Refinancing? Better Think This Through

	By Yunna Barats Co-Partner In-Charge Real Estate Group barats@rbz.com
Publication Date: Summer 2002
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It is a common view that refinancing is not a taxable event. Although true on its surface, sometimes taxpayers can suffer unanticipated, adverse tax consequences triggered by a poorly planned refinancing transaction. In some cases, taxpayers can be faced with the worst of all worlds: phantom income (i.e. income that did not result in any cash receipts) and a large tax bill.

The two most common ways of creating taxable income in a refinancing situation are:

1. Renegotiation of the debt for a lower amount or for a lower interest rate.

2. Substituting a non-recourse loan for a recourse loan (or vice versa).

Refinancing for a lower amount or lower interest rate

It is logical that renegotiating your debt for a lower amount would result in taxable income. After all, the taxpayer has received funds, which they will never repay, thus, an economic gain has been realized.

But how does the refinancing for a lower interest rate create a taxable event? If the current balance of a loan exceeds the present value of the payments under a new loan, cancellation of indebtedness income (“CODI”) is created. This generally would not be encountered in a conventional commercial mortgage that is refinanced for another. CODI will more likely be found in the land of private financing where indebtedness is subject to nonconventional terms, such as lower-than-market interest rates due to various “back-end” participation clauses.

Substituting a non-recourse loan for a recourse loan

The entities of choice for holding real estate are partnerships or limited liability companies taxed as partnerships. The ability to include the liabilities of the partnerships in the bases of the individual partners makes these entities attractive for real estate holdings. This means that individual partners can take the deductions today and “pay” for them in the future. This concept is unique to partnerships.

The process by which the liabilities are allocated to individual partners depends on the character of the liability. Generally, recourse debts (debts which somebody has personally guaranteed) are allocated to those partners who have the ultimate responsibility to repay the debt. This responsibility is commonly referred to as “economic risk of loss.” Thus, if partner A personally guaranteed the debt to the bank, but partner B agreed to reimburse partner A in case of a default, partner B has the ultimate economic risk of loss.

By definition, the allocation of non-recourse loans could not follow the same logic. The reason for this is that the lender has no recourse against any individual, and thus, in case of a default, could not enforce the payment obligations. The Treasury Regulations prescribe a complicated three-tier formula according to which all non-recourse debts are allocated among the partners. Generally, if the debt was not incurred prior to the formation of the partnership, or there were no new partners admitted to an already existing partnership, in most cases, such allocation follows the allocation of profits.

It is important to mention that a decrease in a partner’s allocable share of partnership liabilities is treated as a cash distribution to this partner. If the amount of such a decrease exceeds the partner’s basis in the partnership, the partner will be subject to immediate taxation. Oftentimes this occurs in a refinancing. The point may be best illustrated by the following example:

John, Mike and Brian are partners in real estate partnership (JMB, LP). They managed to convince the bank to finance 100% of their building, which they bought for $900. The loan was non-recourse, secured by the building. In year one, JMB, LP generated $90 in losses which, according to the partnership agreement, were allocated pro-rata to John, Mike and Brian. Thus, at the end of year one, each partner’s basis in JMB was $270 ($300 each partner’s allocable share of JMB’s liability minus $30 of each partner’s allocable share of partnership losses).

However, when a loan is converted so that a single partner has the ultimate economic risk of loss, the scenario changes radically as seen in the continuing example.

In year two JMB, LP breaks even. In addition, JMB receives an offer from another bank to refinance the property on significantly more favorable terms. The only caveat to that is that the bank wants John to personally guarantee the loan. JMB decides to go ahead and refinance the original $900 with the guarantee. Since John is now the only one with the economic risk of loss, the entire liability of $900 is allocated to him and Mike and Brian stand to incur adverse tax consequences. At the end of year two, John’s basis in JMB is $870 (basis at the end of year one of $270 plus the increase in allocable share of partnership liabilities of $600). Since Mike and Brian are not “on the hook” for the new loan, their allocable shares of liabilities decreased from $300 (i.e., allocation of the old loan) to $0. This decrease is treated as cash distribution to Mike and Brian. Since the deemed cash distribution exceeded their bases ($270 each), Mike and Brian will recognize $30 of taxable income each.

Although, this example is very simplistic, the situation is not. Typically, John is a managing partner and Mike and Brian are the investors. If the problem is not recognized early, Mike and Brian will probably never invest in John’s ventures again, and litigation is certain to follow. The business reasons for the renegotiation of a loan are often quite compelling, especially given the current economic climate. However, in assessing these needs, it is important that the tax impacts be considered as well. The situation addressed in the example above could be averted or mitigated with proper planning and careful consideration of all variables. We will discuss this in future issues.