Archives for February 2023

Buying and lending expectations are in flux in most commercial real estate sectors as investors and lenders plan to significantly reduce their activity in 2023 due to rising interest rates, economic uncertainty, and associated impacts on values, according to a new report from CBRE.

The report senses a cautious mood, and CBRE believes “pessimism may have reached its nadir” when its most recent survey was taken in December.

So much is contingent on inflation and the Federal Reserve’s activity.

It cites the multifamily and industrial sectors as the most preferred by investors and lenders and dynamic secondary markets, particularly in the Sun Belt, are where many are focused.

Lenders rate the industrial and logistics sectors as the most favorable with multifamily second best. Investors flip those two as their top preferred sectors. Both groups were more pessimistic about the office and retail assets.

Nearly 60% of respondents expect to purchase less real estate in 2023, while only 15% expect to purchase more. All are waiting for the Federal Reserve to stabilize rates, which could take well into the year or even into the next.

Inflation & Interest Rate Expectations

The key considerations for buying and lending expectations this year are when inflation will peak and where interest rates will end up, CBRE writes.

“About 50% of investors believe inflation will peak in Q1 or Q2, while 35% believe it has already peaked,” according to the survey.

“Along with high inflation, most investors expect higher borrowing costs. More than 70% of surveyed investors believe the 10-year Treasury rate will exceed 3.75% at year-end 2023.”

Brokerage Firms are Reducing Costs

The next 18 months will show a continued slowdown of capital markets until inflation slows and interest rates come down, Doug Ressler, Yardi Matrix, tells GlobeSt.com “Major brokerage firms are reducing costs and FHFA has reduced the GSE debt cap limits with increased affordability goals,” he said.

Joe Iacono, CEO of Crescit Capital Strategies, tells GlobeSt.com that he expects to see the 10-year rate in the mid-3s by Q4.

“If that happens, borrowing costs will come down a bit from today as the market regains some stability due to the feeling that the fed’s position will be more predictable,” Iacono said.

Waiting for Markets to Stabilize

Adam Weissburg, Partner, Cox Castle, tells GlobeSt.com that regardless of what the peak is, lender activity will be constrained until there is some general agreement as to how many rate increases are on the table.

“The issue for lenders is sizing the loan, which goes to the value of the collateral and needed equity,” he said. “Until rates are stabilized, the market doesn’t know what cap rates to use and how to value collateral. Without that, lenders cannot in turn calculate their loan amount. One would hope the activity will pick up as the Fed makes it clear exactly how many raises, we can all expect.”

PCEP is Key Data Indicator

Kyle E. Scheiner, a partner at Romer Debbas, tells GlobeSt.com that after some premature optimism over microdata presented in January, the truth about inflation still being a concern was highlighted by the release of the January Personal Consumption Expenditures Price index.

This is the Fed’s preferred method of measuring inflation, and it came in at .2% above economists’ expectations.

“While this shows that inflation has not yet peaked, the relatively small miss on expectations shows more of a plateauing of the rate of inflation,” Scheiner said. “This is an encouraging sign for the long-term strategy the Fed is employing, though the inability to solve the issue rapidly will continue to wreak havoc on markets. When this storm passes and we look back to analyze this period, I think we will come to consider Q1 as the overall peak of inflation.

“Unfortunately, the housing market will continue to bear the brunt of the Fed’s policies as a 50-basis point raise is all but virtually certain for the next Fed meeting scheduled in March. Future hikes are also being signaled by the Fed.

Scheiner said that with the 10-year treasury already exceeding 3.75%, it’s hard to envision a scenario in which 2023 does not end with the Note at or higher than the 3.75% level given the appetite amongst the Fed Governors and board to continue rate hikes to get inflation at or below its 2% mandate.

“You could see the 10-year UST rate hitting 4.15% before gradually working its way down as inflation comes down off the plateau, but anything under 3.75% in 2023 will be hard to predict at this stage,” he said.

“Cumulatively, this will continue to have chilling effects on a stale housing market with a perfect storm of factors working against a recovery—homebuyers, especially first-timers, being priced out of the market; sellers locked into mortgages with incredibly low-interest rates who are unwilling to sell and pay 2x-3x the borrowing costs they currently pay; overall higher originating borrowing costs for individuals and investors alike and; the declining value of investments, savings and retirement accounts.”

Fed Will Raise Rates ‘A Quarter Point at Each of Next Two Meetings

Larry Jacobson, president and CEO of Jacobson Equities, tells GlobeSt.com that while inflation appeared to have flattened out on a monthly basis in late 2022, monthly inflation in January jumped 1.8%.

“That surprising increase, coupled with a surge in hiring in January, should put to rest any notion the Fed is done raising rates at this point. It is clear neither the Fed nor economists have a clear picture of when inflation will go down nor when the Fed’s past rate increases will cause the economy to go into recession.

“Economists who track money supply are convinced inflation is headed down, yet even if they are correct that inflation was, in fact, transitory (as a result of excessive government stimulus), tight labor markets could still cause inflation to pick back up again.”

Jacobson said the Fed would likely raise rates a quarter point at each of their next two meetings, but no one should be surprised if one of those meetings results in a half-point bump. It’s conceivable a third-quarter point bump will be in the offing. Rates will continue to rise through 2023 to at least the Fed’s target of 5.25 % to 5.50%.

“The CRE market will continue to be moribund until inflation not only levels off, but begins to fall, and the Fed signals a stop in rate increases,” he said.

Date to Reach Goals Keeps Moving Out Further

Patrick Nutt, executive vice president, SRS Real Estate Partners, National Net Lease Group, Market Leader, South Florida, tells GlobeSt.com, “Regarding inflation peaking, there’s a difference between saying inflation has peaked, i.e. when inflation will fall to 0% or below the target rate for the Fed of under 2%, compared to when the rate of inflation will peak.

“I believe we have already seen that figure peak last year when it was running 9%+ and now stands at 6.4%. I’m expecting inflation to slow as the economy continues to digest the higher rate environment that we are in.”

Nutt said on the interest rate front, “the only consistent thing we have seen is that every time a forecast comes out to predict terminal rates, the rate has moved higher and the date to reach that rate has moved out longer in the year.

“The 10-year treasury is more of a forward-looking rate compared to the 2-year T-bill, so I do expect that to be sub-4% at year-end, but likely still above 3.75%.”

Northmarq Sees Renewed Buyer Engagement

Will Harvey, Northmarq senior vice president, investment sales, tells GlobeSt.com that following a quiet Q4 2022, 2023 has brought renewed buyer engagement to the market.

“With internal capital allocations reset, yield-seeking investors are hunting for accretive opportunities and getting creative on their business plans.

The majority of buyers are willing to underwrite 12 to 18 months of negative leverage for the right deal, as long as there is a path forward to positive returns and a strong residual.

“Investment opportunities with favorable in-place debt (remaining IO, extended term, 60%+ LTV) are being priced well inside of free and clear deals – essentially overpaying for the equity.”

Harvey said that the 50bps runup in rates during February has not deterred buyers from chasing deals but rather adjusted their return threshold. “We’re seeing an uptick in buyer activity on the deal level, coupled with a wider spread in pricing,” he said.

“All cash/generational buyers looking for distress have not been successful given the strong fundamentals and organic property level performance in the multifamily market.

“We’re seeing an uptick in interest in development following the thesis that we’re currently in a suppressed capital markets environment.”

Inflation Likely to Weaken Buying Power

Brad Tisdahl, CEO of Tenant Risk Assessment, tells GlobeSt.com that the better question is how long inflation will remain above the Fed’s long-term target of 2%.

“In that instance, inflation will likely remain a factor even if it’s easing into 2024 as prices are demonstrating a stickiness,” Tisdahl said. “Inflation may have peaked in terms of growth compared to the same period last year, but it is likely to continue to weaken buying power and pressure rates to remain elevated.

“As for 10-year treasury rates, TRA falls in the camp of rates exceeding 3.75% at year-end 2023.”

Source: “​CBRE Survey: There Will Be a Significant Reduction in Buying and Lending This Year“

January was a bad month for commercial property prices, which fell “at an annual pace of decline not seen since late 2010 after the Global Financial Crisis,” according to an MSCI report. “The RCA CPPI National All-Property index dropped 4.8% from a year ago and 2.7% from December. The monthly decrease represents an annualized decline of 27.9%.”

There was only one property type index that saw positive annual growth in January: industrial, which was up 6.4% over the previous year. But month over month it was down 0.3%, which when annualized would be -3.2%.

Multifamily prices “tumbled” to the biggest percentage loss of any: 2.8% down from December and 4.6% off from the previous year. Retail fell by a relatively modest 0.9% from December and 0.1% from January 2022.

MSCI groups offices by suburban and central business district (CBD). The former saw price drops between December and January of 1.1% from December and 0.5% year over year. As for CBD properties, they saw an annual decline of 0.9% and no change between months.

“Prices in the 6 Major Metros recorded the sharpest rate of decline since June 2010, falling 6.9% YOY,” the report said. “The index has posted monthly declines for eight months in a row. The Non-Major Metro index dropped 2.0% from a year earlier and 1.8% from December.”

The report said that a spike in mortgage costs in 2022 undermined completion of deals, pushing pricing lower. When fewer parties are able to obtain financing, there is effectively less demand, so prices drop.

In addition, though, there are other forces at work, as GlobeSt.com has previously reported. One is the significant liquidity that was pumped into markets since the global financial crisis and then the increased amount in the fiscal and monetary responses to the pandemic. In the most favored property types, like industrial and multifamily, as investors looked for return when interest rates plummeted so low, prices rose dramatically and cap rates shrunk on the promise of ever increasing rents.

That has come to an end, as the rent jumps have diminished and, with higher financing costs, the lower cap rates are no longer sustainable. That has left the overall market perplexed as to what properties are rightly worth.

In other words, another big reason for the lack of transactions is uncertainty as to overall conditions, future interest rate hikes, inflation, and a possible recession. It will take some time for price discovery to happen and a greater amount of market stability to return.

Source: “CRE Prices Slide at a Rate Not Seen Since 2010“

Introduction
In the context of partnership disputes or marital dissolution, there may be situations where an appraiser is asked to consider whether real estate appreciation over a period of time is the result of active management decisions versus passive market forces, requiring an appraiser to consider the concept of active versus passive appreciation/depreciation. Evaluating a real estate investment manager’s or trustee’s (“Manager”) impact on asset performance is one of the many issues that may need to be addressed as part of the dissolution or restructuring of real estate ownership interests. The evaluation provides the foundation for questioning and challenging a Manager’s ability to carry out their fiduciary responsibilities and their contribution to asset value; it may also form the basis for a subsequent receivership appointment, trustee replacement and/or forced liquidation of assets. When interested parties are unable to agree on how the real property assets and value are to be divided, it is left to the courts to step in and decide for the interested parties.

An asset’s overall financial performance over a given time frame relative to active and passive appreciation forms a basis for identifying a Manager’s contribution, or lack thereof, to value creation and fiduciary care. However, there is limited to no case law regarding the quantification of active and passive real estate appreciation. Further, the body of appraisal theory and knowledge found in The Appraisal of Real Estate (15^th Edition)^[1], and The Dictionary of Real Estate Appraisal (7^th Edition)^[2], is silent as to how to distinguish and quantify active versus passive real estate appreciation.

Real estate appraisers value income-producing assets (including office, retail, industrial and multifamily properties) utilizing the income capitalization approach.^[3] This approach converts income into value by dividing the net operating income (“NOI”) by a capitalization rate (“cap rate”), which represents an investor’s unleveraged return on their investment (purchase price).^[4] It is the authors’ assertion that a) the cap rate differential between two dates of value is solely passive appreciation (or depreciation), and b) the NOI differential between two dates of value can have both active and passive components contributing to appreciation/depreciation. Classifying appreciation as either active or passive can have far-reaching effects on determining the impact of the Manager’s actions in the resultant value changes under their stewardship.

Active Versus Passive Asset Appreciation
Appreciation is defined as “an increase in the price or value of a property or commodity resulting from an excess of demand over supply or other factors.”^[5] Passive appreciation results from externalities, such as market forces, other natural causes, or by the actions of third parties which are outside the control of the Manager.^[6]

For instance, the value of an alternative asset such as a work of art may increase over time by its very existence through heightened demand for the artist, general price appreciation within the art world, and inflation. In contrast, income-producing real estate assets require more active management to preserve value, offset depreciation and enable appreciation. Managers of income-producing real estate must maintain the physical condition of the property, secure and retain tenants, satisfy regulatory requirements, collect revenue, and pay operating expenses to maintain and grow value. Therefore, active management is generally assumed to be necessary for most income-producing real estate. However, market forces and other externalities also play a role in financial performance and there may be situations, such as dissolutions, where an appraiser may determine what portion of appreciation results from this active management and what portion results from externalities beyond the Manager’s control.

External factors such as macroeconomics, local market conditions, regulation, and location impact the value of income-producing real property and contribute to passive appreciation. These include, but are not limited to:

• Macroeconomic conditions including monetary and fiscal policy, and economic growth
• Capital markets conditions including the availability and cost of capital (rates of return), and financing terms
• Local market conditions including shifts in supply and demand, which are reflected in occupancy rates, market rents, and expected risk adjusted investment yields
• Regulatory and legislative requirements, including zoning (land use and density), ease and cost of entitlement, as well as fiscal tax policies and the availability of public benefit incentives
• Neighborhood characteristics and community/economic development initiatives that affect value, including surrounding land uses and investment/development trends, socioeconomics, environmental conditions, infrastructure, and demand generators.^[7]

Appreciation occurs over time and and the authors’ propose a methodology to distinguish between active and passive appreciation and the value of the property at the start and at the end of the period in question. Frequently, the appreciation is measured between the date of partnership (or date of a marriage in a marital litigation) and the date of filing a complaint.

Valuation Methodology
For income-producing real estate properties, analyzing changes in the components of value creation identifies why and how the property has appreciated over time. Identifying whether those changes represent active or passive appreciation determine to what extent it’s a product of the Manager’s actions.

“Income-producing real estate is typically acquired as an investment, and from an investor’s point of view, earning power is the critical element affecting property value. A basic investment premise holds that the higher the earnings, the higher the value, provided the risk remains constant.”^[8] The income capitalization approach to value converts the expected earnings of the property into an indication of present value. Direct capitalization (one type of income capitalization) presents as an example of the components within the valuation calculation, which are present in all income approach methodologies.

In the direct capitalization approach, a capitalization rate (alternatively, “cap rate”) “implicitly values the anticipated pattern of income over time”^[9] using a single year’s NOI. The revenue and operating expenses of the property are netted to produce NOI; the NOI is then divided by the cap rate to yield the property’s present value before capital expenditures. Expected capital expenditures that are not reflected in NOI assumptions, such as lease-up costs for non-stabilized properties or deferred maintenance, are then deducted from the present value of the stabilized property to yield the derived value. Therefore, the components of value that may change and contribute to the appreciation (or depreciation) of the property are:^[10]

• Capitalization rate,
• Sources and amounts of revenue,
• Operating expenses, and
• Capital expenditures.

“An overall capitalization rate (R₀) is an income rate for a total property that reflects the relationship between a single year’s net operating income and the total property price or value. It includes both the return of and return on capital with consideration of the perceived risk and anticipation of future income or value changes by the investor.”^[11] The cap rate is determined by numerous, mostly external factors. ”[The rate applied] should reflect the annual rate of return the market indicates is necessary to attract investment capital. This rate is influenced by many factors, including, but not limited to:

• Degree of perceived risk
• Market expectations regarding future inflation
• Prospective rates of return for alternative investments (i.e., opportunity costs)
• Rates of return earned by comparable properties in the past
• Availability of debt financing
• Prevailing tax law^[12].

Derivation of appropriate capitalization rates requires diligent analysis and can include, but not limited to:

• Use of comparable sales with underlying financial data verified by participants to a transaction (primary sources)
• Use of aggregated market data provided by subscription services such as CoStar and Real Capital Analytics (secondary sources)
• Use of surveys such as PwC Real Estate Investor Survey, RealtyRates.com Investor Survey, RERC Real Estate Report and those performed by brokerage houses (secondary sources)
• “Built-up” rates using band of investment or residual analyses^[13].

A notable, but rare, non-external factor that could influence the cap rate is the nature (risk) of the property itself. However, the nature of the property is generally static over time; therefore, changes in the cap rate over a specified time period caused by active management of a property are extremely rare, but not impossible. As such, changes in the cap rate over time are essentially considered to be a product of market forces and represent passive appreciation.

Calculating Appreciation
The calculation of appreciation from a change in the cap rate over time is straightforward. Since cap rates in the direct capitalization methodology are the denominator in the calculation of value,^[14] the percentage of overall appreciation over the specified time period that is attributable to the change in the cap rate (and thus a portion of the property’s passive appreciation) is the percentage change in the inverse of the capitalization rates. This may be expressed as [1 ÷ Ending Capitalization Rate minus 1 ÷ Beginning Capitalization Rate] ÷ [1 ÷ Beginning Capitalization Rate].

If the cap rate has decreased over the time period, the percentage change in the cap rate multiplied by the change in value over time will yield the amount of passive appreciation attributable to the change in cap rate. If, however, the cap rate increased during that time, the calculation will yield an amount of passive depreciation over the time period.

A simplified base case example of appreciation from an income-producing real property is presented in the following tables and begins with the following assumptions:

• Investment period beginning on January 1, 2010 and ending 10 years later on December 31, 2019,
• Net operating income of $300,000 in year 2010 and growing to $550,000 in 2019, and
• Cap rates of 6.50% in 2010 and 5.00% in 2019.

As presented in the following table, these assumptions result in market values of $4.61M in 2010 and $11M in 2019. These values were derived by dividing the NOI of each year by the corresponding cap rate for that year. The decrease in the cap rate and the increase in NOI over the 10 years resulted in $6.38M of appreciation.

NOI has two distinct components, revenue and operating expenses. The primary variable in NOI over time is revenue, and primarily rent. More often than not, changes in revenue are an appraiser’s primary focus as part of the valuation of active and passive appreciation. The following table demonstrates that 70% or $4.46M of the remaining base case appreciation results from the NOI differential, which may have both an active and passive component.

Typically, property operating expenses fall into a standard range with a steady ratio to revenue over time. Increases in operating expenses generally track inflationary growth and do not significantly contribute to the change in NOI and value over time. If there is a significant change in the operating expenses or the ratio of operating expenses to revenue, the appraiser should understand if a Manager’s actions contributed to this change and determine if they generated active or passive appreciation.

The Impact of Revenue Growth on Active and Passive Appreciation
Income-producing property revenue can increase in two distinct ways: market rent growth and the addition of ancillary sources of revenue. Additional revenue from parking, vending, laundry, cell towers, and signage/billboards is almost always active appreciation resulting from the Manager’s actions, while the classification of market rent growth as active or passive appreciation is more difficult to isolate.

“Inflation is an increase in the volume of money and credit, a rise in the general level of prices, and the erosion of purchasing power.”^[15] Other market forces that can increase rental rates include inventory deficiencies, addition of demand generators (e.g., construction of a new corporate headquarters), demographic changes, and changes in regulatory requirements—all natural causes or caused by the action of third parties.

Although market rent growth does not result directly from the actions of the Manager, if the property was not actively managed (as required of most income-producing real estate), the underlying revenue (from tenants and other sources) would not have been maintained and the growth would not have been captured. Therefore, preservation of revenue and increasing rents to track market growth typically require active management, and the authors’ posit that appreciation from inflationary market rent growth would be active appreciation.

Changes in the consumer price index (“CPI”) can be used to identify inflationary growth in net operating income. As noted above, operating expenses can generally be assumed to track inflation, and any growth in NOI in excess of inflation will typically be from revenue growth or other active management activities. The inflationary portion of NOI growth is captured by the active management required to maintain the revenue stream of the property.

As presented in the following table, the NOI and CPI grew at an annual rate of 6.25% and 4.72%, respectively. Dividing the annual CPI growth from the annual NOI growth resulted in 75.55% of active appreciation, the percent of NOI growth attributable to inflation.

In the table below, $3.37M is appreciation from inflationary growth of 75.55% of appreciation from the NOI differential (active appreciation).

The remaining $1.09M or 24.45% of appreciation from the NOI differential may be active or passive appreciation. An appraiser needs to examine the cause of the revenue changes and determine whether these changes result from active or passive appreciation. The remaining appreciation may be caused by other market forces, by additional revenue, or, in rare cases, by significant decreases in operating expenses such as tax appeals or tax abatements.

It is the authors’ opinion that capital expenditures made over the time period require an active management decision, and any improvement in NOI attributed to those expenditures would be considered active appreciation. Rental growth resulting from active management is a product of specific actions (and often capital expenditures) taken by the Manager such as providing new amenities, upgrading building systems, improving common areas, or other significant periodic upgrades to actively obtain higher rents. Other examples of capital expenditures may include lease-up costs/concessions, deferred maintenance, the addition of tenant space, technological upgrades, and interior or exterior upgrades.

However, if the base case NOI and CPI growth were reversed (CPI growth was 6.25% and the NOI growth was 4.72%), then the authors’ posit that NOI is not keeping up with inflation and 100% of the NOI differential would be classified as active appreciation—and demonstrate a Manager’s failure to achieve market-rate performance. This result would provide the foundation for questioning and challenging a Manager’s ability to carry out their fiduciary responsibilities.

If the base case assumptions are changed and cap rates are assumed to have increased or remained the same over time, then the differential in NOI will contribute to all of the property’s appreciation. (Note that as cap rates increase, values decline if all other components of the value calculation stay the same.)

For example, and as presented in the following table, assuming the cap rate increased from 5.0% to 6.5% over the ten-year period, then $2.46M in appreciation results from the increase in NOI over the period. It is the authors’ opinion that the depreciation attributed to the increase in cap rates is considered passive appreciation.

Conclusion
Real estate appraisers value income-producing assets utilizing the income capitalization approach which converts income into value by dividing the NOI by a cap rate. The cap rate differential between two dates of value is solely passive appreciation (or depreciation), assuming changes in the cap rate over time are effectively a product of market forces. The NOI differential between two dates of value can have both an active and passive component contributing to appreciation. Income-producing real estate requires active management to maintain and grow revenue and enable appreciation. The Manager must maintain the property’s physical condition, secure and retain tenants, satisfy regulatory requirements, collect revenue, and pay operating expenses just to preserve value. Thus, in income-producing real estate, most appreciation from changes in NOI can be defended as active.

Source: “Active Versus Passive Real Estate Appreciation in Real Estate Litigation“

Negative cash flows, high vacancy rates, environmental and geographic concerns and other macroeconomic factors are all risks, and, therefore, reasons why real estate owners may experience operating distress. Furthermore, real estate owners commonly finance the acquisition of properties with debt, which comes along with various debt covenants, restrictions and debt service requirements. As a result of a lack of viability for servicing debt and/or where the fair market value of real property decreases below the remaining balance of debt, real estate owners need to review potential options and outcomes, including the harsh potential of a foreclosure.

In addition to analyzing the economics of a distressed position, real estate owners must consider the tax implications of the various outcomes surrounding debt. In the worst-case scenario of a foreclosure, not only can an owner lose a property, but also be subject to income tax on phantom income.

There are various outcomes relating to debt for a real estate owner in distress. A lender may agree to a reduction of the principal balance of the debt or alternatively allow a borrower to settle the debt at a discount. In other cases, a lender may allow for a debt workout whereby the terms of the debt are modified. In each of these first three scenarios, the real estate owner retains the property. In other scenarios, a real estate owner unfortunately loses the property. A real estate owner may look to sell the asset in a fire sale in order to satisfy the debt balance without going through a foreclosure transaction or alternatively may give up the property in a deed-in-lieu of foreclosure transaction. Ultimately without a satisfactory negotiation result, a lender may foreclose on the loan and force a sale of the asset.

Key factors and definitions

Each of the distress scenarios have tax implications that need to be considered and are discussed in the tables below, which separate the scenarios between when an owner is able to retain the real property vs. when the real property is disposed of. Several key factors and definitions need to be understood prior to considering the tax implications of a given scenario:

•  Solvency: A taxpayer’s status of solvent or insolvent is determined by comparing the taxpayer’s liabilities and assets (at fair market value) immediately prior to discharge of a debt. A taxpayer is deemed insolvent to the extent the taxpayer’s liabilities exceed the value of assets. For non-recourse debt that exceeds the fair market value of property, only the amount of debt actually discharged (in addition to the amount of debt equal to fair market value) is factored into the insolvency computation. If debt is held by a partnership, the solvency factor and availability of exclusions, discussed later, are generally determined at the partner level rather than the partnership level.

• Fair market value: The Supreme Court in United States v. Cartwright, 411 U.S. 546 (1973), as well as Treasury Regulation § 1.170A-1(c)(2) both provide that the fair market value of property is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. Furthermore, “the determination of fair market value is a question of fact, and the trier of fact must weigh all relevant evidence and draw appropriate inferences.” Estate of Adell v. Comm’r of Internal Revenue, 108 T.C.M. (CCH) 107 (2014) (citing Comm’r v. Scottish Am. Inv. Co., 323 U.S. 119 (1944)). For foreclosure transactions, guidance exists that the sale price of property at a foreclosure sale is presumed to be its fair market value, absent clear and convincing proof to the contrary.

• Reduction of tax attributes: Certain exclusions of income from the discharge of debt, discussed later, require that a taxpayer reduce certain tax attributes, thereby deferring the recognition of income to a later date. The taxpayer’s attributes are reduced in the following order: (1) net operating losses, (2) general business credit, (3) minimum tax credit, (4) capital loss carryovers, (5) basis of property, (6) passive activity loss and credit carryovers and (7) foreign tax credit carryovers. Alternatively, a taxpayer may elect to first reduce the basis of the taxpayer’s depreciable property.

• Non-recourse vs. recourse debt: For discharge of indebtedness purposes, the classification of a discharged debt as non-recourse or recourse is a significant factor as the type and amount of income a taxpayer recognizes is directly affected. A debt is classified as recourse if a lender can reach all of the taxpayer’s assets. A debt is classified as nonrecourse if the lender’s sole recourse is against the collateral subject to the debt.

The rules for classifying debt as non-recourse vs. recourse for purposes of debt allocations to partners in a partnership are different than those rules for classifying debt as non-recourse vs. recourse for the discharge of indebtedness rules. For example, although the partners of a partnership may not be treated as having recourse debt on their K-1s from a partnership (i.e., because of no personal liability), the debt may still be considered recourse to the partnership for discharge of indebtedness purposes if the lender can go after any of the partnership’s assets.

Real estate structures are commonly set up to include special purpose entities as the property owning and/or borrowing entities which are disregarded for federal tax purposes in that they are wholly owned by a parent holding entity which is regarded for tax purposes. In regard to debt owned by a disregarded entity, even though such debt may be recourse at the disregarded entity level where a lender could reach all of the disregarded entity’s assets, the IRS has ruled on multiple occasions that such debt is non-recourse with respect to the regarded parent entity since the lender can only go after a specified subset of assets (i.e., the disregarded entity’s assets).

In general, the non-recourse vs. recourse determination is highly based on facts and circumstances and there are differing interpretations on the topic. For example, case guidance exists discussing debt where a lender could go after all of a partnership’s assets; however, the terms of the partnership’s agreement would have prohibited the partnership from acquiring any additional assets that would not be subject as collateral of debt. While the court in Great Plains Gasification Assocs. v. Commissioner, 92 T.C.M. (CCH) 534 (2006) found this fact to being supportive of the determination that such debt would be characterized as nonrecourse, the IRS subsequently questioned several findings of the case and left open uncertainty regarding how much reliance could be placed on the case.

• Qualified real property business indebtedness (“QRPBI”): Discharge of indebtedness income relating to QRPBI may be eligible for exclusion under certain circumstances. QRPBI is defined as indebtedness that meets three requirements: 1) incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by such real property, 2) incurred or assumed before January 1, 1993, or if incurred or assumed on or after such date, is qualified acquisition indebtedness, and (3) is subject to an election made by the taxpayer to have the exclusion for such debt apply.

Real Estate Debt Scenarios and Tax Implications

Scenarios where real property is retained
Scenario	Tax Implications
Lender reduces principal balance or agrees to settle debt at a discount	Solvent taxpayer : Discharge of indebtedness income is recognized as ordinary income by solvent taxpayers. However, if the discharge of indebtedness income relates to QRPBI, some, or all, of such income may be excluded from income, subject to two limitations: 1. The exclusion cannot exceed the excess of the debt immediately before the discharge over the real property’s net fair market value at such time. Net fair market value means the fair market value of the qualifying real property, reduced by the outstanding principal amount of any QRPBI (other than the discharged indebtedness) that is secured by such property immediately before and after the discharge. Note that this rule operates in a manner so as to prohibit the creation of equity in real estate tax free. For example, if the fair market value of property is $1,000,000 with debt of $1,200,000, the exclusion would apply against up to $200,000 of income (whereby fair market value would then equal debt). If any additional exclusion were allowed, equity would be created (i.e., if $300,000 is discharged, the taxpayer would then have $100,000 of equity: $1,000,000 of fair value less $900,000 of debt). 2. Furthermore, the amount excluded cannot exceed the aggregate adjusted bases of depreciable real property held by the taxpayer immediately before the discharge (after reduction for any depreciation claimed during the year as well as any basis adjustments under the insolvent tax attribute reduction rules). The amount excluded from gross income under the QRBI rules reduces the basis of the depreciable real property of the taxpayer. For partnerships that own real property with QRPBI, while the determination of QRPBI and fair market value limitations are applied at the partnership level, the election to have the exclusion apply is made at the partner level and furthermore the exclusion from income applies at the partner level. Correspondingly, a partner must consider the basis reduction that is required. To that end, any interest of a partner in a partnership will be treated as depreciable real property to the extent of such partner’s proportionate interest in the depreciable real property held by such partnership. Furthermore, a corresponding reduction in the partnership’s basis in depreciable real property with respect to such partner is made.
	Insolvent taxpayer : The tax outcome for insolvent taxpayers depends on whether a bankruptcy scenario exists. For insolvent taxpayers not in bankruptcy, the discharged amount of debt is bifurcated into two buckets. 1. The first bucket consists of an amount of discharge which is eligible to be excluded from income subject to a limitation equal to the amount by which the taxpayer is insolvent (i.e., excess of liabilities over fair market value of assets, immediately before discharge). Tax attributes of the taxpayer need to be reduced equal to the exclusion amount (effectively deferring the recognition of the income). 2. The second bucket consists of the remaining amount of debt discharged and is treated similarly to a discharge of debt for solvent taxpayers. For taxpayers in a bankruptcy case, the entire amount of debt discharged is subject to exclusion; however, tax attributes of the taxpayer need to be reduced (effectively deferring the recognition of the income).
	Special rule for purchase money mortgages : If the seller of the property was the lender at the time of purchase, and the seller continues to be the holder of the debt, the reduction of debt is treated as a purchase price adjustment if the taxpayer is solvent. This option is generally not applicable for insolvency or bankruptcy scenarios. Note that unlike the general exclusion rules which apply at the partner level, the exclusion for purchase money mortgages applies at the partnership level. Furthermore, for real property and debt held by a partnership, the insolvency or bankruptcy status of a partnership is disregarded. The IRS has stated it will not challenge the purchase price adjustment at the partnership level if all other requirements are met (i.e., other than the insolvency / bankruptcy status).
Lender and borrower agree to a debt workout (i.e., modifications to terms of debt)	The general theory surrounding debt workouts / modifications is that a modification to a debt is significant enough that the borrower is deemed to issue a new debt instrument in exchange for the existing debt. The issue price of such new instrument is treated as an amount of money which satisfies the existing debt. If this deemed amount of money is less than the existing debt, discharge of indebtedness income results for the taxpayer. Note that a pure reduction of the principal balance of debt is from the outset discharge of indebtedness income as discussed earlier. Two key requirements need to be met in order for a deemed exchange to occur under the debt modification rules. 1. A modification needs to exist. In general, a modification means any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt instrument. 2. The modification needs to be deemed significant. The regulations provide several examples of specific modifications that are significant as well as a catch-all general rule. The general rule is that a modification is a significant modification only if, based on all facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant. The specific modifications discussed in guidance are 1) changes in yield, 2) changes in timing of payments, 3) changes in obligor or security, and 4) changes in the nature of a debt instrument. Thresholds for where each of such changes is deemed significant are provided in the guidance. Some examples of modifications that are not significant modifications are the following: 1. A modification that adds, deletes, or alters customary accounting or financial covenants. 2. A temporary forbearance from collection efforts or acceleration clauses by a lender for a period up to two years plus any additional period of good faith negotiations.

Scenarios where real property is disposed of
Scenario	Tax Implications
Real estate owner sells real property or lender forecloses and forces a sale of real property	Normal gain or loss rules apply relating to sales of property. The gain from the sale of property is the excess of the amount realized over the adjusted basis. If instead there is an excess of adjusted basis over the amount realized, there is a loss on the sale of the property. The sale of real property used in a trade or business is generally treated as Section 1231 gain or loss. Amount realized from a sale includes cash and the FMV of any property received in the transaction. If there is sufficient cash to pay off the debt on the property, the transaction is treated like any other disposition of property. If sales proceeds are insufficient to pay off all debt and the lender discharges any remaining balance, such discharged amount is added to the amount realized if such debt is considered nonrecourse debt and therefore would factor into the gain or loss computation. For recourse debt, any discharged amount would be treated as discharge of indebtedness income similar to any other discharge income which would be ordinary income; however, subject to the insolvency and bankruptcy exclusions described above.
Real estate owner transfers real property to lender in satisfaction of debt in a deed-in-lieu of foreclosure transaction	The transaction is treated as a sale of property where the amount realized is equal to the amount of the debt which is satisfied by the transfer. The difference between the amount realized and the adjusted basis of the property produces gain or loss on the disposition. The sale of real property used in a trade or business is generally treated as Section 1231 gain or loss. If the debt is nonrecourse debt, the entire amount of the debt is treated as the amount realized. If the debt is recourse debt and such debt exceeds the fair market value of the property, the transaction is bifurcated into two transactions. The fair market value of the property is the amount realized for purposes of determining the gain or loss on the deemed sale of the property. The excess of the recourse debt over the fair market value of the property is treated as discharge of indebtedness income which is ordinary income, however subject to the insolvency and bankruptcy exclusions described above.

Other considerations and next steps

As noted in the scenarios above, a deemed sale occurs in most scenarios where real property is transferred voluntarily or involuntarily in satisfaction of debt. Typical recapture and recharacterization rules therefore apply in such transactions. For example, ordinary income recapture for accelerated depreciation, as well as unrecaptured 1250 gain characterization, apply in such cases.

In determining the amount of an unpaid mortgage, unpaid interest is included as part of the amount realized on the discharge of debt. Thereby, for non-recourse debt, this additional amount realized affects the amount of Section 1231 gain or loss on disposition. For recourse debt where the total debt is greater than the fair market value of the property, additional discharge of indebtedness ordinary income is recognized.

As a result of the various nuances involved with distressed real estate and the related debt, careful planning and analysis are required to achieve the most tax efficient results. The loss of a real estate property can be economically devastating, however the possibility of phantom taxable income on top of such loss can create even more economic hardship. A detailed review of the potential workout options with a lender, the non-recourse vs. recourse nature of the debt, solvency of the owner and/or partners of a partnership and analysis of potential exclusions are all important steps when dealing with any distressed real estate scenario. As a result, consultation with a tax advisor is highly recommended.

Source: “Tax Considerations Relating to Debt for Distressed CRE Owners“