recognition likely will inhibit many project owners from electing to restructure their mortgages
under a proposal.

12



Hi. BACKGROUND

Multifamily Section 8 Housing Assistance

The Department of Housing and Urban Development ("HUD") has employed a number
of subsidy mechanisms, contained in the United States Housing Act of 1937 as amended, to
promote and retain adequate and affordable rental housing for low- and moderate-income
individuals and families. The subsidies are either provided to: (1) owners of particular apartment
units (project-based subsidies) or (2) low-income individuals or families (tenant-based
subsidies). The subsidies are either direct (e.g., monthly cash rental payments) or indirect (e.g.,
mortgage insurance provided through the Federal Housing Association ("FHA")).

For the type of multifamily housing projects that are addressed under the most recent
HUD proposal (a proposal HUD calls “portfolio re-engineering”), HUD has previously
combined two different subsidies. These subsidies are (1) mortgage insurance and (2) project-
based Section 8 cash rental payments (by reference to Section 8 of the United States Housing
Act of 1937).

The first subsidy mechanism is mortgage insurance provided through the FHA.
Typically, a mortgage was created upon the development of a project, which had an amortization
schedule that assumed 40 years of Section 8 cash rental payments. The mortgage insurance also
typically had a duration of 40 years, and provided that HUD, through FHA, would pay principal
and accrued interest on the mortgage in the event that the mortgagor fails to meet payment
obligations. For most projects for which it originally was provided, HUD continues to carry this
mortgage insurance. In some cases a default has occurred and HUD now directly holds the
mortgage.

The second subsidy mechanism was Section 8 monthly cash rental payments. These can
be described as supplements to the stream of rental income from a housing project which, when
combined with the rents paid by tenants, generally equal payments on the mortgage on the
project. The duration of these payments varied from 15 to 40 years, with a typical duration of 20
years. While these rental payments were entitled "fair market rents" or "fair market rents for
new construction," they often represented amounts in excess of the rent that would have been
negotiated between a willing landlord and a willing tenant. The amount of rent that would have
been negotiated between a willing landlord and a willing tenant is often referred to as “street
rent.” While the cash rental payment for each project was separately negotiated, it is now
commonly believed to have initially exceeded "street rent" for many of these low-income
projects. The automatic inflator formula in these contracts designed to take into account
inflation often maintained or exacerbated these excessive payments in the years after the project
was placed in service. As a result, many of these projects continue to receive rent payments of
150 percent or more of their street rent.

While there is some variety as to the structure of these deals, the typical formulation was
as follows. A developer of a low-income project (low-income tenants were then classified as


other than C corporations (sec. 108(a)(1)(D)). This exception has the effect that an individual
owner of a project, or an individual investor in a partnership that owns a project, could be able to
exclude an amount of COD income equal to his or her total basis in the project and other
depreciable real estate investments, whether held directly or in partnership form.*

ll Scenari

Under the Proposal and the First and Second Alternatives, there is a possibility that the
owner will be required to recognize taxable COD or subsidy income in an amount up to the
entire principal amount of the Second Mortgage. This could occur as a result of application of
one of several tax doctrines that prevent financial transactions from having the tax consequences
that would normally follow from their form (as opposed to their substance).

Debt v. equity.--The most likely challenge would probably assert that the terms of the
Second Mortgage do not justify treatment as a debt instrument for tax purposes, but rather as
some sort of equity interest in the property.® The determination of whether an investment

* Qualified real property business indebtedness is indebtedness that (1) is incurred or
assumed in connection with real property used to a trade or business, (2) is secured by that real
property, and (3) with respect to which the taxpayer has made an election under this provision.
Indebtedness incurred or assumed on or after January 1, 1993, is not qualified real property
business indebtedness unless it is either (1) debt incurred to refinance qualified real property
business debt incurred or assumed before that date (but only to the extent the amount of such
debt does not exceed the amount of debt being refinanced) or (2) certain acquisition indebtedness
(sec. 108(c)(3)).

The amount excluded under the provision with respect to the discharge of any qualified
real property business indebtedness may not exceed the excess of (1) the outstanding principal
amount of such debt (immediately before the discharge), over (2) the fair market value
(immediately before the discharge) of the business real property which is security for the debt,
reduced by the principal amount of any similar indebtedness to which it is subject (sec.
108(c)(2)(A)). The amount excluded is subject to an overall limitation which is generally equal
to the aggregate adjusted bases of the taxpayer's depreciable real property immediately before
the discharge (sec. 108(c)(2)(B)). Because of this overall limitation, it unlikely that the project
owners subject to the HUD restructuring proposals will be able to avail themselves of the
qualified business real property exception to COD recognition. It is understood that most of the
teal property subject to the HUD restructuring proposals were placed in service several years ago
and thus have a zero or low adjusted basis. However, to the extent the project owners own other
qualified real property, they may be able to use the exception.

° Analytically, the equity interest would be in a constructive joint venture or partnership
that owns the property. For properties that are actually owned by partnerships or joint ventures,
the equity interest would be in that entity.



I. DESCRIPTION OF MORTGAGE RESTRUCTURING PROPOSALS

The Portfolio Re-engineering Proposal

The portfolio re-engineering proposal is intended to place the affected low-income
projects in a true market position and to reduce HUD’s financial responsibilities under both the
Section 8 cash rent payment agreements and the potential mortgage insurance liability (the
"Proposal"). The affected projects are only those which: (1) have Section 8 cash rental payments
in excess of street rent and, (2) have a mortgage in excess of the amount which can be supported
if the amount of cash rental payments is reduced to street rent levels. Under the Proposal, HUD,
the project owners, and the mortgage holder must agree to all three elements of the restructuring.

The three elements are as follows. First, the cash rental payments would be reduced to an
amount intended to reflect street rents (the ability to determine actual street rents could vary
from project to project). Second, the mortgage holder would accept a cash payment from HUD
to reduce the outstanding mortgage (with a level principal and interest schedule) to an amount
which can be supported under the new financing structure (the "First Mortgage"). Third, HUD
would hold a subordinated second mortgage at or below a market rate of interest with a back-
loaded principal and interest repayment schedule (the "Second Mortgage").”

Alternative Proposals

There are two related alternatives to the basic mortgage restructuring proposal described
above. Under the first alternative, where HUD currently holds the mortgage pursuant to the
lender previously filing a mortgage insurance claim after a nonpayment by the project owners
(he “First Alternative”), the restructuring would involve HUD bifurcating the debt into first and
second mortgages. Presumably, the first mortgage would then be sold to a unrelated third party.

Under the second alternative, where the current lender will not continue to be party to the
transaction (the “Second Alternative”), HUD would fully satisfy the outstanding mortgage
currently held by a current lender and replace it with first and second mortgages. This
alternative is contemplated in cases where the current holder of the mortgage refuses to accept
the proposal or HUD has some reason to want to eliminate this party from the restructuring.
Again, the new first mortgage would presumably be transferred to an unrelated third party and
HUD would retain the second mortgage.

In all cases, the cash rental payment would be reduced to “street rent” levels, an unrelated
third party would hold a first mortgage which could reasonably be supported by the project for
the its term, and HUD would hold a second mortgage which would be satisfied at the end of the
cash rental payment contract/first mortgage from the proceeds of the sale of the project.

> A version of this proposal can be found in H.R. 2447, as-introduced by Mr. Lazio.
5



persons with 80 percent or less of area median income) would negotiate with HUD a package of
subsidies to be provided to the low-income project. The developer would then create a single-
asset partnership, interests in which would be issued to investors. The costs of development,
including developer’s fees, would be passed on to the partnership. The developer generally
would act as the general partner in this single-asset partnership. The developer, who typically
would retain a one to five percent interests in the partnership, would then solicit limited partners
for the remaining 95 to 99 percent interests in the partnership. All debt undertaken by the
partnership was nonrecourse, meaning that the partners’ liability was limited to their equity
investment in the partnership. Generally, the equity investment was very small and the assets of
the partnership were very highly leveraged. This structure also served to maximize the favorable
tax aspects associated with these tax shelters. The limitation of these tax benefits, principally
through the passive loss rules of the Tax Reform Act of 1986, may have reduced the
attractiveness of such investments and limited the availability of new capital for these types of
deals.

The partnership usually would finance the project (including development costs) through
a private mortgage secured by the low-income project building. The mortgage could involve
taxable or tax-exempt debt. The tax-exempt debt structure generally involved privately
marketed tax-exempt bonds. Whether the debt was taxable or tax-exempt, a private third party
would grant the partnership a loan secured solely by the low-income project property. The
private third-party would either hold the mortgage or in turn sell interests in the mortgage to
other investors. The type of the private third-party investors could be affected by the nature of
the debt. For example, taxable persons would be more likely to invest in tax-exempt debt than
tax-exempt entities such as pension funds. The private third-party investors contracted with an
unrelated vendor to service the mortgage (collect principle, interest, and escrow accounts) for a
fee.

The crux of the problem is that, with the expiration of many of the Section 8 cash rental
subsidies, HUD now wants to bring these projects into line with true market rents (i.e., street
rents). However because without additional capital contributions by the partners or other cash
infusion, the debt service of the 40-year mortgages cannot be met without continuing the non-
economic rental payments, the problem to be addressed by HUD and-Congress is how to bring
the rental payments down to “street rent” levels and reduce FHA and HUD liability under the
mortgage insurance program. A description of proposed solutions follows below.



recognize income in the taxable year of the refinancing as a result of its terms.

First alternative

These issues are clearest under the First Alternative. Because under the First Alternative
HUD is already the holder of the First Mortgage on the property, the issuance of the Second
Mortgage to HUD in exchange for a reduction in the payments required under the First Mortgage
could be viewed as a "debt-for-debt" exchange between the owner and HUD. In such an
exchange, section 108(e)(10) of the Code provides that a borrower recognizes COD income in an
amount equal to the difference between the amount of the original indebtedness and the "issue
price" of the new indebtedness. The issue price of the First Mortgage as a result of the
refinancing will be its new reduced principal amount (Treas. reg. sec. 1.1273-2(d)). Due to the
low interest rate of the Second Mortgage, its issue price will be an imputed amount lower than its
principal amount, which will be determined by a calculation that discounts all payments to be
made on the Second Mortgage at the long-term Applicable Federal Rate (sec. 1274(b)). Thus,
under the First Alternative, section 108(e)(10) will require that an owner realize COD income in
the amount of the difference between the principal amount of the Second Mortgage and its lower
issue price under this calculation.

In the First Alternative, it is possible that structuring the First and Second Mortgages as a
single debt instrument held by HUD will reduce the amount of COD income realized by the
owner. If treatment as a single instrument is respected, the combined instrument would result in
COD income under the above analysis only if the total of the interest payable on the First and
Second Mortgages was below the long-term Applicable Federal Rate for the combined
instrument. The staff of the Joint Committee has been unable to locate any authority as to
whether combining the First and Second Mortgages into a single instrument would be respected
for purposes of the COD calculation. However, the original issue discount rules provide a
helpful analogy.’ In any event, for owners whose COD income would be reduced by treating
the First and Second Mortgage as a single instrument, there seems little downside to structuring
the First Alternative in this manner.’

Depending on the situation of the individual owner, all or a portion of any COD income
realized may be excluded from recognition under the rules of section 108 of the Code in
exchange for a reduction of favorable tax attributes. One of these rules allows exclusion of COD
income arising from "qualified real property business indebtedness" in the case of taxpayers

3 Under the original issue discount rules, all debt instruments issued in the same
transaction or related transactions are treated as a single debt instrument (Treas. reg. 1.1275-

2(c))

* Even if the First and Second Mortgages are not structured as a single instrument, an
owner may be entitled to claim such treatment as a reporting position based on the analogy of the
original issue discount rules.



WRITTEN TESTIMONY

OF THE STAFF OF THE JOINT COMMITTEE ON TAXATION
REGARDING FEDERAL INCOME TAX ASPECTS OF
PROPOSALS TO RESTRUCTURE CERTAIN FHA-INSURED

MULTIFAMILY MORTGAGE PORTFOLIOS

FOR A HEARING
OF THE
SUBCOMMITTEE ON HOUSING
AND COMMUNITY OPPORTUNITY
OF THE HOUSE COMMITTEE
ON BANKING AND FINANCIAL SERVICES

SEPTEMBER 17, 1997

PRESENTED
BY
KENNETH J. KIES
CHIEF OF STAFF
JOINT COMMITTEE ON TAXATION
U.S. CONGRESS

SEPTEMBER 17, 1997
JCX-46-97



In the First and Second Alternatives, HUD becomes the holder of both the First and
Second Mortgages. In these Alternatives, the issue of reclassification of the Second Mortgage
as equity should be reduced somewhat if the First and Second Mortgages are combined into a
single debt instrument. Because the First Mortgage possesses nearly all of the indicia of debt
established by the case law, the First Mortgage terms may be sufficient to protect a combined
First and Second Mortgage from reclassification as equity.

Other doctrines.--It is possible, although less likely, that the Second Mortgage could be
successfully challenged on the basis of other tax doctrines which can be used to modify the tax
consequences ordinarily flowing from the "form" of a transaction. For example, it is possible
that the refinancing could be challenged on the basis that it is a "sham transaction"? or that it
serves only a tax avoidance purpose rather than a non-tax economic purpose.'° Because the
impetus for the refinancing came from documented housing policy concerns, and the rights
granted to HUD under the Second Mortgage are significant, a successful challenge of the Second
Mortgage under such doctrines seems less likely than on the basis that it is in substance equity.
Possible challenges under doctrines other than debt/equity would be reduced if the Second
Mortgage were required by the enabling legislation.

Tax consequences.--Regardless of the particular doctrine utilized, if the form of the
Second Mortgage as a valid debt relationship between the owner and HUD is successfully
challenged, the owner will be treated as recognizing income in the year of the refinancing due to ,
the reduction in the First Mortgage resulting from the new cash infusion provided by HUD. This
income could be characterized either as COD income or as a taxable subsidy. The amount of
such taxable income should be the principal amount of the Second Mortgage, reduced to account
for the value of HUD's rights to cash flow and sale or refinancing proceeds under the terms of
the Second Mortgage. If the income recognized by the owner were characterized as COD
income, the statutory exceptions to the recognition of such income discussed above would be
available.

Imputed Income Based on Interest Rate of Second Mortgage

Even if no taxable COD or subsidy income is realized by the property owner under the
above analysis, there is still a issue as to whether the owner will be required to recognize taxable
income in the year of the refinancing as a result of the treatment of the Second Mortgage as a

advisable for the owner to grant significant rights to HUD in addition to those in the Second
Mortgage--such as participation in an increase in rents or the profits from sale of the property--in
order to increase the total value of the equity.

° See, Knetch v. U.S., 364 U.S. 361 (1960)

1° ACM Partnership v. Commissioner, T.C. Memo 1997-115 (1997).
10



constitutes debt or equity for tax purposes is generally made on the basis of factors which have
been articulated in a long line of court cases. These factors generally reflect terms that would be
required by an unrelated debtor making a commercial Joan on arm's length terms. One recent
case provides the following list of debt/equity factors that have been used by the courts:

names given to certificates evidencing the indebtedness;
presence or absence of a fixed maturity date;

source of payments;

right to enforce payments;

participation in management as a result of the advances;
subordination to other creditors;

intent of the parties to credit a debt;

ratio of purported debt to equity;

ability of debtor to otherwise obtain credit from outside sources;
10. use to which the advances were put;

11. failure to debtor to repay; and

12. issue involved in making advances.’

OSNDARWN

od

The Second Mortgage in this scenario may be viewed as lacking several of the indicia of
debt established by the case law due to the special nature of the refinancing. The refinancing is
motivated by housing policy concerns of reducing the debt to a level which can be serviced by
projected rents. These are not concerns that would motivate a commercial lender. As a result,
the terms of the Second Mortgage lack some of the case law indicia of debt, including the lack of
adequate security and the lack of required payments on the indebtedness (until sale or
refinancing) in the absence of the adequate cash flow. Although somewhat less important, the
non-market rate of interest also is a factor against characterization of the Second Mortgage as
debt. However, the Second Mortgage also possesses a number of the indicia of debt under the
case law, including the form of the certificates, the intent of the parties to create debt, the fixed
maturity date, the unrelated nature of the parties, HUD's lack of a management relationship or
interest in upside profit beyond the principal amount of the Second Mortgage, and other
provisions found in standard commercial loan documents. Thus, if the Second Mortgage is
challenged on the basis that it constitutes a type of equity rather than debt, it is not possible to
predict with certainty how a court would resolve this issue.*

7 Dairies Corp. v. Commissioner, 74 T.C. 476 (1980). See also Plumb, "The Federal
Income Tax Significance of Corporate Debt," 26 Tax L. Rev. 369 (1971).

* As an alternative, it is worth considering structuring the Second Mortgage in the form
of an equity interest. This would prevent challenge under the debt/equity case law and would
also reduce the likelihood that the owner has COD income under the First Alternative. However,
this variation would still be subject to challenge on the basis that the equity rights granted by the
owner are not equal in value to the cash infusion by HUD, with the result that the difference
must be treated as taxable income to the owner. Thus, under the equity variation, it would be

9



IV. FEDERAL INCOME TAX ASPECTS RESTRUCTURING PROPOSALS

Tax Issues of Mortgage Restructuring, in General

Because HUD is a tax-exempt government entity, the major tax issues of the refinancing
are those facing the owners of the various properties covered.

Under section 61 of the Code, the gross income of a taxable individual or entity includes
“all income from whatever source derived." Specifically included in gross income is income
from cancellation of indebtedness ("COD") (sec. 61(a)(12)). Government subsidies provided to
a taxable individual or entity are also included in gross income for unless excluded pursuant to a
specific exception.

Section 7872 of the Code addresses the tax treatment of certain below-market loans and
generally imputes taxable payments on such loans to account for the difference between the
interest actually paid and interest at the Applicable Federal Rate (generally the rate at which the
Federal government borrows money for the term of the instrument in question).

Owners possibly will be required to recognize taxable income in the year of the
refinancing either as a result of (1) the treatment of the refinancing terms as a taxable subsidy or
COD or (2) an imputed payment on the Second Mortgage under the below-market loan rules of
section 7872.

The issues of taxation as a result of the terms of the refinancing is different for the three
different scenarios. Under the First Alternative, the owner (under the appropriate facts and
circumstances) likely will recognize COD income in the amount of the difference between the
principal amount of the Second Mortgage and a lower imputed principal amount determined by
treating a portion of future payments on the Second Mortgage as payments of interest at the
long-term Applicable Federal Rate (currently 6.45 percent). Under each of the Proposal and the
First and Second Alternatives, there is also a issue that an amount up to the total principal
amount of the Second Mortgage will be treated as taxable COD or subsidy income to the owner.

Even if taxable COD or subsidy income does not result from the refinancing, there is an
issue under all scenarios that the owner will recognize taxable income in the year of the
refinancing as a result of treatment of the Second Mortgage as a below-market loan subject to the
tules of section 7872. The amount of such income would be equal to the difference between the
principal amount of the Second Mortgage and the imputed principal amount which results from
discounting at the long-term Applicable Federal Rate. Unlike the issue of taxable COD or
subsidy income, the issues of income recognition to the owner under the below-market loan rules
of section 7872 is roughly the same under all three scenarios.

Cancellation of Indebtedness or Subsidy Income

Under each of the scenarios, there is a possibility that the owner will be required to



treatment under any of the HUD restructuring proposals, it is likely that many project owners
will not elect to restructure their FHA-insured mortgages before the expiration of their Section 8
contracts for fear of incurring immediate tax liabilities. Thus, the budgetary cost of providing
tax relief legislation should be balanced with the budgetary savings that the restructuring
proposals represent and with the program goal of maintaining the stock of low-income housing.

The analysis contained herein is based upon the application of the present-law provisions
of the Intemnal Revenue Code of 1986 ("Code"), Treasury Department regulations issued
pursuant to these provisions, relevant judicial decisions, and common law tax principles. The
understanding of the staff of the Joint Committee on Taxation as to the operation of current and
proposed HUD multifamily housing programs is based upon a review of materials provided by,
and conversations with, the staff of the Subcommittee on Housing and Community Opportunity,
Congressional Budget Office staff, HUD personnel, and representatives of interested parties.

Following is a discussion of the background on multifamily housing assistance (Part II); a
description of housing restructuring proposals (Part III), the Federal income tax aspects of these
proposals (Part IV), and a brief economic analysis (Part V).



V. ECONOMIC ANALYSIS

According to the Congressional Budget Office, approximately 850,000 rental housing
units receive project-based Section 8 rent subsidies and have mortgages insured by the FHA.
The Section 8-assisted rental payments exceed market value (as determined by the rent received
by comparable unassisted units) for about 58 percent, or almost 500,000, of these units. These
units receive Section 8 rent subsidies pursuant to contracts that ranged originally from 15 to 40
years, with a typical rent subsidy contract lasting 20 years. The FHA-insured mortgage typically
lasts about 40 years. Most of the Section 8 contracts are scheduled to expire by 2003, while the
mortgage insurance obligations will continue another 20 years.

Under present Jaw, the Section 8 rent subsidy contracts may not be renewed at more than
120 percent of the fair market rent. At these rent levels, it is anticipated that many of these
projects default on their mortgages, which would result in large losses to the FHA insurance
fund, and probable displacement of a large number of the low income tenants. HUD anticipates
that many of those owners who anticipate default will fail to maintain their properties during the
years immediately preceding the default, thus causing a decline in value of the properties FHA
would eventually be forced to acquire. The staff of the Joint Committee on Taxation
understands that the Congressional Budget Office estimates that losses to the FHA insurance
fund would total approximately $7.6 billion over the 1998 - 2010 period. The cost in terms of
eventually restoring the housing stock lost to the disinvestment in the protracted foreclosure
process is likely to be much higher.

These mortgage restructuring proposals are designed to reduce the cost of unexpired
Section 8 contracts, to reduce losses to the FHA insurance fund, and to reduce losses in the
supply of low-income housing, by providing an incentive for investors to restructure their
mortgages, rather than default on them. A successful restructuring of the mortgage would limit
the FHA/HUD exposure to the amount in the second mortgage, and ensure that the affected units
continue to be maintained and to be made available to low-income tenants. However, if the
restructuring is deemed by the Internal Revenue Service to trigger taxable income, the resulting
income tax liability is likely to make the restructuring deal unattractive to many of the affected
investors.

In particular, very few investors whose Section 8 contracts expire after the year the
restructuring program would sunset are likely agree to restructure their mortgages early. It
would be preferable to most investors to default on the mortgage at the time the contract lapses,
and claim capital gains treatment on the default, rather than to take the restructured amount into
income in the earlier time frame contemplated by the proposal as ordinary income. Thus, to the
extent that this restructuring mechanism is expected to trigger taxable income at the time of the
restructuring, it is likely to attract fewer investors, and result in little savings to the Section 8
program or the FHA insurance fund.

If this legislation were amended in such a way as to ensure that the restructuring
mechanism would not trigger taxable income for the investors, it is likely that a larger percentage

13


1. INTRODUCTION

My name is Ken Kies. I am the Chief of Staff of the Joint Committee on Taxation. It is
my pleasure to present the testimony of the Joint Committee at this hearing on the Federal
income tax aspects of various proposals to restructure certain multifamily housing mortgages
that are insured by the Federal Housing Association ("FHA").

Under present law, the Department of Housing and Urban Development ("HUD") utilizes
a number of subsidy programs to promote and retain adequate and affordable rental housing for
low- and moderate- income individuals and families. As described in detail below, among these
is a program wherein owners of multifamily housing projects are provided cash rent subsidies
from HUD and mortgage insurance provided through the FHA. In many cases, the duration of
the term of the rental payments (typically, 20 years) is shorter than the term of the mortgage
(typically, 40 years), and the expiration of the rental subsidies may cause some project owners to
default on their mortgages, potentially triggering the FHA guarantees. There have been several
proposals to address this situation. These proposals generally would involve an up-front infusion
of cash by HUD that is used to restructure the original project mortgage, with HUD then taking a
second mortgage, generally at a below-market interest rate.

The principal Federal income tax issue presented by these restructuring proposals is
whether the project owner would recognize income as a result of the mortgage restructuring.
Income recognition may be required if (1) the up-front cash payment from HUD is treated as a
taxable subsidy to the project owner or (2) the project owner is treated as having cancellation of
indebtedness income under the transaction. Whether or not the project owner is treated as
having cancellation of indebtedness income under the transaction depends upon a variety of
factors, including the extent to which the second mortgage is recognized as a bona fide debt, and
whether the stated principal amount of the debt is respected for tax purposes. These
determinations often are based upon all the relevant facts and circumstances underlying the
transaction. Because each HUD mortgage restructuring will involve a unique fact pattern, a
blanket statement accurately describing the likely Federal income tax consequences for all
project owners cannot be made. Rather, the following testimony describes the general Federal
income tax aspects that must be considered in the typical proposed restructuring transaction.
However, it is likely that if all project owners restructure their mortgages pursuant to any of the
proposals, some of these taxpayers would incur increased tax liabilities as a result of the
transactions.

Absent legislation or a Treasury announcement clarifying the Federal income tax

' This document may be cited as follows: Joint Committee on Taxation, Written
Testimony of the Staff of the Joint Committee on Taxation Regarding Federal Income Tax
Aspects of Proposals to Restructure Certain FHA-Insured Multifamily Mortgage Portfolios
(JCX-46-97), September 17, 1997.


CONTENTS

I. INTRODUCTION ....000 cece dene

Il. BACKGROUND

Ill. DESCRIPTION OF MORTGAGE RESTRUCTURING PROPOSALS ....

IV. FEDERAL INCOME TAX ASPECTS OF MORTGAGE
RESTRUCTURING PROPOSALS ..........0.0...00.0...0.000000.

Vv. ECONOMIC ANALYSIS .. 2.20.0. 2 occ cece eee



below-market loan subject to the imputed interest rules of section 7872."

One type of loan that is subject to the provision is a "tax-avoidance loan" (sec.
7872(c)(1)(D)). Another type of loan that qualifies is a loan with a "significant effect" on the tax
liability of the lender or the borrower (sec. 7872(c)(1)(E)). There is a possibility that the Second
Mortgage will be treated as one of these types of loans subject to the imputed income rules of
section 7872. If the Second Mortgage is so treated, the owner would recognize taxable income
in an amount.equal to the excess of the principal amount of the Second Mortgage over an
imputed principal amount determined by discounting all payments to be made on the Second
Mortgage at the long-term Applicable Federal Rate (sec. 7872(b)(1))."”

There is a possibility that the Second Mortgage will be excepted from section 7872 under
a Treasury regulation which covers "loans subsidized by the Federal . . . government (or any
agency or instrumentality thereof), and which are made available under a program of general
application to the public" (Temp. Treas. reg. sec. 1.7872-5T(b)(5)). However, there is a issue
that the HUD refinancing program will not qualify under this regulation on the basis that it is not
a program of "general application," but only an offer made to certain owners. Moreover, the
regulations provide that the exception for government-subsidized loans is not available if the
taxpayer structures a loan to qualify for this exception and "one of the principal purposes of so
structuring the transaction is the avoidance of Federal tax" (Temp. Treas. reg. sec. 1.7872-
5T(a)(2)). There is a significant issue as to whether the Second Mortgage will fail to qualify for
the exception for government-subsidized loans on this basis. Even if this occurred, additional
arguments would be available against treating the Second Mortgage as subject to the imputed
income rules of section 7872. The issue of application of section 7872 to the Second Mortgage
would be reduced if the execution of a Second Mortgage is required by the enabling legislation.

Conclusion

As the discussion above indicates, there are a variety of factors that must be analyzed in
order to determine whether or not a project owner would recognize taxable income upon the
restructuring of its FHA-insured multifamily mortgage. However, it is clear that if all project
owners restructure their mortgages under any of the proposals, it is likely that some of these
taxpayers will recognize taxable income as a result of the transaction. The possibility of such

" Tf the Second Mortgage is not respected as a valid debt instrument under the above
analysis, there would be no imputed income under these rules because they apply only to debt
instruments.

? Under section 7872, the Second Mortgage would be treated as an bearing original
issue discount, with the result that the owner would be entitled to deductions over the term of the
Second Mortgage representing accrual at the long-term Applicable Federal Rate. However,
because the owner would have income in the year of the refinancing and deductions only over
the term of the Second Mortgage, there would be a timing "mismatch" to the owner.

11



of the investors would take advantage of the restructuring proposal, resulting in a greater savings
to the Section 8 program and FHA insurance fund, and in the preservation of more units of
housing for low-income tenants. The cost savings would be partially offset in the latter part of
the budget period with a loss of Federal income tax receipts. Alternatively, the amount of money
provided by HUD in the restructuring of the mortgages could be increased to compensate
investors for their tax loss.

Any tax legislation that provides that investors will not recognize taxable income as
result of the restructuring proposal will decrease Federal budget receipts. The staff of the Joint
Committee on Taxation cannot, at this time, determine the magnitude of the revenue loss
because such amount will be dependent upon the drafting specifications of the tax proposal. In
addition, the Joint Committee staff would need to consult with the staff of the Congressional
Budget Office in order to determine the extent to which such tax legislation, coupled with the
underlying housing legislation, would entice investors to restructure their mortgages.

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