National Housing Law Project Housing Law Bulletin

One of the many important unresolved issues essential to the ultimate success of the new Section 8 project-based restructuring program (popularly known as "Mark to Market") is the tax treatment of the refinancing arrangements contemplated by the law.¹ In July, the Internal Revenue Service issued a favorable Revenue Ruling that, for many owners, will reduce the risks of adverse tax consequences from the restructuring transaction.This ruling, Revenue Ruling 98-34 (July 21, 1998), in turn, will make it somewhat easier for HUD and state agencies to move forward with program implementation, since restructuring can now prove a viable option for many owners.

Congress enacted the restructuring program in the "Multifamily Assisted Housing Reform and Affordability Act of 1997"² to reduce the budget authority required to renew expiring project-based Section 8 contracts on those properties carrying above-market subsidies that also have FHA-insured mortgages. In order to reduce these subsidies to market levels, the restructuring program offers the possibility of reducing the currently serviceable debt on eligible properties by bifurcating the existing mortgage loan into two parts. The new first loan is the amount that could be serviced with market-level rents, assuming applicable underwriting criteria.The second loan would be held by HUD and reflects the difference between the original mortgage balance and the amount of the new serviceable first mortgage.The second loan would bear an interest rate somewhere between zero and the Applicable Federal Rate ("AFR," approximately the federal cost of borrowing), would be payable only from a share of excess cash flow available after payments on the first loan and project operating expenses, and would become due and payable upon amortization or repayment of the restructured or new first loan. The entire inventory of properties eligible for restructuring contains billions of dollars of debt that is not currently serviceable at market rent levels.

For some owners, one of the primary barriers to considering restructuring as an available option is the prospect that the IRS would characterize the transaction as a "tax avoidance" scheme, and assess income taxes on the amount of indebtedness moved into second mortgages. Were the IRS to take this position as to all of these proposed second mortgages, few owners would consider restructuring a realistic option, because it would produce no cash with which to satisfy the tax liability. Fortunately, at least concerning the general application of the restructuring concept, the IRS has just ruled that restructuring does not create "cancellation of indebtedness income" for a participating owner.

In brief, here is the IRS position from Revenue Ruling 98-34.

The issue presented was whether a below-market-interest-rate second-mortgage loan made by HUD under the Act is exempt from the provision of the Internal Revenue Code (§ 7872) which ordinarily would impute income to the borrower in the amount of the discount resulting from the below-market rate.

In analyzing this issue, the Ruling posited a hypothetical set of facts, not unlike that which may be typical for many restructuring transactions:

• The property is secured by a non-recourse first-mortgage note insured by FHA;
• The owner receives HUD project-based rental assistance;
• The contract rents (assistance payments plus tenant contributions) exceed the market-value "street rents" for the property;
• The owner would be unable to satisfy its existing debt service obligations if assistance were reduced to market "street rents";
• Upon reduction of the contract rents to "street rents," HUD makes a cash claim payment under the FHA insurance contract to the existing lender of 35 percent of the original principal value of the loan;
• The terms of the existing loan are modified, resulting in a new first loan with a principal amount of 65 percent of the original level, bearing interest above the AFR, with debt service supportable by the reduced contract "street rents"; and
• In exchange for the claim payment made to the existing lender, the owner executes a non-recourse note to HUD secured by a second mortgage under the Act, reflecting a principal balance of 35 percent of the original level, bearing interest at below the AFR; this debt qualifies as "indebtedness" under tax law.

In addressing this situation, the Ruling begins the analysis by restating the law generally applicable to below-market loan transactions, pursuant to I.R.C. § 7872. The general rule is that the borrower is treated as having received from the lender (on the date of the loan) cash equal to the excess of the amount loaned over the present value of all payments required under the loan. The regulations, however, provide that this rule usually does not apply to certain listed exempt loans because they do not have a significant effect on the federal tax liability of the borrower or lender, unless the otherwise exempt loan is part of a "tax avoidance" scheme. These exempt loans include those subsidized by federal, state or local governments, so long as they are made available under a program "generally applicable" to the public. In addition, the regulations permit other loans to be exempt if the IRS finds that they have characteristics similar to those loans already listed as exempt.

In applying this framework to the second loans from HUD under the restructuring program, the IRS found that the factors justifying exemption of the second loans are similar to those supporting the government-subsidized loan exemption.The public policy purposes of the Act preclude a finding that the below-market second loans from HUD are structured with a principal purpose of avoiding federal tax liability.

This IRS Revenue Ruling means that, in general, the restructuring program can proceed without wholesale resistance from project owners. It does not, however, solve all of the tax issues confronting every specific property. Nor does it address the owners "exit tax" problem in the event of a sale or transfer of the property.

For example, in any restructuring, the owner will have to show under specific facts and circumstances that the second loans meet all of the qualifications for valid indebtedness under the law. This means that the second loan must be real debt, not disguised equity, and must have a reasonable likelihood of repayment. The fact that the second loan is not currently serviced, but instead accrues unpaid interest and is payable only from excess cash flow, may make this more difficult.

Especially for some properties where the amount of the second mortgage is higher that the 35-percent hypothetical used in the Ruling, it may be harder to show that the second mortgage has a reasonable prospect of repayment, even with a nominal interest rate. The Act requires HUD or the PAE to provide second mortgages only to the extent that repayment is likely, which will require a conscious calibration of the principal amount and the interest rate. If the second is not being paid down from excess cash flow during the term of the first, its size relative to the first, together with any accrued unpaid interest, may make it difficult to refinance when the first is repaid or fully amortized. Other projects may face the issue up-front, where, despite creative structuring, it is clear that some of the existing first mortgage cannot ever be repaid.

It remains to be seen how the IRS will evaluate any of these more specific issues likely to be raised by numerous restructuring transactions, and how owners will respond. Over the next year of the program's implementation, some of these answers will begin to emerge.

¹  For background on the new "Mark to Market" program, seeThe New Section 8 Renewal and Restructuring Program: An In-Depth Review, 27 HOUS. L. BULL. 175 (Nov. 1997); and Moving Forward on Project-Based Section 8 Expiring Contracts, 27 HOUS. L. BULL. 198 (Dec. 1997).
²  Pub. L. No. 105-65, Title V, 111 Stat. 1344, 1384 (Oct. 27, 1997).