The Federal Pandemic Unemployment Compensation program expired at the end of July, which likely will cause economic impacts on housing and the real estate market. Recent statistics may be an indicator of the direct effect that federal unemployment compensation has had on the economy. The National Multifamily Housing Council reported that 91.3% of apartment households made a full or partial rent payment by July 20, 2020, as opposed to a potentially significant lesser amount if the federal program had not been providing support. That is only a 2.1% decrease from the July 2019 rate.
The expiration of the $600 per week federal unemployment benefit coupled with the fact that many businesses are still restricted in their operations could be disastrous if Congress does not act.1 There is some positive news in that one study found “that PPP loans led to a 14 to 30 percentage point increase in a business’s expected survival, and a positive but imprecise effect on employment.”2
Many investors own real estate through a limited liability company. See, for example, “What is a Holding Company and How Does it Work?” The LLC owning real estate is generally treated as a partnership for federal income purposes if there is more than one member for reasons beyond the scope of this article. However, the tax treatment does not affect the legal status of a limited liability company.
In the discussion that follows, we will focus on a SARE as a non-SARE debtor generally proceeds under Chapter 11 as any other debtor. SARE is an acronym for single asset real estate, a designation of the Bankruptcy Code. Under the Bankruptcy Code, the estate is a SARE when a single property or project other than residential real property with fewer than four (4) residential units generates substantially all of the debtor’s gross income on which no substantial business is being conducted by a debtor other than the business of operating the real property.3
The determination of whether an entity is a SARE is facts and circumstances based. In a bankruptcy petition, the debtor must elect to be treated as a SARE although a secured creditor could file a motion to have the debtor designated a SARE. Common examples of a SARE include shopping centers, apartment complexes, office buildings, industrial buildings and warehouses.
Designation in a Chapter 11 case as a SARE imposes tighter timelines on the debtor to either file a plan of reorganization that has a reasonable chance of being confirmed or begin making monthly payments to the secured creditor at the loans nondefault contractual rate.4 The view of the courts is that a debtor, which is a SARE, must file the petition in good faith. The majority view applies a “subjective test” in determining if the petition was filed in bad faith by, for example, to frustrate the secured creditors’ ability to enforce their rights.5
What is a single property or project? In determining whether multiple parcels are a single project, the generally accepted test focuses on the debtor’s intent or purpose.6 The SARE provisions can apply to a debtor with multiple properties where those properties are linked together in some fashion via a common plan or scheme surrounding their use.7
Does the property generate substantially all of the debtor’s gross income? The analysis is whether there are other sources of income whereby the property does not generate substantially all of the debtor’s gross income. For example, a hotel would not be a SARE when it operates restaurants, bars or gift shops that generate a significant portion of its revenue.8 Similarly, a marina that also stores, repairs and winterizes boats, as well as gas concessions, is not a SARE.9 However, a well-known NJ developer was held to be a SARE.10
Although a SARE has a compressed timeline to develop a plan of reorganization and pay interest, it does provide some breathing room if there is a pending foreclosure (see bad faith above though). The protection of the bankruptcy court may enable the SARE to sell the property(ies) in a “section 363 sale,” raise additional capital, or obtain new financing.
If the secured creditor’s claim is underwater (i.e., the value of the collateral is less than the creditor’s claim), the claim is bifurcated into two claims: 1. A secured claim to the extent of the value of the collateral; and 2. An unsecured deficiency claim equal to the excess of the claim over the value of the collateral (“deficiency claim”).11 This permits the creditor to vote twice on the plan of reorganization: once as a secured creditor and once as an unsecured creditor.12 This could create a problem in getting the plan approved as the deficiency claim is likely the largest unsecured claim.
If you are a real estate developer or investor, you should be taking proactive steps to protect your investment considering the uncertainty surrounding the continuing economic impact of COVID-19. If you have questions or need assistance, please contact us today to discuss your options to protect your investment and minimize any negative tax implications associated with cancellation of indebtedness income.
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