News & Events: Foreclosure Defenses, Workouts and Tax Issues
« Back to News & Event Listing
Foreclosure Defenses, Workouts and Tax Issues
By: Nicholas J. Santoro and Andrew J. Glendon
The valley’s numerous strip malls and commercial centers have been turning vacant for some time now and, unfortunately, it appears that the foreclosure boom that started with the residential real estate market is headed towards the commercial sector. When faced with foreclosure, a borrower may feel that they have been wronged by their lender and, as such, want to obtain relief from the Courts. There are a number of possible claims that should be evaluated by a borrower.
The initial question that a borrower must investigate is whether the lender breached a term set forth in an existing loan document or a loan commitment. Such action could give rise to a breach of contract claim. If there is no breach of a written contract, then a borrower should consider whether the lender breached the “covenant of good faith and fair dealing” that is implied in all contracts. In general, to mount a colorable lender-liability claim for breach of such covenant, the lender must have either taken control of a borrower’s operations resulting in detriment to the business of the borrower, or the lender must have taken an action designed to deprive the borrower of his rights.
In addition to these claims, a borrower may also be able to maintain an action for fraud, in the event the lender made a material misrepresentation to the borrower, or breach of fiduciary duty against a lender, to the extent a fiduciary relationship can be established. Of course, the underlying facts associated with the matter must establish such a claim and the foregoing is not intended to be an exhaustive list of all claims that may be available to a borrower.
A borrower may be able to mount these claims in an effort to set aside or stall a foreclosure, in a post-foreclosure action by the lender to establish a deficiency, or as a potential defense in connection with a lender’s suit on a guaranty. Depending on the status of the foreclosure proceeding and the strength of a borrower’s case, due consideration should be given to the timing of borrower’s initiation of such an action.
In the event that the facts of a given matter do not support a lender-liability claim and otherwise do not give rise to a legal defense, or during the pendency of litigation, a borrower may be able to convince a lender (typically through presentation of economic forecasts and other data) to modify the terms of an outstanding loan (at least in the short term) or the borrower may be able to negotiate a discounted purchase of the loan. These and other ”work-out” strategies may be employed by a borrower in an effort to substantially discount the obligations of a borrower.
When a borrower’s obligations to a lender are substantially modified or a borrower is able to acquire its debt at a discount, such borrower could be faced with income from the discharge of indebtedness (or, simply, cancellation of debt income). Such income is “ordinary” in character (i.e., it is taxed like wages, it is not eligible for capital gains rates) and, although the underlying business deal may be too good to pass-up, such tax consequences could be a trap for the unwary if proper planning is not done ahead of time.
Although the bankruptcy and insolvency exceptions to cancellation of debt income are fairly well known, the qualification for such exceptions can be burdensome when dealing with borrowers organized as a limited liability company (taxed as a partnership). This is because qualification for such exceptions is determined at the “member” level; thus, even though a specific entity may be insolvent, the insolvency exception would not be applicable if the members would not similarly insolvent.
Taxpayers other than “C” corporations can elect to exclude cancellation of debt income to the extent derived from the discharge of qualified real property indebtedness. This is indebtedness that was incurred in connection with the acquisition or construction of real property used in a trade or business (and secured by such property). The effect of the exclusion is a reduction of the basis of depreciable real property by the amount of the discharged debt, in lieu of recognizing income. Although there are some limitations in application, the qualified real property indebtedness rules may be the most likely manner in which a borrower engaged in a trade or business can “escape” (or at least defer) the tax ramifications of a loan work-out.
With assistance from competent professionals, owners of commercial centers may be able to forestall a pending foreclosure and/or restructure their debt in a manner that makes business sense for all parties involved – a result that is superior to another vacant strip mall on the corner.
To comply with IRS regulations, we advise that any discussion of Federal tax issues in this article was not intended or written to be used, and cannot be used (i) to avoid any penalties imposed under the Internal Revenue Code or (ii) to promote, market or recommend to another party any transaction or matter addressed herein.
BIOGRAPHIES
Nicholas J. Santoro is a shareholder with the firm of Santoro, Driggs, Walch, Kearney, Holley & Thompson and has handled cases in a wide variety of civil matters, including contract, tort, real estate, and defense of professional liability claims. He has been lead counsel in numerous trials. Martindale Hubbell has designated Mr. Santoro as an AV-rated lawyer, which is its highest rating. Mr. Santoro attended law school at the University of San Diego (J.D., 1983) and was admitted to the Nevada Bar in 1983.
Andrew J. Glendon is a shareholder with Santoro, Driggs, Walch, Kearney, Holley & Thompson. His practice focuses primarily on the representation of clients involved in commercial and real estate transactions and advising clients on corporate and tax issues. Mr. Glendon graduated With Distinction from McGeorge School of Law, University of the Pacific, in 1998 before pursuing an advanced legal degree in taxation from New York University (1999). He was admitted to practice in Nevada in 2000.