A Note to Our Readers

After serving as the Partner-in-Charge of the firm’s real estate practice for many years, we are pleased to announce the election of Harry Moehringer to Managing Partner of Marks Paneth LLP. As of January 1, Mr. Moehringer leads Marks Paneth along with fellow Managing Partner Mark Levenfus. Mr. Moehringer will oversee the firm’s operations, manage business development efforts and consult on key accounts. He also will play a major role in developing strategy, setting policy and overseeing acquisitions. He is a member of the firm’s Operating and Executive Committees. Succeeding Mr. Moehringer as the Partner-in-Charge of the firm’s extensive real estate practice is William Jennings. With a particular interest in low-income housing, Mr. Jennings has developed strong relationships with governmental agencies, frequently meeting with members of Congress and the Secretary of Housing and Urban Development. Going forward, this newsletter will come to you directly from Mr. Jennings. We know you will join us in congratulating them both and wishing them well in their new roles.

Know the Tax Consequences of an Installment Sale

In a slow real estate market where financing can be tough to obtain, some investors are finding they have a better chance of disposing of real property in an installment sale. When structured properly, this type of transaction provides some financial benefits to both buyer and seller. Installment Sale Benefits An installment sale occurs when a seller transfers property in exchange for a promissory note and receives at least one payment after the tax year of the sale. For the seller, the beauty of an installment sale is that it allows you to receive interest on the full amount of the promissory note, often at a rate that exceeds the rate you could earn from other types of investments, while simultaneously deferring income taxes. Installment arrangements can pay off for buyers, too. Buyers avoid paying the full purchase price upfront without dealing with the headaches of obtaining outside financing. Not to overlook the obvious, there may also be some disadvantages for sellers, such as the buyer defaulting on the note for failure to make payments when due. Additionally, with tax rates scheduled to increase in 2013 unless Congress acts, deferring gain recognition into future years can result in an increase in income taxes. The Installment Method You generally must report an installment sale on your tax return using the “installment method” rules. Each installment payment typically comprises three components:

1. Interest income,
2. Return of your adjusted basis in the property, and
3. Gain on the sale.

For every taxable year in which you receive an installment payment, you must report as income the interest and gain components. Calculating taxable gain involves multiplying the amount of payments (excluding interest), received in the taxable year by the gross profit ratio realized on the sale. The gross profit ratio is equal to the gross profit (the selling price less adjusted basis and selling costs) divided by the total sales price. The portion of any gain attributable to depreciation recapture (which converts a portion of the capital gain into ordinary income) is ineligible for installment sale treatments. Also, taxpayers must pay interest to the Internal Revenue Service on the deferred tax liability attributable to any installment obligation in excess of $150,000 that arose during the taxable year and remains outstanding at the close of the taxable year (if the face amount of all such obligations that arose during the year and remain outstanding at the end of the year exceeds $5 million). As a general rule, dealers in real or personal property are ineligible to use the installment method. However, certain limited exceptions to this rule are available to dealers of time-shares and residential lots if these taxpayers elect to pay a special interest charge. Your financial advisor may be able to help you structure your transactions to avoid this special interest charge. Many Considerations While an installment sale can be beneficial to the seller as well as the buyer, be aware that you can elect out of installment sale tax treatment and report all of the gain as income in the year of the sale. This might be preferable if you expect tax rates to increase or you have loss carryforwards or other carryforward deductions. The rules are complicated and there are many factors to consider, so discuss the transaction with your accountant to determine whether an installment sale could work for you.

Decisions, Decisions: Options for Minimizing Exit Costs from a CMBS Loan

Commercial mortgage-backed securities (CMBS) loans provide real estate investors access to a larger pool of financing at lower rates than they could qualify for on their own. But when buying a property that you’re financing with a CMBS loan, it’s important to consider the consequences of exiting the loan. Such forethought will be rewarded with greater flexibility and lower costs if you later decide to refinance or sell the property. To sell or refinance a property before the term of its CMBS loan expires, you must first be released from your debt obligations. One way is to locate a buyer with sufficient capital to assume your remaining debt. But this is often unrealistic and may even be prohibited by the loan agreement. Other routes to consider include: 1) yield maintenance and 2) defeasance. Option 1: Yield Maintenance Under this option, you prepay the outstanding principal balance on your loan, including any prepayment penalty. Prepayment penalties on vintage CMBS loans are based on a percentage of the outstanding balance that declines over the term of your loan. More common today are prepayment penalties that allow the lender (or trustee, in the case of a securitization) to recover the same yield it would have earned if you’d made all payments on the loan through maturity. The penalty equals the net present value of the remaining payments multiplied by the difference between the loan’s interest rate and the “replacement rate,” typically the rate on the U.S. Treasury security that has the closest maturity date to the loan. The lender or trustee can then reinvest the prepaid principal balance in government securities to maintain its yield. The higher the loan rate and the lower the Treasury rate, the greater the penalty. Why? In theory, the lender will now be left to invest its money in a Treasury security with a lower yield than the loan would have paid. Even if the Treasury rate exceeds the loan rate, you’ll probably incur a penalty. That’s because yield maintenance provisions generally incorporate a minimum penalty of 1% to 3% of the outstanding balance. Minimum penalties dissuade you from prepaying or refinancing CMBS loans when interest rates drop. Option 2: Defeasance With defeasance, you substitute collateral — a portfolio of noncallable and nonprepayable U.S. government securities — for the real property that originally secured the loan. A successor borrower assumes the loan, and future payments come from the cash flow generated by the portfolio. A Real Estate Mortgage Investment Conduit (REMIC) prohibits defeasance for at least the first two years following securitization. While defeasance usually imposes no formal prepayment penalty, you could incur a penalty which is embedded in the cost to purchase a portfolio that corresponds to the loan’s debt service schedule. If the interest rate on the loan being defeased is greater than the Treasury rate on the substitute portfolio, the cost of the substitute portfolio required to cover the outstanding balance on the loan, will exceed the outstanding balance. But if the Treasury rate is more than the loan rate, it will cost you less to purchase a substitute portfolio of government securities. Regardless, you’ll always incur transaction fees with defeasance. Compared to yield maintenance payoffs, defeasance is more administratively complex and time consuming. Craft the Loan Document The cost to exit a CMBS loan ultimately turns on current interest rates and the loan terms, and you can influence only one of those things. Loan provisions addressing yield maintenance should include an explicit formula for computing the penalty, with the replacement rate clearly defined and set as high as possible. A high replacement rate translates to a reduced penalty. Try to avoid any reference to a minimum prepayment penalty; if not possible, limit the minimum penalty to 1%. From a defeasance perspective, you should retain the right to purchase the portfolio and hold governmental agency securities in it. These can pay a higher yield than Treasury securities, which in turn can result in lower costs. Existing CMBS Loans If you already have a CMBS loan in place that you want to get out of, it’s probably too late to negotiate the exit terms. The current low Treasury rates will likely make yield maintenance a better option because the cost of a portfolio for defeasance might exceed the loan’s outstanding balance. Defeasance will become more attractive if higher Treasury rates return, because you may be able to avoid a quasi-penalty and will definitely avoid a formal prepayment penalty. Look Down the Road Ideally, you should consider exit scenarios from CMBS loans at the outset so that you can secure favorable exit provisions. It can be difficult, if not impossible, to renegotiate loan terms.

How to Leverage Loss Deductions when Transferring FLP or LLC Interests

Perhaps like many real estate investors, you hold properties in a family limited partnership (FLP) or limited liability company (LLC). In such a case, you’re likely making transfers of ownership interests to family members in an effort to “shift” income to those in a lower tax bracket or to tax efficiently transfer wealth to the next generation. But, in the current economy, some properties held by an FLP or LLC may be generating operating losses. And that’s where you need to be careful. Beware the Pitfalls Transferring FLP and LLC interests to family members can provide opportunities to shift taxable income from a higher-income-tax-bracket taxpayer to a lower-bracket one, as long as the recipient isn’t subject to the “kiddie tax.” For 2012, the kiddie tax is applied- at the recipient’s parents’ marginal tax rate- to unearned income in excess of $1,900. Children under age 18 (or those who are 19 through 23 years old and a full time student during the year) whose earned income is less than or equal to half their support, are subject to the tax. But this income-shifting strategy can backfire if you’re transferring interests in an FLP or LLC holding rental real estate that’s operating at a loss for tax purposes: You may be transferring losses to a taxpayer whose tax benefit from the loss would be at a significantly lower rate or, worse yet, who doesn’t have enough income or basis to absorb or take the loss. For example, if you’re in the 35% tax bracket and you shift $25,000 in annual losses through a gift to your 25-year-old daughter in the 10% tax bracket, there’s a 25-percentage-point differential in tax rates, resulting in $6,250 less tax benefit from the loss. Even worse, your daughter may not be able to currently deduct any of the loss because of the passive activity rules. Unless she qualifies as a real estate professional, the losses will be passive to her. And she may not have any passive income and, as a result, likely won’t qualify to deduct the loss. You, on the other hand, may have passive income to absorb the loss or qualify as a real estate professional for whom real estate activity losses are deductible against ordinary income. Maximize Loss Deductions You can still make a gift of an FLP or LLC interest and maximize the benefit of loss deductions. One way is to make gifts via an “intentionally defective” grantor trust (IDGT). Instead of transferring the interest to an individual, you transfer it to the IDGT, which is designed to be a completed transfer for gift and estate tax purposes, but not for income tax purposes. So, while the asset is removed from your taxable estate for estate tax purposes, you continue to get the benefit of the losses from the interest owned by the trust. (Note that you also will continue to pay tax on any income the trust assets earn.) Professional Help Helps As you can see, transfers of FLP and LLC interests to family members can be tricky. Your CPA can help you maneuver through the maze of tax laws, so you can reach your intended goals.

Ask the Advisor: My Commercial Tenant Just Filed for Bankruptcy - Now What?

The uncertain economy is teaching landlords a hard lesson. Even reliable, long-time tenants can tread water for only so long, and bankruptcy is an inevitable reality for some. A tenant’s bankruptcy filing has repercussions for its lease obligations, so it’s important to know what to expect and how to protect yourself. Important Deadlines In a Chapter 7 liquidation, a tenant must assume or reject an unexpired lease within 60 days of filing or within any additional period granted by the bankruptcy court. In a Chapter 11 reorganization, the tenant typically has 120 days, which the court may extend 90 days without landlord consent. Further extensions require landlord consent. The tenant must make all payments due under the lease during the decision period. If the tenant doesn’t make payments, the landlord can get permission from the court to seek remedies, including repossession. However, a tenant doesn’t have to pay any outstanding rent obligations incurred before the bankruptcy filing in order to stay in possession. The landlord will have a claim for the pre-filing rents owed and will line-up with other creditors in filing a claim for payment. Rejection If the tenant doesn’t make a decision by the applicable deadline, the lease is deemed to be rejected and the landlord regains possession of the property. If the tenant doesn’t surrender the premises, don’t take action to evict or you might be liable for your tenant’s damages, including legal fees and possibly punitive damages. You must instead file a motion with the bankruptcy court. Similarly, if the tenant proactively decides to reject the lease, the tenant must surrender the premises. The pre-filing rent due remains outstanding and the landlord can file a claim for rejection damages if the lease has at least one year left. Rejection If the tenant doesn’t make a decision by the applicable deadline, the lease is deemed to be rejected and the landlord regains possession of the property. If the tenant doesn’t surrender the premises, don’t take action to evict or you might be liable for your tenant’s damages, including legal fees and possibly punitive damages. You must instead file a motion with the bankruptcy court. Similarly, if the tenant proactively decides to reject the lease, the tenant must surrender the premises. The pre-filing rent due remains outstanding and the landlord can file a claim for rejection damages if the lease has at least one year left. Assumption or Assignment To assume the lease, the tenant must obtain bankruptcy court approval, cure all lease defaults and provide adequate assurance of future performance on the lease. If the tenant wishes to assign the lease, it first must assume the lease and then it can propose an assignee. Bankruptcy courts generally approve assignment, regardless of anti-assignment clauses in leases. You can object if:

• The assignee isn’t as financially sound as the original tenant when the lease began,
• The tenant will alter percentage rent rates,
• The assignee will disrupt your tenant mix, or
• The assignment violates location, use or exclusivity provisions of the lease.

It’s up to the judge to decide whether your objection is reasonable. Act to Protect Yourself Landlords should look for bankruptcy warning signs .If your tenant is in default under the terms of the lease, exercise your legal rights and seek available remedies sooner rather than later. But if bankruptcy strikes, take measures to enforce your rights.

Spotlight on Marks Paneth

Marks Paneth Names New Leader for Westchester Office Eric Marks, MPA, MBA, SPHR, has been appointed Principal-in-Charge of the firm’s Westchester office. From our base in Tarrytown, Marks Paneth offers accounting, auditing, tax, consulting, restructuring, bankruptcy and advisory services as well as litigation and corporate financial advisory services to businesses and individuals throughout Westchester and Fairfield Counties. An executive coach and business advisor providing leadership in strategic human resource and specialized business management issues to closely held, family-owned and mid-sized companies, he continues to lead Marks Paneth in a broad range of human resources activities. He is a Certified Coach and one of only a few practitioners of the Herrmann Brain Dominance Inventory (HBDI).

For Further Information

If you have any questions, please contact William Jennings, Partner-in-Charge of the Real Estate Services Group at 212.503.8958 or wjennings@markspaneth.com or any of the other partners in the Marks Paneth Real Estate Services Group:

• Timothy Andrews at tandrews@markspaneth.com
• Vincent Barra at vbarra@markspaneth.com
• Bradley Eckstein at beckstein@markspaneth.com
• Robert Feldman at rfeldman@markspaneth.com
• Kurt Kiess at kkiess@markspaneth.com
• Harry Moehringer at hmoehringer@markspaneth.com
• Susan Nadler at snadler@markspaneth.com
• Abe Schlisselfeld at aschlisselfeld@markspaneth.com
• Michael Saul at msaul@markspaneth.com
• Michael Siino at msiino@markspaneth.com
• Howard Warshaw at hwarshaw@markspaneth.com

IRS Circular 230 Disclosure

Treasury Regulations require us to inform you that any Federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © Marks Paneth LLP 2012 MANHATTAN | LONG ISLAND | WESTCHESTER | CAYMAN ISLANDS

About William H. Jennings