Taking The Tax Bite Out Of Mortgage Refinancing |
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The current environment of low interest rates could offer one bright spot. Urgently needed relief could be provided by Mortgage Refinancing the costly debt on many multifamily properties. Many troubled properties could quickly become economically viable. For several years, multifamily real estate has been hurt by regional overbuilding, the national recession, downward pressure on rents and high debt burdens from mortgages carrying high interest rates typical of the 1980s. Much needed cash could be freed up to improve operations and maintenance. Unfortunately, that relief is blocked by a provision in the Tax Reform Act of 1986, which amended Section 108 of the Tax Code. Section 108, in its current form, makes Mortgage Refinancing economically infeasible in many cases, where it could be very useful. That hurts
owners, residents and lenders. By increasing the likelihood of mortgage default, Section 108 also places added pressure on an already overburdened Resolution Trust Corp. (RTC). The damage from Section 108 needs to be better understood. Let's take a look at what has happened. Before 1986, a troubled loan could be refinanced, such as Mortgage Refinancing, with lower interest rates and even a smaller principal balance without setting off an immediately taxable event. That is, under rules in effect before 1986, a borrower did not owe tax on any canceled portion of mortgage debt until the borrower sold the property and realized a cash gain. But in 1986, tax writers in Congress and the Treasury concentrated on the need to shut down tax shelter abuses that had been unleashed by the 1981 Tax Act. A special target of their scorn was the excesses in real estate. The makers of tax policy determined that it was too generous to let owners of real estate defer taxes on the discharge of indebtedness. With certain exceptions, Section 108 of the Tax Code now treats forgiven debt as taxable income in the year the debt is forgiven. The 1986 tax writers apparently believed that real estate owners would always have such deep pockets that they could easily pay taxes on the amount of any forgiven debt even if the owners were to receive no cash from the transaction in the tax year. That belief rested on the assumption that real estate's prosperity of the mid-1980s would last indefinitely. The assumption soon proved to be wrong. An illustrative case of mortgage refinancing shows how this provision actually affects investor behavior and why the law needs to be changed. Let's say an investor has owned a property for several years financed with an outstanding loan of $1 million. It now has a present tax basis of $800,000 after depreciation, and, with declines in property values, it has a fair market value of $600,000. As is the case with many such properties, other changes in the tax law give the investor no economic incentive to put additional capital into the project. If the lender is ready for mortgage refinancing and to forgo $400,000 of debt to make the project viable, the investor would be faced with a taxable event of $400,000 even though the investor received no cash. If the investor is in the 31% tax bracket, the investor would be hit with a tax bill of $124,000 if the investor agrees to the refinancing, compared to a tax charge of only $62,000, perhaps in a later year, if the investor lets the property go to foreclosure. The change in tax policy falls hardest on real estate owners who are struggling to keep troubled properties viable. The new tax treatment does not apply if a taxpayer is in Chapter 11, insolvent or a farmer. As a result, the present law tends to create more bankruptcies. Many more troubled properties have been thrown into the laps of lenders, the RTC, the Federal Housing Administration and other federal agencies than would have been the case under the pre1986 rules for Section 108. The impact on multifamily housing is particularly perverse. Section 108 hurts not only owners and lenders but also the residents whose quality of life suffers when funds needed for prudent management and repairs are choked off. The country's scarce supply of affordable housing is damaged because multifamily properties quickly deteriorate when they fall into default and foreclosure. |
