recent 2020 Federal Real Estate and
Partnerships Tax Webinar hosted by the NYU
School of Professional Studies Division of
Programs in Business.
Background
A like-kind exchange has straightforward
requirements that are not easy for owners of
underwater properties to meet. There has to be an
exchange, the transferred property must be
qualifying real property, the replacement property
must be of like kind, and both the transferred and
replacement property must be held for use in a
trade or business or for investment (section
1031(a)). When the transferred property is
underwater, the qualifying property and
exchange elements are the most difficult to meet.
Boot on the exchange is taxable (section
1031(b)). Net relief from liabilities is taxable as
boot (reg. section 1.1031(d)-2). The basis of the
replacement property equals that of the
transferred property, increased by liabilities
assumed, gain recognized, or cash paid (section
1031(d)). If the transferor’s basis in the underwater
property is greater than fair market value, it will
have to do something to equalize the values in the
exchange; otherwise it will have to recognize boot.
Like-kind exchanges have been turbocharged
by statutory permission to use deferred
exchanges, intermediaries, and cash escrow
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HIGHLIGHTS
principal amount would be COD income, which
could be sheltered by an exception (section 108).
Nonrecourse real estate loans typically have
covenants that, when violated, cause the loan to
be converted to recourse status. Called “bad boy”
covenants, these provisions cover acts like
bankruptcy of the owner and nonpayment of real
estate taxes. Bad-boy covenants can be viewed as
contingent liabilities. So the recourse nature of the
converted loan may not be recognized for tax
purposes until the lender seeks to enforce the loan
as recourse. That is, just breaching a bad-boy
covenant may not be enough.
The Times Square Edition goes dark. (John Nacion/STAR
MAX/IPx)
(section 1031(a)(3)). A replacement property is not
going to be easy to find for an owner wanting to
dispose of a property with a billion-dollar
mortgage on it. In a big-money deal, there is
usually a deferred exchange handled by a
qualified intermediary (reg. section 1.1031(k)1(g)(4)).
Property being property, there would be
recording and transfer tax issues on an outright
transfer to the intermediary. So when a qualified
intermediary is used, the transferor usually
makes an assignment of all of its rights in the
proceeds of a sale contract to the intermediary,
with notice to affected parties, rather than making
a formal conveyance of the property itself to the
intermediary (reg. section 1.1031(k)-1(c)(4)(v)).
Taxpayers typically assign contracts to the
intermediary, which closes on the contracts and
transfers the properties to the buyer and seller,
which complete the title transfers. Participants
speak in terms of sale and purchase prices.
When a property is worth less than loan
principal, and the loan is nonrecourse, tossing the
keys back to the lender will result in capital gain
to the borrower. When there is a foreclosure or a
deed in lieu of foreclosure, the difference between
the loan principal amount and the FMV of the
property is capital gain (Commissioner v. Tufts, 461
U.S. 300 (1983)). That’s the gain that owners of
underwater property hope to avoid by using a
like-kind exchange.
If the debt were recourse, the difference
between the FMV of the property and the loan
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What Equity?
Does the transferor own anything? Is
whatever the transferor owns considered
qualifying property? This was the question posed
at the NYU conference. The transferor clearly has
no equity in the property.
Practitioners have advanced theories about
what the taxpayer might own. Richard Lipton of
Baker McKenzie theorized that the taxpayer
might be transferring its right to the phantom gain
on the underwater property. After all, in Tufts, the
taxpayer had a big gain despite having no equity
in the property. Section 1031 requires an
exchange; it doesn’t require proceeds or equity.
Lipton suggested that a carefully planned likekind exchange should involve the lender giving a
peppercorn of consideration to the borrower, so
that the latter could transfer the right to that
consideration to the qualified intermediary
(Lipton, “Are Underwater Like-Kind Exchanges
the Answer?” 115 J. Taxation 253 (Nov. 2011)).
However, Lipton and the NYU panelists
noted the analogy to basis in tax-free
reorganizations. Is a like-kind exchange
analogous to a reorganization? Yes. Structurally,
the rules operate similarly. In the reorganization
context, assumption of liabilities is boot, and by
definition underwater property cannot sustain a
basis that includes the debt on it. In a corporation
formation, the amount of the contribution — and
the transferor’s basis in shares received in
exchange — is limited to the FMV of the property
(section 357(c)). And debt assumed in a
reorganization is limited to the FMV of property
transferred (withdrawn prop. reg. section 1.3681(f)). This analogy would dictate that gain
TAX NOTES FEDERAL, JULY 6, 2020
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HIGHLIGHTS
recognition on an underwater transfer is
inevitable.
The IRS seems to have answered the question
whether underwater property can be the subject
of a like-kind exchange in a letter ruling (LTR
201302009). In the ruling, the taxpayer, a
partnership, held the property in a single-member
LLC, which the tax law disregards (section
1031(e)). The taxpayer was preparing to transfer
the underwater property to the lenders, subject to
the nonrecourse loans on it, and had a contract to
that effect. It assigned all its rights in the proceeds
of that contract to the qualified intermediary, with
notice to the lenders.
So the lenders would step into the shoes of the
taxpayer and participate in the like-kind
exchange, and the intermediary would transfer
replacement property with a value equal to the
remaining principal amount of the loans to the
taxpayer. The taxpayer would enter into an
acquisition contract for replacement property and
assign its rights in that contract to the
intermediary. Because the property was
underwater, the taxpayer was expected to make
up the difference in values with cash or debt.
Does the transferor own anything? Is
whatever the transferor owns
considered qualifying property? The
transferor clearly has no equity in the
property.
The IRS ruled that the taxpayer’s assignment
of its rights in the contract to the intermediary
would be a transfer of relinquished property for
purposes of determining whether there was an
“exchange of property held for productive use in
a trade or business or for investment” under
section 1031(a), even though the FMV of property
was less than the principal amount of the
outstanding nonrecourse debt.
Implicit in the ruling is the IRS
acknowledgment that underwater property can
be exchanged, provided something else is
acquired. The IRS expressed no opinion on
whether the transfer otherwise qualified for likekind exchange treatment.
TAX NOTES FEDERAL, JULY 6, 2020
What Boot?
Whether something has been exchanged is a
different question than whether the transferor has
to recognize boot on the exchange. The transferor
wishing to avoid boot has to ensure that the
purchase price of replacement property exceeds
the sale price of transferred property and that all
equity is rolled over, according to Lipton.
How can the transferor ensure that the basis
taken in the replacement property will equal that
of the transferred property? The transferor can’t
be broke to obtain that result in a like-kind
exchange because it will need to have cash or
borrowing capacity to equalize the values of the
two properties. There are flush property owners
that have underwater properties, so it’s not
impossible. But even they might not want to
deploy large amounts of cash to defray taxes.
Well, what if the taxpayer doesn’t have the
cash? The debt overhang on the transferred
property can be matched with debt on the
replacement property if there is no new cash.
NYU panelists and Lipton suggested that the
replacement property could be credit net lease
property encumbered by debt equal to or
exceeding the debt on the transferred property.
Also called “zero cash flow” property or triple net
lease property, the cash flows of such property are
locked down and entirely devoted to debt service.
Lenders like these arrangements, which is why
such properties can carry enormous debt. The
point of having credit net lease property as
replacement property is that the debt would be
included in basis. The lawyers cautioned that the
lease terms should be reviewed carefully.
NYU panelists wondered whether lenders
would cooperate with like-kind exchange
planning involving qualified intermediaries. The
usual drill for such an exchange involves a
transfer of rights in a sale contract to the
intermediary, rather than outright transfer of the
property. But in the underwater situation, there
may be a lender or servicer about to foreclose. In
a normal foreclosure, there is no sales contract.
The lender gets the property. Without the
cooperation of the lender, there is no opportunity
to set up a like-kind exchange if foreclosure
occurs first. If the lender would accept a deed in
lieu of foreclosure, the taxpayer could assign its
obligations under the deed to the intermediary.
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HIGHLIGHTS
Well, what if the lender won’t take a deed in
lieu of foreclosure? What if the original lender
isn’t even in the picture and the institutional
servicer has no power to accept a deed in lieu of
foreclosure on behalf of bondholders? The
borrowers on big securitized mortgages really
have no good way of negotiating with servicers.
Whether something has been
exchanged is a different question than
whether the transferor has to
recognize boot on the exchange.
What if the taxpayer instead transferred the
encumbered property directly to the
intermediary, as the regulations permit? That
transfer may breach a bad-boy covenant and
convert the loan to a recourse loan if the lender
enforces the loan as recourse. Or the transfer may
be a prohibited assignment that would prevent
the taxpayer from passing title to the
intermediary. Lipton pointed out that if the
intermediary received the encumbered property
and the lender then foreclosed, the transaction
would be treated as a sale for the amount of loan
principal, assuming no recourse conversion of the
loan.
NYU panelists wondered what the date of the
transfer for federal income tax purposes would
be. This isn’t a sale that occurs when the benefits
and burdens of ownership pass. State law has a
redemption period during which the foreclosure
transaction can be reversed if the lender recovers
the funds from the borrower, even if the property
had been sold at auction. Case law says that the
transfer occurs at the expiration of the redemption
period. In a Depression-era case, the foreclosure
sale occurred in late October, but the court
sustained the IRS determination that the transfer
took place three months later, into the following
year, when the redemption period expired,
regardless of whether the lender pursued the
borrower (R. Odell & Sons Co. v. Commissioner, 169
F.2d 247 (3d Cir. 1948)).
10
NEWS ANALYSIS
Problems With GLOBE:
Scratching the Surface
by Mindy Herzfeld
The OECD has been highlighting the
purportedly less controversial pillar 2 of its
project on digital economy taxation, following a
letter from Treasury Secretary Steven Mnuchin to
several European finance ministers announcing
an impasse in negotiations over pillar 1. In recent
interviews, OECD Centre for Tax Policy and
Administration Director Pascal Saint-Amans has
emphasized that work on pillar 2 has been
progressing well and is likely to reach some type
of agreement by year-end. (Prior coverage: Tax
Notes Int’l, June 29, 2020, p. 1536.)
But pillar 2 — the global anti-base-erosion
(GLOBE) proposal — has avoided dissent only
because its contours are so vague that there isn’t
enough information to cause controversy. Aside
from a 38-page overview released late last year
requesting comments on one small aspect of the
proposal, no other part of the four-pronged plan,
which includes a global minimum tax and an
outbound anti-base-erosion rule, has seen the
light of day.
Before signing up for a global minimum tax,
inclusive framework members might wish to look
at the 2017 U.S. tax reform for lessons on how a
good policy idea can go bad, especially when
rushed. The United States enacted both a
minimum tax on the foreign earnings of U.S.
multinationals and an outbound base erosion rule
as part of the Tax Cuts and Jobs Act. Although the
global intangible low-taxed income provision
adopted many aspects of proposals for taxing
controlled foreign subsidiaries’ earnings that
were debated for over a decade, the final law was
publicly released only a few weeks before
passage. It is riddled with mistakes, some creating
tax avoidance opportunities, others imposing
unintended hardship on taxpayers. The almost
three years since its passage has required
herculean efforts by Treasury and the IRS to issue
interpretive guidance to help taxpayers comply.
(Prior coverage: Tax Notes Federal, Jan. 14, 2019, p.
156; and Tax Notes Federal, Jan. 21, 2019, p. 266.)
TAX NOTES FEDERAL, JULY 6, 2020
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