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 [email protected].
