Worried about interest rate risks?

Consider a swap agreement Murky watersDistinguishing between an investor and a dealer for tax purposes

Easements on mortgaged properties Appeals court paves way for charitable deduction

Ask the AdvisorIs it safe to accept a letter of credit as a security deposit?

Real Estate advisor

March • April 2013

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Worried about interest rate risks?

Consider a swap agreement

T he continuing uncertainty of the credit market is prompting concern among many owners and investors about the

risk of rising interest rates. Some have turned to interest rate swap agreements to mitigate their risk. The arrangements, which are especially appealing when fixed rate loans are unavailable, can pay off for both borrowers and lenders.

How they workAn interest rate swap agreement is a type of derivative contract — independent of the underlying loan — that can be used to manage the risk of interest rate fluctuations and convert a borrower’s exposure from a variable rate to a fixed rate.

The most common type of interest rate swap is known as the “plain vanilla” swap. Here, a party (usually the lender) with fixed-rate liabilities agrees to “swap” interest payments with a party (the borrower) with variable-rate liabilities, such as a mortgage. Effectively, the lender agrees to

make the borrower’s variable interest payments over a given period. In exchange, the borrower agrees to pay a fixed interest rate on the same “notional” amount.

The swap’s fixed rate equals the present value of expected future variable rates, customarily based on London Interbank Offered Rate (LIBOR) futures. The accuracy of this prediction deter-mines whether the bank gains or loses money. The borrower usually pays no other incremental fees associated with the interest rate swap, and principal payments aren’t affected by interest rate swaps.

Typically, one party pays out each month (or quarter) for the difference between the variable and fixed rates. If the variable rate ends up rising above the fixed rate, the lender pays the bor-rower the difference.

Conversely, if the variable rate falls below the fixed rate, the borrower pays the lender the difference. Should the rates stay constant, neither party pays. When payments under the agreement are combined with the variable rate, the net amount paid by the borrower equals the fixed interest rate specified in the agreement.

For example, let’s say you have a variable rate loan with a current interest rate of 5%,

and you enter a swap with your lender. If the

If the variable rate ends up rising above the fixed rate, the lender pays the borrower the difference.

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floating interest rate falls to 4%, the rate on your loan also drops to 4%, and you must pay the lender 1% interest to account for the difference.

The result: You still end up paying a total of 5% interest. But if the floating rate climbs to 6%, thereby increasing your loan rate to 6%, the lender must pay you the 1% difference, effectively leaving your rate at 5%.

The role of title insuranceLenders may require borrowers to secure their swap obligations with a mortgage subject to a title insur-ance policy. But such insurance typically excludes losses sustained by the insured lender as the result of a court ruling that the mortgage is invalid or unenforceable because the mortgage allows for interest rate changes. For that reason, title insurance policies associated with swap arrangements require endorsements (and additional premiums) that provide the lender coverage against such losses.

A direct obligation endorsement provides coverage to the lender if the insured mortgage is invalid, unenforceable or lacks priority as security for the repayment of the swap obligation. An addi-tional interest endorsement provides coverage if the insured mortgage is invalid, unenforceable or lacks priority as security for repayment of the “additional interest.”

Both endorsements typically don’t cover:

n Changes to the swap agreement after the date of endorsement,

n The stay, rejection or avoidance of the insured mortgage, or any other remedy ordered by a court under bankruptcy or similar creditors’ rights laws,

n The calculation by a court of the amount of the borrower’s swap obligation or additional interest, and

n The invalidity, unenforceability or lack of priority of the insured mortgage due to the failure to pay all applicable mortgage recording taxes, where applicable.

The fourth exclusion would apply only in states where the government assesses a mortgage tax based on the loan amount.

Look before you leapInterest rate swap agreements can protect borrow-ers from fluctuating interest rates and help secure fixed effective rates, but they’re not for everyone. Your financial professional can run the numbers to determine whether such an arrangement could work to your benefit — and put you in touch with a commercial or investment bank that offers these contracts. n

One key benefit of swaps is flexibility — they come in unlimited forms. Many swaps are based on standardized forms, but some are custom-made to fit the parties’ financing needs. For example, the notional amount could change over the swap’s lifetime, either increas-ing (known as an “accreting” swap) or decreasing (known as an “amortizing” swap).

In “forward-start” swaps, the parties agree to enter an interest rate swap at a future date but under terms negotiated at the present time. The contract specifies the effective and maturity dates, as well as the fixed rate for the swap. “Forward-rate arrangements” typically don’t require a periodic exchange of payments, instead calling for a cash settlement at the end of the term.

Another option is the “swaption.” It represents the option, rather than the obligation, to initiate an interest rate swap under specified terms at any time until the option expires. The holder of the option pays an up-front premium for it.

Beyond “plain vanilla”

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A s someone who deals with real estate transactions on a regular basis, you may wonder why it’s necessary to make

the distinction between being an “investor” as opposed to a “dealer.” But that distinction is key in the eyes of the IRS and can have a significant impact on your tax bill. Here’s why.

Making it perfectly clearReal estate investors enjoy several tax advantages that aren’t available to those deemed to be real estate dealers. Perhaps foremost, an investor’s gains on sales of property held long term (more than one year) are subject to tax at capital gains tax rates. Investors can also engage in tax-free Section 1031 (like-kind) exchanges and installment sale transac-tions that allow for the deferral of taxes.

Dealers face steeper taxes in many instances. Under Internal Revenue Code Section 1221, real property held by a taxpayer for sale to customers in the ordinary course of a trade or business — that is, property held by a dealer — isn’t a capital asset. Dealers, therefore, must treat gains as ordi-nary income, which is taxable at a substantially higher rate (up to 39.6% beginning in 2013) than long-term capital gains (generally 15%, but 20% for higher-income taxpayers beginning in 2013, with even higher rates applying to certain depre-ciation recapture).

In addition, unless a dealer has set up a separate entity to reduce their tax exposure, the dealer’s ordinary income (including gain on the sale) will also be subject to self-employment tax (a maximum

of 15.3 %). Investors aren’t required to pay self-employment tax on their gains (though, under the health care act, beginning in 2013 they may have to pay a new 3.8% Medicare tax on some or all of their gains).

On the plus side for dealers, their losses are con-sidered “ordinary” losses, so they aren’t subject to restrictions that limit the amount of capital losses a taxpayer can offset against ordinary income to reduce tax liability. Dealers also are allowed to deduct their full interest expense on property from ordinary income; investors can’t claim an interest expense deduction greater than the amount of their net investment income. And dealers can offer “rent-to-own” lease programs, in lieu of installment sales, to defer recognizing gains.

Understanding the differencesSo how do the IRS and the courts distinguish between an investor and a dealer for tax purposes? There’s no definitive list of criteria. Based on various court decisions, though, relevant factors include the taxpayer’s sources and amounts of income and the value, volume and frequency of the taxpayer’s real estate transactions.

Generally, investors purchase properties and hold them with a long-term perspective. Dealers buy and sell properties relatively quickly. So how long

Murky watersDistinguishing between an investor and a dealer for tax purposes

Generally, investors purchase properties and hold them with a long-term perspective. Dealers buy and sell properties relatively quickly.

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Savvy property owners are always looking for ways to reduce their income taxes. Now, thanks to a ruling by the U.S.

Court of Appeals for the First Circuit, owners may be able to claim a deduction for donating conservation easements on their properties even if those easements are subject to a mortgage.

The donation and deductionIn Kaufman v. Commissioner, the taxpayer bought a $1.05 million row house in an area of Boston subject to local restrictions aimed at historic preser-vation. She and her husband renovated the home, including restoring the original details of its façade.

Internal Revenue Code (IRC) Section 170(h) provides an incentive for taxpayers to donate real property interests to nonprofit organizations and government entities for “conservation purposes.” Taxpayers can claim a deduction for donating such an interest — including an easement — “exclusively for conservation purposes,” if certain requirements are met.

The couple in Kaufman granted the National Architectural Trust (now known as the Trust for Architectural Easements) a historic preserva-tion façade easement. Because the house was mortgaged, they had to obtain a subordination

Easements on mortgaged properties

Appeals court paves way for charitable deduction

the taxpayer has owned the property is critical. For example, if you hold a single property for more than a year, the IRS is likely to consider you an investor. If you hold multiple properties for less than a year, expect to be designated as a dealer.

Courts also look at the nature and purpose for which the taxpayer acquired, held and sold the property, as well as the nature and extent of the taxpayer’s efforts to sell the property. Plus, the extent of subdivision, development and improve-ments made to the property to increase sales will be evaluated. A court might weigh whether a business office and brokers are used to sell prop-erty, the character and degree of control by the taxpayer over the individual(s) who sells the prop-erty and the extent of advertising the property.

Last, courts will consider whether the taxpayer has experienced a “change of plans” — such as a divorce or relocation — that modified the original

intent regarding the property. Also important is how the taxpayer holds itself out to the public (that is, as a dealer or as an investor).

Due to the facts-and-circumstances nature of these items, you need to maintain appropriate documentation to evidence your activities, plans and intent. No single factor or combination of factors will settle the issue. You could even qual-ify as an investor for one property and a dealer for others, depending on how you structure your transactions.

Swim to safetyYou don’t have to muddle through the murky waters of determining whether you’re an investor or a dealer by yourself. Your tax advisor can help you determine not only which category currently applies to you, but also which one would work better for you and, if appropriate, what you need to do differently to change your status. n

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of the bank’s right to the easement to satisfy the IRC requirement that a contributed easement be enforceable in perpetuity. The bank agreed but reserved the right to first priority on insurance proceeds and proceeds related to condemnation of the property.

The couple subsequently claimed a charitable contribution of $220,800 for the easement dona-tion. The IRS disallowed the deduction, and the couple sought review by the U.S. Tax Court.

Tax Court sides with the IRSThe Tax Court disallowed any deduction for the easement. It relied on a regulation known as the “extinguishment provision.” For an ease-ment donation to be deductible, it must provide that, if the easement were ever extinguished by a court, the donee organization would be “entitled” to a portion of the post extinguishment proceeds. (Those proceeds might come from a subsequent sale, exchange or involuntary conversion of the subject property.)

The Tax Court found that the bank’s right of first priority on insurance and condemnation proceeds undercut the charity’s right to postextinguishment proceeds.

First Circuit disagreesOn appeal, the First Circuit rejected the Tax Court’s interpre-tation of “entitled” as meaning “having an absolute right.” It found that a grant of an easement that’s absolute against only the owner-donor (like the couple

in Kaufman) is also an entitlement that satisfies the extinguishment provision.

The appellate court also pointed out that the couple had no power to make the bank give up its priority — or to defeat tax liens the city might use to claim insurance proceeds. In fact, because tax liens are superior to most claims, the Tax Court’s interpretation would doom most easement donations.

The bigger pictureThe First Circuit sent the case back to the Tax Court to determine the proper value of the ease-ment. The IRS had argued that the value was zero because, among other things, even before the easement, the local historic preservation rules subjected the property to severe restrictions on alterations. The appellate court observed that, in light of these preexisting restrictions, the Tax Court could find that the easement was worth little or nothing.

But it also suggested that the IRS’s “aggressive legal positions” regarding valuation and other issues in the case represented an attempt to settle larger questions related to the abuse of conservation easements and preempt the litiga-tion of individual claims. The court advised the IRS to simply adopt new regulations to prohibit abusive practices. n

Because tax liens are superior to most claims, the Tax Court’s interpretation would doom most easement donations.

Even as the economy crawls its way forward, the prospect of tenant bankruptcy remains a real threat for landlords. That risk is a good reason to reconsider whether you should continue to accept letters of credit as security deposits.

Benefits and risksCommercial landlords have historically preferred that their tenants provide letters of credit, rather than cash, for security deposits. A cash security deposit might become part of a bankrupt tenant’s estate if the tenant files for bankruptcy before the landlord has applied it.

Letters of credit, though, aren’t affected by a bankruptcy filing and won’t become subject to claims by the tenant’s creditors. A letter of credit also isn’t covered by automatic stays imposed by bankruptcy courts, so the landlord can draw on it immediately, without seeking approval from the court.

But enforcing letters of credit can be tricky and time-consuming, delaying the actual receipt of the deposit. And letters of credit can come with an annual fee payable by the tenant, which can make them resistant.

The banking crisis has highlighted another risk related to letters of credit. Prior to the crisis, banks were widely considered quite capable of paying off letters of credit. When they began to fail, however, the Federal Deposit Insurance Corporation (FDIC) alerted commercial landlords that it isn’t legally required to honor letters of credit issued by banks that fail or fall into FDIC receivership.

Key safeguardsTo reduce the risk of lost security deposits, landlords should consider revising their leases so that:

n They must approve of the bank issuing the initial letter of credit,

n If that bank becomes materially weaker during the lease term, the tenant must provide an additional letter of credit from another bank,

n If the issuing bank is declared insolvent by the FDIC, or it closes, the tenant must immedi-ately provide a substitute letter of credit, and

n The landlord has sole discretion to approve the issuer of a substitute letter of credit.

It’s also a good idea to regularly review bank ratings and check the FDIC’s list of failed banks against the list of banks that have issued any letters of credit that you currently hold.

Protect yourselfLetters of credit are less secure than they once were but are still viable. By using a properly drafted lease and monitoring your bank’s health, you can improve your odds of recovering security deposits after ten-ants default. n

This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. ©2013 REAma13

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