Category: Real Estate Law

Lenders Should Take Careful Note of Potential Vulnerabilities Exposed in TOUSA Decision


The United States Court of Appeals for the Eleventh Circuit issued its much anticipated decision in the TOUSA, Inc. bankruptcy cases on May 15, 2012.  The decision provides an ominous reminder to Lenders to carefully assess the value of accepting asset pledges or guarantees from borrowers’ subsidiaries, sometimes referred to as upstream guarantees.  TOUSA should also give creditors pause in accepting payments for existing obligations from the proceeds of transactions that may later be avoided as fraudulent transfers in violation of the bankruptcy code.

On July 31, 2007, TOUSA, Inc. reached an agreement to settle existing obligations to various lenders (“Previous Lenders”) with financing from new lenders (“New Lenders”).  The New Lenders secured the new loans with liens on the assets of TOUSA’s subsidiaries (“Conveying Subsidiaries”).  The loan agreement with the New Lenders required that the funds be used to pay the Previous Lenders.  Six months after this payment, however, TOUSA and its subsidiaries filed for bankruptcy.  The Committee of Unsecured Creditors of TOUSA filed proceedings against the New Lenders to avoid the liens as fraudulent transfers and against the Previous Lenders to recover the value of the loans.

In a stunning decision, the United States Bankruptcy Court for the Southern District of Florida, Fort Lauderdale Division, granted both requests.  The court ruled that the granting of the liens by the Conveying Subsidiaries to the New Lenders were fraudulent transfers under Section 548(a)(1) of the bankruptcy code, finding that the Conveying Subsidiaries did not receive value “reasonably equivalent” to the liens.  It therefore avoided the liens held by the New Lenders.  Because the loan agreements required the loans be used to pay the Previous Lenders, the court further held that the Previous Lenders were the entities “for whose benefit” the transfer was made, and ordered them to disgorge the loan proceeds to the bankruptcy estate under Section 550(a)(1) of the bankruptcy code.

Both groups of lenders appealed the decision to the United States District Court for the Southern District of Florida.  The court overturned the bankruptcy court’s decision and held that the intangible value the Conveying Subsidiaries received in the form of “opportunity to avoid bankruptcy, continue as going concerns, and make further payments to their creditors” was not disproportionate to the value of the liens held by the New Lenders.  It also ruled that because Previous Lenders were “subsequent transferees” and not “immediate beneficiaries” of the new loan agreements, the Previous Lenders could not have been the entities “for whose benefit” the transfer was made and did not have to return the proceeds.

The Eleventh Circuit reversed the district court and reinstated the bankruptcy court’s decision.  It noted that the bankruptcy court previously conducted a detailed factual analysis of the purported intangible benefits of the transaction and found that in total, the tangible and intangible benefits of the new loans did not confer a ‘reasonably equivalent value’ to the value of the liens held by the New Lenders.  Additionally and perhaps further alarming to creditors, although the court acknowledged that “immediate beneficiaries” are the “paradigmatic case” of “entities for whose benefit” a transfer was made, it held that “when a debtor transfers a lien to a lender who proceeds to transfer funds to the creditor,” the creditor can be liable.

 The court therefore regarded the Previous Lenders’ status as a subsequent transferee to be merely a “formality” because the new loan agreements required the debtors (TOUSA and the Conveying Subsidiaries) to wire the funds to the Previous Lenders immediately upon receipt of the proceeds from the New Lenders.

The TOUSA ruling provides at least two cautionary notes to lenders.  First, it shows that lenders must be especially diligent when relying on upstream pledges or guarantees.  They must ensure that subsidiary corporations are either solvent or are receiving value that is no doubt “reasonably equivalent” to the value of the loan, because bankruptcy courts have wide discretion to make those determinations.

 Also, creditors should be wary when debtors satisfy their obligations with proceeds from new transactions.  If the new transaction is avoided in bankruptcy and found to be made for the benefit of the new creditor, the paid off creditor could be forced to disgorge proceeds.


Categories: Real Estate Law

When You Can Avoid Paying Income Tax on a Forgiven Mortgage


As discussed in “Strategies for Avoiding Foreclosure”, if you sell your home in a short sale or return it to your lender by providing a deed in lieu of foreclosure, you still could be responsible to pay income tax on the forgiven mortgage.

Historically, forgiven debt (also known as cancellation of debt income or “COD”) had to be included in a taxpayer’s gross income for tax reporting purposes unless it (1) occurred in a Title 11 bankruptcy case, (2) occurred when the taxpayer was insolvent, (3) was a discharge of qualified farm indebtedness, or (4) was a discharge of qualified real property business indebtedness.

During the Subprime Mortgage Crisis of the past two years, more and more taxpayers have faced the realization of COD income on a variety of loans, including credit cards, student loans, car loans, and home loans. In order to offer some relief to taxpayers, Congress passed the Mortgage Forgiveness Debt Relief Act of 2007. The Act amended provisions of 26 USC § 108 of the Internal Revenue Code (Income from Discharge of Indebtedness).

A key feature of the Act is that taxpayers do not have to pay federal income tax on up to $2 million ($1 million for married individuals filing separately) of debt forgiven for a loan secured by their principal residence if the forgiven debt meets certain criteria. The criteria to qualify for this principal residence exclusion are as follows:

The Criteria

1. This exclusion only applies to debts discharged from January 1, 2007 to December 31, 2009.

2. The exclusion applies to qualified principal residence indebtedness, which is the original purchase price, plus improvements, of the taxpayer’s principal residence. It doesn’t apply to discharges of second mortgages or home equity loans, unless the loan proceeds were used to acquire, construct, or substantially improve the taxpayer’s principal residence.

3. If the amount of the original mortgage is more than the cost of any substantial improvements, only the debt that is not more than the cost of the principal residence plus improvements qualifies for the exclusion.

4. Refinanced indebtedness qualifies to the extent it doesn’t exceed the amount of indebtedness being refinanced (i.e. cash-outs don’t qualify for the exclusion).

5. The exclusion only applies to forgiven debt on a taxpayers’ principal residences not second homes, vacation homes, business property, or investment property. A taxpayer can only have one principal residence. It is the place where the taxpayer ordinarily lives most of the time.

Final Thoughts

This principle residence exclusion can be a tremendous benefit. However, if you are eligible, keep in mind the following:

1. Taxpayers report COD income, including whether it is subject to a exclusion, on IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), which is filed with the Taxpayer’s federal income tax return.

2. When the exclusion applies, the basis of the taxpayer’s principal residence exemption is reduced by the amount excluded from income. The discharged indebtedness is subject to taxation when the taxpayer sells or exchanges the principal residence. However, in many cases the reduction will not result in additional tax, because any gain on that sale or exchange will qualify for the $250,000 ($500,000 for married couples filing jointly) home-sale exclusion.

3. If only a part of discharged debt qualifies for the principal residence exclusion, the remainder of the discharged debt may qualify for another exclusion under 26 USC § 108 of the Internal Revenue Code (Income from Discharge of Indebtedness).

Categories: Real Estate Law