SPEAKERS CONTENTS INSERTS
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TAX CONSEQUENCES OF FHA MULTIFAMILY RESTRUCTURING
WEDNESDAY, SEPTEMBER 17, 1997
House of Representatives,
Subcommittee on Housing and Community Opportunity,
Committee on Banking and Financial Services,
Washington, DC.
The subcommittee met, pursuant to call, at 2:15 p.m., in room 2128, Rayburn House Office Building, Hon. Rick Lazio, [chairman of the subcommittee], presiding.
Present: Chairman Lazio; Representatives Leach (ex officio), Kelly, Hill, LaFalce, Kennedy, Gutierrez, J. Maloney of Connecticut, and Redmond.
Chairman LAZIO. This hearing shall come to order. Good morning. I want to welcome everybody and thank you for coming here today. We have an outstanding panel, and I am looking forward to hearing from them.
I understand that my good friend, Mr. Kennedy, is on his way, or will be here shortly. And when that time comes, I will turn to him. And we may go out of order if that is the case, so that we can accept his statement.
Let me just make a unanimous consent request on behalf of any of the Members that come in and go out, that if they have a statement, it will be included in the record. Without objection, it is so ordered.
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The purpose of this hearing is to provide Members of the subcommittee with an opportunity to ask, and hopefully to educate themselves, on what must be one of the most complex problems faced by this subcommittee and Congress. Most of you know that I speak of the restructuring efforts that must be undertaken with regard to many of the Section 8 contracts and mortgages in HUD's multifamily inventory.
There is general consensus that these contracts, subsidized at rent levels in excess of market rents, are unsustainable in their present form. Simply stated, if Congress does not act, expiring contracts will either have to be renewed at current levels, a prospect that threatens to consume HUD's entire budget authority by the end of the decade, or be allowed to expire, thereby leaving many of our poorest citizens without housing.
For several years now, Congress and the Administration have been discussing alternatives and possible approaches to developing realistic solutions to the problem. Several different versions of legislation have been introduced. A prominent feature of the Senate legislation is to use bifurcation of the mortgage, splitting the mortgage into a performing first mortgage and a ''soft second'' as a restructuring tool.
This subcommittee has not objected to using bifurcated mortgages in a restructuring program. In fact, the bifurcated mortgage is a restructuring tool contained in H.R. 2447, the Multifamily Housing Restructuring and Affordability Act of 1997, which I introduced to address the Section 8 problem. However, both Chairman Leach and I have repeatedly expressed our concerns that the possibility that adverse tax consequences could befall owners as a result of such restructuring could very well render any legislation ineffective.
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One group representing owners wrote in, for example, that ''Until a definitive tax solution is agreed to, owners and investors will not be able to participate in debt restructuring. This inability to participate will lead to widespread mortgage defaults and tenant displacement at contract expiration.''
For this reason, we have been demanding that clarification on this crucial matter be provided in some form, so that owners would voluntarily restructure their mortgages, confident of the tax implications.
On June 18 of this year, I wrote to Treasury Secretary Rubin requesting clarification on this issue. Unfortunately, such guidance has not been forthcoming. The reason given was that the Internal Revenue Service and the Treasury Department are reluctant to make broad statements, preferring to confine the focus of their statements to individual circumstances. We need to hear from them.
I feel it is imperative to at least get this issue before the relevant public forum in order to better understand the chances of success of any mark-to-market proposal that we might enact. That is why we have assembled a group of panelists who have both experience and technical background in order to give us some guidance on this issue.
Probably no other persons in this room, other than the four practitioners we have on the panel, have been as directly involved in major restructuring efforts. And while Treasury and the IRS have been of minimal assistance on this issue—and I am being understated—I am gratified to have our own Joint Tax Committee here to offer help.
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Let me thank the panel again. What I would like to do is turn to Mr. Maloney, and if he has a statement, recognize him, and then go to the panel. I will introduce each of the panelists one at a time, hear from each of you, and then open it up to questions if that is acceptable.
Chairman LAZIO. My good friend from Connecticut.
Mr. MALONEY. Thank you, Mr. Chairman.
Mr. Kennedy will be here, and he will give an opening statement for the Democratic side. But in his absence, I just wanted to thank the panel for coming here today to testify on this matter. This is a very important issue and calls for a solution that is both responsible and sensitive to the realities that are faced. Realities which could be very detrimental if not addressed, both to organizations that own this housing and to the tenants.
I think that we will be looking for a solution that addresses both sides of that, that protects the tenants, but makes sure that the organizations that have built and managed this housing over many years also have an opportunity for a fair resolution of the problems that they face.
Thank you, Mr. Chairman.
Chairman LAZIO. I thank the gentleman from Connecticut. I appreciate his presence here.
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I would also ask unanimous consent that a September 16, 1997, letter from Ernst & Young, addressed to the Chairman of the subcommittee, and a September 16, 1997, letter from Ernst & Young, addressed to the Senate staff, regarding ''The analysis of the tax effects of using a below-market interest rate, soft second mortgage, and a mark-to-market restructuring transaction,'' be placed in the official hearing record.
Chairman LAZIO. I want to continue the unanimous consent that an August 22 letter from HUD Secretary Cuomo, along with the attached FHA Multifamily Demonstration Report, be placed in the official hearing record. And without objection, that is so ordered.
Chairman LAZIO. I want to turn now to the panel and welcome you once again. I will begin by turning to Kenneth J. Kies, known to many of us as one of the most constructive forces on the Hill. We have had a great working relationship, and he has provided guidance in a number of different policy areas.
He has served as the Chief of Staff for the Joint Committee on Taxation since January 1995. He received his LOM from Georgetown University Law School in 1986 in taxation. His area of emphasis included real estate taxation and the tax aspects of bankruptcy. From 1982 to 1987, Mr. Kies served as Chief Minority Tax Counsel on the Ways and Means Committee, and was involved in several pieces of legislation, including the Tax Reform Act of 1986. He has also practiced before the Internal Revenue Service, the U.S. Treasury Department, and the United States Tax Court.
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I want to turn to Mr. Kies. Before I do that, though, I just want to mention that we have a Congresswoman from New York here who has been a great advocate on housing issues, and we appreciate that Mrs. Kelly is here too. I don't know if you want to be recognized for any reason.
If I duck out, it is only because I have a markup going on at the same time right across the hall on FDA reform. But we will try and continue the hearing if at all possible.
Mr. Kies.
STATEMENT OF KENNETH J. KIES, CHIEF OF STAFF, JOINT COMMITTEE ON TAXATION
Mr. KIES. Thank you, Mr. Chairman.
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 Federal income tax aspects of various proposals to restructure certain multifamily housing mortgages that are insured by the FHA.
Under present law, HUD utilizes a number of subsidy programs to promote and retain adequate and affordable rental housing for low- and moderate-income individuals and families. Among these is a program wherein owners of multifamily housing projects are provided cash rent subsidies from HUD known as Section 8 contracts and mortgage insurance through FHA.
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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.
Many of the Section 8 contracts provide for rent subsidies in excess of true fair market rents. We understand that there may be 850,000 housing units in this situation. Most Section 8 contracts are scheduled to expire by 2003 and cannot be renewed at more than 120 percent of fair market rent. At this level, it is anticipated that many projects will go into default. And CBO projects FHA insurance losses at $7.6 billion for the period 1998 through the year 2003.
There have been several proposals to address this situation. These proposals generally would involve providing for true fair market value rent subsidies and an up-front infusion of cash by HUD that would be used to restructure the original project mortgage, and HUD taking a second mortgage generally at below market interest rates for the amount of the cash advanced.
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 the up-front cash payment from HUD is treated as a taxable subsidy to the project owner or the project owner is treated as having cancellation of indebtedness income under the transaction.
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The second issue presents the more significant issue. 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 bona fide debt and whether the stated principal amount of the debt is respected for tax purposes. These determinations are based on 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, I will describe the general Federal income tax aspects that must be considered in the typical proposed restructuring transaction.
In general, gross income includes cancellation of indebtedness income. COD income may arise in a debt restructuring if the borrower is relieved from having to pay all or a portion of the principal amount on an outstanding debt. However, COD income may arise in the debt restructuring even if the nominal principal amount of the new debt arising is at least equal to the principal amount of the old debt. This is so because the nominal debt may in some instances be treated as equity, especially in cases where there is little likelihood of repayment of the new debt.
In addition, in cases of tax avoidance and where the new debt carries an interest rate less than the Federal Government's cost of funds, present law requires a reallocation of stated principal and interest, resulting in a lesser principal amount. Both of these issues potentially arise in the proposed HUD mortgage restructurings.
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Whether an interest is debt or equity and whether the principal should be recast as interest depends upon all the relevant facts and circumstances. It is likely that if all project owners restructure their mortgages pursuant to any of the proposals, some of these taxpayers would incur tax liabilities as a result of the transactions.
Thus, absent legislation or a Treasury announcement clarifying the Federal income tax 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 the Section 8 contracts for fear of incurring immediate tax liability.
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.
Any tax legislation that provides that investors will not recognize taxable income as a result of the restructuring proposals will decrease Federal budget receipts. The staff of the Joint Committee cannot at this time determine the magnitude of the revenue loss, because such amount will depend upon the drafting specifications of the tax proposal. In addition, the Joint Committee would need to consult with CBO in order to determine the extent to which the tax legislation, coupled with the underlying housing legislation, will entice investors to restructure their mortgages.
I hope this information is helpful to your subcommittee, Mr. Chairman. We are prepared to provide any additional assistance which you might require.
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Chairman LAZIO. I thank the gentleman.
I want to acknowledge the fact that the Chairman of the full committee, Mr. Leach of Iowa, is here. I don't know if he wishes to be recognized. I am happy to recognize him.
Mr. LEACH. No, sir. Just, please, you are holding this very important hearing. And I actually wanted to welcome particularly Mr. Ravitch, who is an old personal friend and whose judgment on these issues carries great weight.
Thank you.
Chairman LAZIO. That is ''O-L-E'', not ''O-L-D''?
Mr. LEACH. Yes, sir.
Chairman LAZIO. I also want to acknowledge that this is the first hearing of our newest Member of the subcommittee, and I am delighted that he is here, Mr. Bill Redmond of New Mexico.
I want to welcome you and thank you for being willing to serve on this subcommittee.
I want to take this a bit out of order. I am going to turn to the Ranking Member. I hope you will bear with me, but I want to give Mr. Kennedy an opportunity to make a statement, and I want to recognize him right now.
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Mr. KENNEDY. Thank you very much, Mr. Chairman.
First of all, I would like to take the privilege of welcoming a fine new Member to the subcommittee, Bob Weygand. Let all of the rest of the committee Members know that we are excited about having Rob's participation. And I am particularly delighted that he is serving on the Housing subcommittee.
It is good to have both voices of these two new Members, and I look forward to working with them on meeting the housing concerns of the people of our country.
If the Chairman of the full committee, Mr. Leach, would prefer, I have a statement that I wanted to make concerning the underlying issue that we are dealing with here. But I know the Chairman's time is probably in great demand.
So, if you want to introduce Mr. Ravitch now, Mr. Chairman, you will be more than——
Mr. LEACH. Oh, no. I said enough, and I would be delighted to listen to the perspective of the distinguished Massachusetts Representative.
Mr. KENNEDY. Thank you.
Mr. Chairman, I just want to make a brief opening statement. I want all of the Members of the panel, and Members of the subcommittee, to understand that I think this is one of the most important housing challenges that we face in this country.
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The number of housing units that are affected by this issue is just astounding. And even if it appears to be one of those issues that, when you start talking about project-based Section 8, and you start talking about mark-to-market, and you start talking about the tax implications for some of the smaller investors in these packages, it sounds as though you are talking about a very infinitesimal issue.
The truth of the matter is that the number of units that will be affected by these decisions can be as many as exist in the entire public housing system of America. After all, there was, with the best of intentions, a program set up in the 1960's and 1970's in this country that effectively told landlords and building developers that we as a Nation thought that it was good housing policy to incentivize them to go into some of the poorest communities in the country and build really nice buildings.
We had hoped that this would stimulate economic development. We hoped that it would provide decent, affordable housing. And the basic deal was, ''Look, you go ahead and build this stuff, and for the next 20 or 25 years, we are going to guarantee you that you are going to have an income stream if you take the poorest people in the country.''
The trouble is that the 20 or 25 years has come due, and now the landlords—in many cases, some of these communities have gotten much nicer—and in those communities, the landlords can effectively throw out the tenants and make themselves a nice tidy profit. And it means that we could potentially lose tens of thousands of housing units simply because landlords, after making a very nice profit off of the Government, can make an even nicer profit off of the public sector.
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There is another group of housing, probably several hundred thousand housing units, where just the opposite is true, where these housing units are now in communities where we are paying rents that are significantly above the normal market rates in those communities. The landlords have been used to receiving this income stream. Some of these projects are in very bad shape, and we need to do something about it.
The whole point is to mark these housing units to the market. If we do that, it has a very strong impact on the tax consequences for the limited partners in the deal. And the question is whether or not we can find a way of providing those limited partners with an out that doesn't create a huge taxable liability for them.
So, I hope we will hear some analysis that recognizes the important implications for Government policy, and behind Government policy, for a lot of very poor people who are going to be put at enormous risk if the four smart fellows sitting in front of us this afternoon can't come up with some way of dancing through the raindrops and making sure that when the IRS finally reviews the—what I hope is the Senate bill that we can go ahead and mark up—that once that bill is passed, we have got to have the kind of support that indicates that this thing is going to stand up.
I think that testimony like this, this afternoon, Mr. Chairman, is important. I think you are to be commended for looking at an honest review of where we are. It won't do any of us any good to come up with a solution that ends up being knocked out by the IRS as a transaction that they collapse into a taxable transaction.
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What will make a difference is if we can use the brains of the individuals that are before us to help fashion language that will enable us to get through that thicket and protect the poor and come up with a reasonable compromise, in terms of the rent structures and the like, for the landlord.
So, I want to thank you, Mr. Chairman, for your efforts, and I look forward to trying to find that solution to the problem.
Thank you, Mr. Chairman.
Chairman LAZIO. Also, I wanted to concur in welcoming our other newest Member, Mr. Weygand.
Thank you very much for being willing to serve on the subcommittee. We are looking for great things out of you.
The next panelist, David Reznick, thank you very much.
Mr. Reznick is the founding principal and Chairman of the Board of Reznick, Fedder & Silverman. David Reznick works closely with real estate developers, syndicators, lending institutions, and managing agents regarding all aspects of commercial and residential developments. He is often involved in the tax analysis and structuring of major real estate syndications.
Mr. Reznick has assisted many developers in preparing financial forecasts and structuring syndications for HUD-insured properties and State-financed housing projects. He is a member of the National Leased Housing Association and the National Housing and Rehabilitation Association. And I welcome him here today.
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Mr. Reznick.
STATEMENT OF DAVID REZNICK, PARTNER, REZNICK, FEDDER & SILVERMAN
Mr. REZNICK. Mr. Chairman, thank you very much.
I also have turned in a paper. And rather than reading it off, I would like to go on to some of the important points in it.
Chairman LAZIO. Without objection, all statements, written statements, will be entered into the record.
Mr. REZNICK. Thank you very much.
Principally, what we have is a situation where owners went into a program which really was never aimed for economic profit, the principal benefit being the tax incentive of tax deferral, the ability to deduct losses beyond current actual cash investment for a period of time. That clearly is a deferral, only with an ultimate day of recognition. That day of recognition is principally as the mortgage amortizes in its normal fashion. Ordinary income is recognized when rental monies come in to pay the mortgage payments, part of those rental payments coming from Section 8 subsidy without a deduction going out against it.
What we have in this mark-to-market situation here is the true potential of a premature recognition of income, putting an automatic hard income tax impact at harm that I don't believe was really intended when you originally addressed the mark-to-market issue.
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In listening to Ken Kies' discussions, I agreed with almost all parts of it until the very, very end when he addressed the budgetary effect of the loss of income that would be created if we found a solution to the issue.
The income was never projected, in my view, in the first place had this not come up, because it would have been earned and recognized over the following 20 years as the mortgage, which is now being considered to be written down, was going to be amortized out of rents. We should make sure that the restructuring does not create inadvertent harm.
Most of the owners that I am speaking to, or have spoken to, are not looking for tax relief, they are principally looking for parity, being able to pay taxes, as they were planning on paying taxes, on the income earned.
Ernst & Young has drawn a very, very, very careful program of how, in following the current code, without changes, this could help many project owners—not all—many project owners. David Smith has presented a paper that basically concurs and gives more background on this.
I believe, though, as you read the paper, the road has many potholes. The potholes have to be covered by the IRS, recognizing and following the road as it is drafted, and being able to give substance and recognition. They can't be silent on this issue. It is somewhat similar, as I talk to an owner, and I talk about the paper, and I show them the positions and what could and couldn't happen, but why it could work. If we want them to voluntarily go into this program, they can't think, as I think when I sit in an airplane and listen to the stewardess tell me that the seat cushion can be used as a flotation device, ''I don't want to be the first person to test that.'' I don't believe that I have any owner clients who want to be the first one to test it.
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I truly believe that the IRS can rule on a set of circumstances without at all changing the current current tax code. I also believe that there is no windfall being asked for by the current owner group. There is no forgiveness. There will be recognition as cash flow is paid on to soft mortgage, even with the reduced interest rate, and ultimately on disposition.
Thank you.
Chairman LAZIO. Thank very much.
Our next panelist is David Smith. He is the Founder and President of Recapitalization Advisors, Inc., a Boston-based corporation specializing in the financing of existing affordable housing. He has written a textbook on affordable housing as an investment and has published articles in Real Estate Review, Real Estate Finance, and Affordable Housing Finance.
David has served on industry, HUD, and congressional task forces involved with mark-to-market and the FHA multifamily business strategic planning effort. He has appeared before the subcommittee in the last Congress on the same subject, and I personally appreciate his continued assistance to the subcommittee. I don't know if the gentleman from Massachusetts wanted to mention——
Mr. KENNEDY. No.
Chairman LAZIO. I know he very much appreciates, as well, you being here and being a hometown boy.
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Mr. KENNEDY. He is a terrific fellow, OK.
Chairman LAZIO. Mr. Smith.
STATEMENT OF DAVID A. SMITH, PRESIDENT, RECAPITALIZATION ADVISORS, INC.
Mr. SMITH. Mr. Chairman, Mr. Kennedy, Members of the subcommittee, and, in particular, Chairman Leach, thank you for inviting me here today.
We started working on the problem of mark-to-market 2 1/2 years ago. Mr. Chairman, Mr. Kennedy, you were among the people who first recognized that it was both a complicated issue and an issue that balanced economics and policy.
I am pleased to say that 2 1/2 years later, after a great deal of work, many of the important policy issues have been resolved, and the issue that is before this subcommittee in this hearing today is the one that is left, which is, how can we do that which makes good economic sense without triggering an adverse, unexpected, unintended tax consequence to the current investors?
Now, Mr. Kies, in summarizing the problem, stated that there were many projects involved. There are, in fact, about 450,000 apartment units, as Mr. Kennedy alluded to, that are subject to this. Mr. Kies also said that if tax legislation were needed, it would have a large revenue-scoring impact. And in today's climate, with the budget constraints that we face, legislation that has negative revenue-scoring impact is very difficult to obtain.
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I, however, have the good fortune to have worked in the field of affordable housing for 22 years. I have worked on these projects since before their inception in some cases. And I felt that it was possible to structure within the current code, a restructuring that would recognize the economic reality without triggering tax, without being a tax avoidance scheme.
So, my colleague, Conrad Eagan of the National Housing Conference and I set out to work on this. We were able to persuade the good people at Ernst & Young to look at it. And amongst us all, we have, I believe, been able, to paraphrase Mr. Kennedy, ''to dance between the raindrops.''
I believe that a technical review of the Ernst & Young report will conclude that bifurcating the loan into a hard smaller first mortgage and a soft second that accrues at a low interest rate and is due and payable out of future cash flows and future residual values will, in fact, be respected for tax purposes and will not run afoul of cancellation of indebtedness income, original issue discount, or any other of the potholes that my friend, Mr. Reznick, has been kind enough to identify for us.
I also believe that using soft secondary notes is analogous to, and a reflection of, the policy direction that this subcommittee and its counterpart in the Senate, have been providing for affordable housing for the last decade, which is, ''Let's go back to cheap rents and low debt, and let's use Federal resources at the margin to cover the difference between the affordable earning power of the development and the cost of the development.''
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If you look at the home program, or the CDBG program or, indeed, the low income housing tax credit, which has been a very successful property-based program, what you see is the Federal Government is bringing equity or soft debt into a transaction to cover that margin.
If we knew back in 1977 what we know now, we might have designed the Section 8 program that way. We are making up for lost time. We are fixing something. I believe, as I say, that the current tax code permits it.
I also note that, to the extent that a soft second is used, it has economic and policy benefits. If the property becomes more valuable as a consequence of appreciation or inflation or whatever, the soft second consumes most, two-thirds, three-quarters, of the up-side, so the Government gets a recovery here.
If the owner defaults on the affordability covenants, if the housing ceases to be affordable, ceases to serve its residents, then you can do as you do in the tax credit arena, you can declare a default in the soft secondary note, you can trigger tax. You maintain leverage over the owner to secure the affordability.
So, there are economic reasons to do it. There are tax reasons to do it. In many ways, I believe it is the last piece of the puzzle.
And the last thing I would say to you, Mr. Chairman, to Mr. Kennedy, and the subcommittee is, it is important to do this now, because in fiscal year 1998 an immense number of above-market rents come to expiration, and if there is not a rational program in place, then you will have uncontrolled defaults, you will have chaotic behavior, you may have displacement, you will have anxiety among residents and among communities, you will have bad public policy.
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We can enact good public policy. This is part of the answer. And I would urge you, if you do enact mark-to-market, to request the Internal revenue Service to rule on the Ernst & Young structure, so that the owners and the investors have, indeed, got a parachute.
Thank you very much.
Chairman LAZIO. Thank you.
The next and last panelist is a friend of the Chairman of the committee and a friend of many Members of the House. Richard Ravitch is currently a partner with Ravitch, Rice & Company, LLC. He has had a long and distinguished career in the business and real estate world, including the affordable housing sector. He currently serves as Chairman for the AFL-CIO Housing Investment Trust and the Corporation for Support of Housing.
In addition, Mr. Ravitch served as Chairman for the New York State Urban Development Corporation during the UDC bailout. Among the many offices he has held, Mr. Ravitch has also served as President of the Citizens Housing and Planning Council of New York, and Director of the Board of Governors of the American Stock Exchange.
I want to welcome you and thank you. I know you had to actually accommodate this event, as you had other personal concerns, and I appreciate you arranging that.
I don't know if the Chairman of the full committee wishes to be heard in addition.
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Mr. LEACH. No, sir.
Chairman LAZIO. Thank you.
Mr. LEACH. Other than that, clearly, one of the most cogent articles that has ever been written on the subject is Mr. Ravitch's, and I hope Members read it. It is on the table in lieu of testimony, which I understand is going to be off-the-cuff.
Chairman LAZIO. I thank the Chairman.
Mr. Ravitch.
STATEMENT OF RICHARD RAVITCH, PRESIDENT, RAVITCH, RICE & COMPANY, LLC
Mr. RAVITCH. Mr. Chairman, Mr. Kennedy, Chairman Leach, and Members, I appreciate the opportunity to come before you today. Thank you for distributing my article in The New Republic. Be careful of consequences when you write articles. I am delighted to share my views with you.
I don't have the tax expertise that my colleagues have. I have experience in my public service of having been involved in the restructuring of a lot of mortgages when the New York State Urban Development Corporation ran into financial difficulty, and the same with the City of New York when the City of New York almost went bankrupt in 1975. Practically all of the housing mortgages which the City held, had to be restructured in order to ensure the same objectives that you are trying to reach here.
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So, let me state, at the risk of being somewhat redundant with my article, what I think have to be the objectives here, and then try to put the tax question in context.
Number one, I think the most important thing is to act quickly on this issue. There are too many expiring contracts that require a clear public policy. Maintaining uncertainty is not a healthy thing for owners, or tenants, or the financial institutions involved. So, I hope the Congress, in its wisdom, resolves its differences as expeditiously as possible, so that people can make economic and personal decisions in a context of maximum certainty.
Second of all, I think it is important that your resolution of all the legislation in this area be motivated by three principal concerns. One is to ensure the continued existence of the housing stock, to prevent the deterioration that has already begun to occur in many of these units because of a failure to spend adequately on capital reinvestment.
Number two, to ensure that every family of modest income, who is currently the beneficiary of this program and is in occupancy of one of these units, is assured of their continued entitlement to live there as long as they continue to pay a reasonable percentage of their income in rent. We should not create a program, no matter the cost to the Government, which results in their losing occupancy rights.
And third of all, given the exigencies of the budget problems that this country faces and that the Congress has resolved, we recognize that a third objective has got to be to reduce the cost of this program to Government; that for those of us who believe in an active Governmental role in creating affordable housing, we wish it were otherwise. We wish we could provide an increased supply of affordable housing. But, we recognize what is most important is how you resolve this problem will establish the credibility of the Government in this area.
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And any chance we have in the future for a significant new affordable housing program when this country has the resources, will depend on how equitably and intelligently this problem is solved, whether the tenants and the owners are treated with sensibility and fairness.
Now, those broad principles don't provide a clear solution to some of the specific questions, but let me try to put this down in specific context.
The bifurcated mortgage is a sensible idea. The question that you have to answer, with all respect, before you get to the tax question, is, what should the terms of that second mortgage be? How do we protect the taxpayer, the Government, against the possibility that enormous, unintended perhaps, economic rewards can redound to an owner as a result of getting a soft second? A mortgage where the mortgagee has no rights of foreclosure and no right to receive interest currently?
I think the answer to that, very simply, is you have to structure a program in which the second mortgage is held by—or in behalf of—somebody, or under the control of somebody—or some institution—that is going to be responsive to national housing policy; who is going to be concerned with the affordability covenant.
Since many of these projects that were insured by the FHA do not contain any limited dividend component, it is important to make sure that if the owner is going to receive the benefit of the restructured mortgage, that any additional economic benefit that the owner may receive, either via the tax code or via the continuation of a subsidy that he had no contractual right to receive, that that incremental benefit is shared somehow with the public. And that can be done in many ways by setting either limitations of profit, or ensuring that debt service will be paid on the second mortgage before the property owner receives any cash flow or surplus cash.
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It has also traditionally been true, and it certainly guided us when we restructured all those billions of dollars of mortgages back in the 1970's, when a billion dollars was a lot of money, that we made sure that the owner would not be penalized, but we wanted to make sure that the owner got no additional benefit, or that any additional benefit was shared with the public.
I think, therefore, one of the necessary things here is that the administration of this program be conducted by an entity that has the ability to attract able lawyers and economists and business types, that has an organic connection to the Department of Housing and Urban Development. Because the fact of the matter is, the Secretary of HUD is the leader, and I think everybody in this field recognizes that you have to look to the leader for leadership in this field. So, there should be a connection with HUD. This should not be turned over exclusively to State housing finance agencies, not that they are not capable or honorable, but for the simple reason that their interest is in minimizing the first, maximizing the second, and they have no economic or public policy interest in enforcing the second mortgage.
I think if you examine the economics of these projects, you will see that the public interest requires, as I have suggested, that that second mortgage, to the extent practical, receive cash flow, and certainly that it be an obligation that continues on the property before an owner can pull out any equity.
I also think that view is not incompatible with the traditional view of the Tax Code, that if it is a bona fide mortgage and there is no equity created as a result of the restructuring, there is no cancellation of indebtedness income.
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Mr. Chairman, I will conclude by saying that it is terribly important that in an area which is as complex as this, that there be clarity, not ambiguity, on the objectives. Any plan should ensure that the owner suffers no incremental penalty as a result of the restructuring. But such a determination would have to take into account that such owner, if he had continued the present arrangements, would have paid income taxes, or having to recognize income on the difference between amortization and depreciation in the last 20 years of the mortgage. If that could be ensured through regulation, through tax rulings, that is fine. If not, I would hope very much that the Congress, in its wisdom, would provide some legislative relief to ensure that result.
Thank you, sir.
Chairman LAZIO. Thank you.
I am going to recognize Mr. Kennedy for questions.
Mr. KENNEDY. Thank you, Mr. Chairman.
I apologize to Mr. Kies for missing his testimony. It sounds as though, from what I have gathered, that you were somewhat more pessimistic about the ultimate tax implications and the fact that there would, in fact, be liabilities that the IRS might very well assess against these soft seconds.
You have been around here probably longer than any of us, in terms of trying to figure out these issues. Is it your sense that on the one hand, you have this enormous budgetary consequence; on the other hand, if you don't take care of that, then you are going to throw a whole lot of poor people out on the street?
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If what we are trying to do is fit this whole problem into this box, is there a way that you can see structuring the box so that the IRS is going to at least give it a wink?
Mr. KIES. Well, Congressman Kennedy, I think rather than the word ''pessimistic,'' I think I would use the word ''realistic.'' We have a simple problem here, and that is that a number of investors own an asset that is worth $25,000, for example, but they owe $50,000 on it. And your objective is to get them into a situation where the debt they have equals the value, so it basically reflects the fair market value, so that these people can then stay invested in these units, receive a fair market rental, combined with whatever assistance can be provided by the Federal Government. And these projects are then viable for another 20 years. That is the basic objective.
What my testimony says, and is contrary to, I think, what Mr. Smith said it actually does—specifically, does not try to quantify the size of the tax problem. It specifically says, ''We believe there is a tax issue here.''
I think Mr. Reznick will tell you that his clients are not going to go forward with these restructurings without IRS assistance or comfort, which tells you a little bit about his confidence in terms of whether he would advise his clients to go into them without that clarification.
Mr. KENNEDY. Can I just stop you for a second, Kenny? Would it be appropriate for David to respond, because he is the one who came up with a lot of this concept to begin with, to fix the problem that you are suggesting?
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Mr. KIES. Can I do two more seconds here? Because I think it gets to the bottom line of what you are really concerned about. If you do nothing, CBO is telling you that you are looking at $7.6 billion in expenses under the FHA guaranty program.
I think the question for you and the Congress is to structure a package that gives you a net positive effect on the budget. The fact that there might be some tax cost is not the critical question. The critical question is whether the net tax cost, combined with the savings in terms of avoiding the default expense, is a net positive.
Mr. KENNEDY. Well, the bottom line to me is also, making certain that we protect the tenants.
Mr. KIES. And the only way you are going to protect the tenants is to avoid the defaults, and keep the owners owning these projects.
Mr. KENNEDY. All right. So how do we do that?
Mr. KIES. Well, I think if you want the owners to not default, I think you have to give them enough comfort that the tax consequences will not make this so——
Mr. KENNEDY. So, you are just saying take the money out of FHA and transfer it to the properties?
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Mr. KIES. No. I am saying you, the Congress collectively, should probably pass legislation that clarifies the tax treatment so that these investors——
Mr. KENNEDY. That is never going to happen. Come on.
Mr. KIES. Well, I mean, the net budgetary effect could be positive. The savings on the FHA side is in the $7 billion range. We haven't yet assessed the tax cost, but I frankly will be surprised if it is anywhere near that. So, I mean, that is one possibility. Unless you can convince the Internal Revenue Service to say what we think they are going to have a hard time saying—which is that there is no tax problem here.
Mr. KENNEDY. I just think that it is very difficult to get anything through Ways and Means. If it happens to have a positive tax benefit, then, as you well know, it is used as an engine to pull an awful lot of other boxcars. And if it has a negative tax consequence, then they say, ''Well, we can't obviously move on this, because it is going to hurt the budget,'' right? So, trying to get a stand-alone bill moved out of Ways and Means on an issue like this is a very difficult proposition.
Mr. KIES. But, the net budgetary impact may well be positive when you combine the spending side savings with the tax cost, and that goes to the issue of whether there is a net negative effect on the budget or not.
Mr. KENNEDY. Well, maybe we could follow up sometime after this meeting and see whether or not we can get together with some folks from the Ways and Means Committee and convince them of your notion.
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If one of the others wanted to have a comment, I would be happy to listen.
Mr. SMITH. If I may, the best protection against a tax risk is, of course, a patch in the Tax Code. About that, there is no argument. The second best is a court decision. And the third best, I guess, is an IRS ruling. The fourth best is a letter, whether it is an opinion or letter of comfort, from your accountant or your lawyer.
The Ernst & Young accounting letter says that in their view—to paraphrase, they ''think it works.'' But the fact that they think it works is of far less comfort to owners and other people restructuring deals than if the IRS says it works.
I would love to have a piece of legislation. I deal, unfortunately, in the realm of the much less ambitious. I think the Internal Revenue Service can give a ruling on this. I think the IRS should be requested to give a ruling on this. I submit to you that a ruling would be sufficient—maybe not perfect, but it would be sufficient.
Mr. KENNEDY. David, would it?
Mr. REZNICK. I believe that it would, sir; yes, sir.
In following the letter completely and going through it with my own staff and following that road, if you do in fact follow that road, you can get there truly with what you have today.
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However, there can be differing views. And the IRS has to look at it, understand, and see it as it is drafted, which is absolutely there, and concur with it, so that other transactions can be structured in similar fashion, and you can, ''Roll them out and create positive energy.''
What we have seen for 4 years is negative energy, and nothing has happened because of that. Positive energy, with just a little bit of IRS review of this and acquiescence, because it is there, will make it work.
See, I don't believe there is a tax cost. People address tax costs. There is only a tax cost if you believe that there is an assumption that there should be an immediate tax recognition today. If you say it is an immediate tax recognition today that you are not going to recognize, then there is a tax cost.
Otherwise, you are still going to have—as the soft second is amortized—you are still going to have that same recognition of income that you would have if the Section 8 contracts were renewed, and the amortization of the old mortgage paid. It is still going to amortize.
And based on what we have read, structuring it as a valid mortgage with valid value at the end of the line, it will still have to be paid off then, which will continue to pay whatever the tax implication is then.
Mr. KENNEDY. Thank you.
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Chairman LAZIO. Thank you.
I want to turn now to the Chairman of the full panel, the distinguished gentleman from Iowa, Mr. Leach.
Mr. LEACH. Thank you, Mr. Chairman.
I think some of these issues underscore the import of having the subcommittee look at this issue in a new way. And, obviously, there are three parties to this transaction: The tenant, the landlord, and the taxpayer. And each has a slightly different perspective, and how you balance the three so that we have a workable system is going to be a work of art, but I think it must be done.
The great strength of the landlord today is that the current system is inordinately expensive. And, in retrospect, a lot of the questions that have been raised in Mr. Ravitch's article clearly weren't raised at appropriate periods of time. So that gives the landlord a lot of leverage.
Having said that, I think this Congress really is obligated to move quickly. And I agree very definitely with the premise of Mr. Smith: It would be better to act this fall in preparation for next year than at any other time.
Whether we can, however, will depend a little bit on the judgments that are applied. And at issue is not only will it score in totality slightly better than the current system, but I think the goal of the Congress should be substantially better than the current system. I don't think that is an unrealistic goal.
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With that as a promise, one has a different outlook than simply saying ''make it just barely better than the current system.'' Maybe it can't be done. I mean, that may be an unrealistic promise, but I think the current circumstance is one in very bad need of repair.
Now, for a question, Mr. Ravitch. In your statement today, you indicated that it was imperative that the tenants stay where they were. In your written statement, or your article, you added ''or be provided some alternative circumstance.'' And I think that ''or'' is a very important ''or,'' because some current circumstances are not the best alternative. Would you concur in that there is an ''or'' there, or is that a fair thing to say?
Mr. RAVITCH. Yes.
Mr. LEACH. Second, you have raised, more than anyone in the discourse that I have been involved in this, the last 6 or 8 weeks, the issue of the role of nonprofit organizations. How do you visualize that, and where and how do you insert the nonprofit?
Mr. RAVITCH. Well, I think the nonprofit organization can be inserted at any one of several levels. There are all kinds of nonprofit organizations; those that own and/or manage residential properties; those that perform a panoply of other services in connection with maintaining the supply of affordable housing.
I think it is important to understand, Mr. Chairman, the housing units that we are talking about fall under many different categories. Some are quite sustainable at market rents without subsidy; some can't even pay real estate taxes even if there was no debt service out of market rents. You don't necessarily have the same solution for every one of these projects just because they are, quote: ''a Section 8 project.'' And you have to make that distinction, which is why there has to be some administrative discretion and some leeway in the way this solution is administered.
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But the role for the nonprofit group is, in many cases, one arising from the following fact. If you have an owner who is not maintaining the property properly in accordance with standards established by the Department of Housing and Urban Development, that owner should not be given the opportunity to continue to own with a renewed subsidy contract, and in which case, whoever has control over the mortgage has control over the property, and the mortgage could ensure that that property be transferred to a nonprofit organization.
In most communities in this country, there are many highly qualified nonprofit organizations that maintain and run housing, and maintain it properly, both in the physical sense, as well as being skillful in using all the economic tools available to ensure the maximum amount of affordable housing.
Mr. LEACH. Thank you, sir.
Chairman LAZIO. Thank you.
The gentlelady from New York, Mrs. Kelly.
Mrs. KELLY. Thank you.
Mr. Chairman, I would like to ask the panel in general a couple of questions. One of them is: How will the new capital gains tax change owners' behavior, do you think? And what do you think would be the tax consequences from the mortgage restructurings there?
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Mr. KIES. Mrs. Kelly, if the current investors in these projects choose to default because the values of the properties are substantially below the current debt, in the event of a default, there is a capital gains consequence to them. They essentially, at that point, have to pay a capital gains tax on what is referred to as their ''negative capital account.''
Because the capital gains rate has been lowered, the tax cost of choosing default is slightly lower than it would have been under prior law, but not substantially. The maximum capital gains rates have gone from 28 to 20 percent. So, the choice of default is slightly more attractive than it would have been.
However, the balance is still between the tax cost of default as compared to what would be the tax cost if the Congress does nothing to clarify the tax treatment, of choosing the restructuring option. And that will become a question of how the restructuring option is actually designed and how much confidence firms like Ernst & Young, and those like them, can give their clients.
As we have said in our testimony, we think that there are some serious tax issues. We think the fact that many people will be reluctant to go forward confirms that. But the lower capital gains rate probably has only a small impact on the decision between to default or to take the restructuring option.
Mrs. KELLY. Mr. Smith, do you agree with him?
Mr. SMITH. I completely agree. The difference in the capital gains rate, in my view, will make no difference. These owners want to avoid default, and they want to work hard to restructure loans. It does not obviate the need for a clear answer to a tax question here.
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Mr. RAVITCH. Could I respond also?
Mrs. KELLY. Yes, by all means.
Mr. RAVITCH. I agree with what the other two gentlemen said, but I want to point out where this legislation deals not just with those projects where the value is as described, where an owner has a choice. We are not talking about only the situation where we are creating a series of legislative inducements for an owner to come in and volunteer to restructure, we are talking about a situation where a Section 8 contract is expiring, tenants face the possibility of eviction, and an owner has very few choices, and where the Government has some options as well.
So, you have to take that into account. But I agree that the differential of capital gains tax is not consequential enough to affect an owner's decision.
Mrs. KELLY. If we were to bring that capital gains tax down even further, do you think it might even have a strong impact?
Mr. Smith.
Mr. SMITH. Well, a problem that you face is that when an owner loses the ownership of his property, you may gain not on the cash you receive but, in essence, the accumulated losses you have already taken. And whether that is taxed at 39- or 28- or 20-percent, it is still a great big number. It is still unpleasant, and there is no cash to pay it. So, there is a very powerful desire to find a way not to do it, or defer it as long as possible.
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Mrs. KELLY. OK. Thank you.
Mr. Reznick.
Mr. REZNICK. I agree with Mr. Smith. The key here is to try to have efficiency and to induce people to move forward. Nobody wants to prematurely pay a tax, whether it be at a 20 percent rate or 39 percent rate.
Mrs. KELLY. OK. Can I fit in one more question here?
Chairman LAZIO. Sure.
Mrs. KELLY. My question is about a bifurcated mortgage. Do you think that is going to inhibit the sales of property to other owners?
Mr. Smith.
Mr. SMITH. It depends on the terms. If the note matures or accelerates upon any sale or refinancing, then it is a powerful barrier, yes. If the note is assumable, or if it is assumable in the context of a sale to a buyer who agrees to continue the affordability, then it would not be a barrier.
Mrs. KELLY. OK. Thank you very much.
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Chairman LAZIO. I thank the gentlelady.
The gentleman from Montana, Mr. Hill.
Mr. HILL. Thank you, Mr. Chairman.
I am going to ask one of you, and I guess it doesn't matter which one, if you would take me through a typical transaction so that I understand fully how you are proposing that this would occur?
So, let us just say, all right, it is a development where the construction costs were $5 million. And so that project was probably syndicated at—what—$6 million, I suppose, with the difference between the $5 million development costs and the $6 million being the tax credits.
Would that be—am I correct on how that probably went together?
Mr. SMITH. Let us take your $5 million project. It was probably about a 150-unit garden apartment complex, OK; could even be in Billings or Helena. It had a $5 million first mortgage and about a $6 million aggregate cost, and that is what it cost to build; that money went into the bricks.
Mr. HILL. But, generally, weren't these financed at close to 100 percent? That is part of the problem.
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Mr. SMITH. It was financed with a $5 million mortgage and $1 million worth of equity, so that a lot of it—it all went into either the bricks or the development fee.
Then what happened is, over the next 20 years, the owner took depreciation. So, that $6 million depreciable basis has been reduced to, let us say, $1.5 million.
Mr. HILL. OK.
Mr. SMITH. That owner has taken $4.5 million worth of losses. Put up $1 million, write off $4.5 million; whether the bracket is 50 percent or 35 percent or some other variation, you collected a lot of tax benefit. As Mr. Reznick said in his testimony, that is why you did it.
If, however, that loan were foreclosed, the owner has $5 million worth of debt from which he is going to be relieved. But, he is giving up an asset which, on his books, is worth $1.5 million. So, he has gain of $3.5 million, payable at either capital gains or ordinary income based on depreciation rules—depreciation recapture rules—which Mr. Reznick remembers and I don't.
Mr. HILL. Let me just interject a couple of questions.
What would typically be the current market value of that property?
Mr. SMITH. OK. Before you can answer the question of what that project's market value will be, you have to say, what would it rent for? Today, that property is renting, in our hypothetical example, for rent that is 130 percent of HUD's FMR, which is a calculation HUD makes.
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If we reduced the rent to 100 percent of FMR, that property could probably sustain, in our example, $2 million worth of first mortgage. That is typical.
We did a study, and, in fact, Ernst & Young did another study, that suggested that the typical newer Section 8 project, if reconstituted under mark-to-market, would be able to support a mortgage of about 40 cents on the dollar.
Mr. HILL. From the original development cost?
Mr. SMITH. From the original cost.
Mr. HILL. OK.
Mr. SMITH. That value is a function of the fact that it is no longer value based on its cost, it is based on its earning power. And we have controlled its earning power.
If I went into a restructuring and my friends at HUD tore up my $5 million mortgage and gave me a $2 million replacement loan, well, unfortunately, my accountant, Mr. Reznick, is going to tell me I just made $3 million. I have income of $3 million. I have cancellation of debt. So, what I want to do is avoid that cancellation of the debt.
Now, what the Ernst & Young proposal says is, ''We agree to pay that back to the Federal Government out of future cash flow and out of residual value when the project is sold, and between now and when we do that, it will run interest at 1 percent.''
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This, for your benefit, is exactly like the way we finance tax credit deals with CDBG. It is the way HUD used to do flexible subsidy loans. Flexible subsidy loans work for tax purposes. CDBG works for tax purposes. The issue is whether doing it retrospectively also works.
So, the debt stays on the books. I don't have gain, I still have debt, but I have changed the structure of the deal. At issue, the thing that the Ernst & Young thing is about, is whether that triggers the so-called ''original issue discount rules'', which would impute income even though the debt is still out there.
Mr. HILL. OK. Let us go back to the example, though, that you just described, the $6 million property at its full development cost. More than likely, the $5 million, which is the original mortgage amount, was the bricks and mortar, land, and those costs. And the rest were developer fees, soft costs, including profit to the developer, and the incentive there was tax credits; right?
Mr. SMITH. No, there were no tax credits. It was straight depreciation.
Mr. HILL. OK. So there were no tax credits in the deals that we are talking about. More recent ones have tax credits in them.
Mr. SMITH. That is correct. They don't have this problem.
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Mr. HILL. OK. The older ones didn't have tax credits. And the mortgage amount was usually 100 percent of the hard costs, typically.
Mr. SMITH. Mr. Reznick cost-certified a bazillion of these.
Mr. REZNICK. These projects have 90-percent mortgages, maximum. The HUD program allows for a 90-percent mortgage. They allow and include it in a calculation for the 90-percent mortgage, a builders and sponsors profit and risk allowance, which is a phantom number, it is not funded out of the mortgage, to help get you there. But they are not 100-percent financed.
Mr. HILL. So, the instance we just described where the original mortgage was $5 million, that has been paid down some; there has been some principal.
Mr. SMITH. What Mr. Reznick said was that it originally cost $5.6 million, 90-percent financing to build. So there was $400,000 of profit. Yes, sir, you are correct. And in the example, to the extent we had paid down principal, that would have come to us in our tax returns as phantom income.
I just made it simple to keep it to math that I could do in my head.
Mr. HILL. If I could just continue on this line. So, there is some incentive at this point for the owners of that property, because they have this tax liability that is hanging over them. So, in the proposal that is before us, we are asking them to put some additional cash into the refinancing of this proposition.
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Mr. SMITH. The mark-to-market proposal, as contained in H.R. 2447 and its Senate analog, S. 513, does not specifically call for the owners to contribute new capital, no.
Mr. HILL. But there would be some incentive for them to contribute some new capital?
Mr. SMITH. There is certainly an—if you believe the contribution of capital would defer in a permanent, or long-term way, an otherwise certain recognition of tax—there is absolutely an incentive, yes.
Mr. HILL. It just seems to me that the taxpayers have subsidized these investors substantially. They were, in the years, given accelerated depreciation schedules. More recently, people got tax credits. They subsidized the mortgage by virtue of the FHA guaranty. And so, at this point, if we restructure these and we give them 100 percent FHA guaranty again and we, in essence, subsidize them by lowering the rent, at least on part of the mortgage, without requiring them to make any kind of cash investment, I mean, it just seems to me like we are asking the taxpayer to give about the fourth or fifth subsidy to these projects.
Mr. REZNICK. Where I disagree with your position, or statement, is that the owner isn't asking for a reduction in income tax or an elimination of tax. They are only asking to be in the same position they would have been had you not done a mark-to-market and continue the Section 8 contract as you currently have it, which is expensive.
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They are not looking to try to eliminate an ultimate tax transaction. They are looking to get what they thought they bought, which was an extended amortization of that over the period, which is what this soft second would do.
I don't believe anyone is looking for a waiver or anything else. Remember, there was no tax savings, merely a deferral. The ultimate return that the investor is going to be getting will be his yield or spread on using early tax savings as they were to get it back later over a longer period of time.
If you max the dollars, they are principally basically the same. Potentially there could be a little variance in real dollars of tax if at the end it was recognized as capital gain, but it is only a deferral.
So, the profit, or what we are talking about these fat investors getting, was merely their ability to earn on this deferral as they were financing affordable housing. Without the investor or owner capital, the properties couldn't be built. The leverage that was provided was enough to get 90 percent. Someone had to put in the other 10 percent, with basically no real cash return and potential risk. Over the years, there have been foreclosures and premature recognitions of income.
Mr. RAVITCH. I have to disagree with Mr. Reznick in part, Congressman. And if I may, as I said earlier, the tax situation varies from project to project. You have to always distinguish between those projects which have a limited dividend—limited return—to the owner, and those which don't. And there are many projects, as I think Mr. Reznick knows, in which there is very substantial cash flow going to the owner.
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Mr. HILL. Let me go to the example, if I could, just because I want to make sure I understand this. Going back to the example, you said where there was about $1.5 million in remaining basis, if there is a write-down of that mortgage, the investors can write down that against the remaining basis; is that correct?
Mr. SMITH. No. What would happen is, if there is a cancellation of that chunk of the mortgage, they have immediate income.
Mr. REZNICK. You can offset it against the balance of a depreciable basis.
Mr. HILL. But you can eliminate your remaining basis against that; is that correct? Am I right or wrong about that?
Mr. REZNICK. Yes, you can. But in that $1.5 million that is left, a significant amount of that is going to be land, which is nondepreciable.
Mr. HILL. But to the degree that there is remaining depreciation, you can take that against that?
Mr. REZNICK. Yes, sir. But you are talking about properties that were principally depreciated over a CRS life of 18 years, 15 years, so that the bulk of the depreciable basis is truly gone. It is principally the land that is left.
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Mr. KIES. However, Mr. Hill, these investors, if they have other real estate assets with basis, can also offset that COD income against that basis because of a 1993 Act change. Some may, some may not.
Mr. HILL. It just seems to me that if we are going to do something that is going to take the investors off the hook, there ought to be some contribution on their part to the solution of the problem. And maybe I am the only one that believes that.
Mr. SMITH. Well, Mr. Hill, I have the pleasure of doing business with various investors at various times. One of the problems that I have in persuading them of these kinds of situations in workout contexts is, back in 1986, under the 1986 Tax Act, the Government changed the rules with respect to the losses that they thought they bought. They became passive losses, and the investor was not able to shelter them against what he thought he was going to get.
So there is an inequity, based on what you are saying. There is no question about it. And if this were purely a financial asset, you could consider playing that kind of game. You could say, ''Doggone it, guy, you have got a contract.'' But we have an asset that is both financial and social in nature. If that is the negotiation you want to have, you naturally will expect the investors to resist in whatever way they can.
The proposals in H.R. 2447 and in S. 513 say that, in essence, ''We will let you''—the investor—''We will relieve your sense of stress, but you must preserve the property as affordable for a long period of time.'' That is a policy trade that is made in both of those bills. It is obviously within the purview of the Congress to decide whether that is a good policy trade. I happen to think it is.
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Mr. HILL. Thank you, Mr. Chairman.
Chairman LAZIO. I thank the gentleman.
We have a vote on right now. Let me just ask the panelists if anybody has an extraordinary time problem where we could try and get back here in 15 minutes?
Mr. KIES. Mr. Chairman, I have a meeting with the Chairman of the committee.
Chairman LAZIO. That is an extraordinary time problem. Let me just ask you, then, one question, and we will come back in 15 minutes, and we will try and wrap the whole hearing up by 4 o'clock. How is that? Is that fair enough?
OK. Let me ask you, is there precedent for having legislation enacted that would include a provision that any mortgage restructuring would not trigger tax consequences to the purportedly benefiting party?
Mr. KIES. Mr. Chairman, I just alluded in my comment to Mr. Hill, in the 1993 Act, the Congress did include legislation that gave favorable tax treatment to cancellation of indebtedness income in the case of real estate restructuring, partly in response to the S&L problems, which allowed taxpayers to not include it in income and be able to offset it against basis they had in other assets.
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It wouldn't be the first time that Congress has acted favorably to assist in restructuring transactions.
Chairman LAZIO. And just by way of opinion, you think it is entirely possible that that might not score positively?
Mr. KIES. Our conclusion, which is in my testimony, is that we believe that it will score negatively. We have specifically declined from predicting the magnitude of the effect, because it will depend upon what is the programmatic change that your subcommittee would approve, and we would have to hear from CBO as to what they would expect the utilization rate to be. So all of those things would have to be taken into account if you were to structure some sort of favorable tax approach here.
Chairman LAZIO. Finally, in your written testimony, you speak to the issue of the general application of regulations. Let me ask you, how do you think that we can change the regs for general application, or can we open them up to the general public?
Mr. KIES. Sure. The issue that we raised is whether or not this exception, which is in, I believe Section 7872 of the Code, applies so that this type of preferred financing from the Federal Government, if you will, would not be treated as giving rise to income. This exception applies to financing that is generally available to the public. There are only, I think, temporary regulations that interpret this provision.
What we have said in our testimony is that we think there is a significant question as to whether the proposal in your legislation would fit that definition, because there are other projects that would not have this option available to them.
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In order to be 100 percent confident, you would have to expand it substantially, which would make the program more costly on the programmatic side. Conversely, you could either do a legislative clarification or ask the Internal Revenue Service or the Treasury Department to issue a ruling that says this exception does apply. Those are the options.
Mr. Smith raised the question of getting a case decision. Clearly, Mr. Reznick is not going to have any clients that want to be the guinea pig to go test whether this works and we find out 3 years from now, which is going to be too late for to you effectively do what you want to do.
I think those are the options you have really got available to you.
Chairman LAZIO. You have 30 seconds.
Mr. RAVITCH. Mr. Chairman, it would be interesting to me to know Mr. Kies' view of the fact whether his judgment would be different if the second mortgage bore a market interest rate and if all cash flow were to be applied first to servicing that second mortgage so that, in fact, there was no equity, true equity, in the transaction. Why would that give rise to cancellation of the debt?
Mr. KIES. If the second mortgages were true fair market value interest rate, none of us would be sitting here, but also, nobody would take this option, because the whole reason this works is because it is a soft second.
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Mr. RAVITCH. Excuse me, sir. It could be a soft second with a high coupon that accrues but isn't payable with no right on the part of——
Mr. KIES. You have the same exact issue.
Mr. SMITH. The problem that you have is if you have—interest accrues rapidly.
Chairman LAZIO. Let me just cut you off, only because we have about 7 minutes to go. I have to get to the vote. I will give you an opportunity to finish up. And if you don't mind, Ken, I am going to get to you with some questions on behalf of the subcommittee, and you can answer them.
Mr. KIES. We would be glad to answer you on any question you have Mr. Chairman.
Chairman LAZIO. I appreciate it very much.
The hearing now is adjourned for 15 minutes.
[Recess.]
Chairman LAZIO. This hearing shall come to order.
At the end of the discussion prior to the recess of the hearing, Mr. Smith was about ready to answer. I want to give him the opportunity to answer.
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Mr. SMITH. The discussion was centered on the issue of whether AFR accruing debt would work. And if I may, I would like to take the opportunity to answer a little more broadly, because Mr. Kies alluded to the fact that every transaction depends on its facts and circumstances.
Even if we use a bifurcated mortgage, some number of properties will not be able to avail themselves of it, because you have a valuation problem. That is, it is not enough for the debt to have to form of debt. There has to be a reason to believe it can be paid off at some time in the future. And for some fraction of the deals—bad properties, deals which will acquire excessively large write-downs on the first mortgage, even with what we have here, there will be a piper to pay.
So, if Mr. Hill was concerned about deals where there had been excessive tax benefits, those deals are not going to survive. They are not going to get protection even if the ruling works. That was really the point I wanted to make.
Chairman LAZIO. Just a couple of questions that come to mind. The first question, which is sort of a lead-in, is if you give the owner the option of choosing between restructuring and default at the time of the contract expiration, what will they choose?
Mr. SMITH. Well, they will choose to come and negotiate and see what is on offer. Very few people will willingly choose default. Those that can prepay, Mr. Ravitch alluded to, will do so or are getting ready to do so.
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Chairman LAZIO. And, presumably, those would be in more favorable areas, buildings in better condition, where you can attract higher market rents?
Mr. RAVITCH. Yes, sir. Then the question is a different question. If you have a property which is capable of sustaining itself, paying full debt service on existing mortgage and full real estate taxes, out-of-market rents, then the question is whether you, the Government, want to subsidize it in order to preserve more affordable apartments. That is a subsidy question.
Chairman LAZIO. Should we?
Mr. RAVITCH. Well, in a world of unlimited resources, absolutely. In the world that we face, with limited budget authorization for HUD, I said in my article and I believe that, unfortunately, in order to restore credibility to Government housing programs in general, I think apartments, where possible, ought to be rented at market.
Chairman LAZIO. I take it everybody would agree that the party doing the restructuring and deciding how large that soft second mortgage is, has significance as to what incentives you have regarding how far you write down the first in order to have a second?
Under one element of discussion that is ongoing, the State financing agency would have responsibility for the restructuring, and there is a discussion about the State actually retaining or holding title to that note. It would seem that that would create an incentive to have an extraordinary or excessive write-down of the first in order to almost create an equity position in the second, which would provide potential income.
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Do you see it that way? Does anybody want to speak to that?
Mr. RAVITCH. I think I said that in my testimony, Mr. Chairman. I am concerned about that, and that is why I think sound public policy requires that you don't separate this ultimately from what one hopes is a sensible national housing policy. The agency that administers this has got to deal with different fact situations, projects where the value will never equal the mortgage, projects where the market value of the property exceeds the amount of debt, and you have different solutions in both those cases, and therefore the way to control it is through the second mortgage. That is how the taxpayers' interest ultimately gets protected. That is why I think that it can't be done exclusively.
I think there are some instances in which the State housing finance agencies are the proper vehicle to execute the policies of this new entity. In some cases, there may be nonprofit organizations, pension trusts, community organizations; it depends.
Mr. SMITH. I would say three things. First, this is not purely a financial restructuring; there is a policy element. So I personally believe that all the restructurers should be publicly accountable.
Second, I completely agree with Mr. Ravitch and with Mr. Leach that the taxpayer is a stakeholder. The taxpayer needs a proxy as part of the transaction to make sure that there is efficient use of Federal resources. So I have no problem with the HUD oversight role, the quasi-HUD role that you have in your bill, the creation of an agency. I think that is a constructive step.
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Third, if the soft second has genuine economic substance and if it consumes two-thirds, three-quarters, of the future cash flow, or all of it, as some others might suggest, then if the first mortgage is written down too far, the Government can get a recovery.
If the Government makes the mistake of creating a bunch of soft seconds and giving them away or selling them for 5-, 10-cents-on-the-dollar, I think you will have lost something both on accountability and long-term public value. I would recommend those notes be held by a public entity.
Chairman LAZIO. I take it that also speaks to a potential issue of tax consequence, how much you write that down.
Mr. SMITH. Yes. We did some analysis in the many permutations looking at this, and we came to the conclusion, for example, if you used AFR debt, you couldn't survive more than a 25 percent mortgage write-down and still have a credible valuation argument. If you used 1 percent debt, you could write off between 50- and 70-percent of the first mortgage and still be solid for value purposes. If you get above 70 percent, it is very hard to make an argument that you have good value.
Chairman LAZIO. Mr. Reznick, in the Ernst & Young study there was, as I understand it, a conclusion that the current tax code would work for some percentage of the properties. Any sense of what percentage of the properties we are talking about?
Mr. REZNICK. Basically the same thing that Mr. Smith really said. It is those properties where there could be reasonable fair market value attributed to the properties for the soft seconds to contain enough value. They were principally the same thing.
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Chairman LAZIO. Can you make a reasonable judgment? I might be putting you in an unfair position, about the current drafts of the two major pieces of restructuring legislation, one on the Senate side and one on the House side. Because we have not completely resolved the tax issue, does that present a very significant impediment to a restructuring to a voluntary workout? Can you still overcome that?
Give me some guidance as to what we are looking at here.
Mr. REZNICK. I believe that it does have an impediment, because I believe that the road to get you to allow for the debt to be recognized under the relief provisions in Section 7872 are very, very narrow. And what you have in the bill, as I have looked at it—and I have really not studied it—is giving too much choice. And when you start having too much choice to the owners as to whether they want a second or not have a second, you start really questioning whether it is true debt or tax avoidance.
I really believe that temporarily, depending on how much time it takes to do it, if someone were to look hard at what E&Y has prepared, an attempt to compare your drafting to that, I think their guidance is very good guidance. I think that does work.
I do believe that, simultaneously with this, the IRS should be given an opportunity to look at this. I do believe that they have the time to do it and that it can be looked at reasonably if they want to make the effort and put it on to do that, so that you can simultaneously get this moving forward along with the IRS approving it. Because if they don't, then you have wasted an awful lot of time really restructuring something and then having nobody, once you have done it, really accepting it in the same positive sense, because it doesn't have that independent insurance, as Mr. Smith went through, the various different layerings of comfort to the owners.
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Chairman LAZIO. Right.
One last question, if I can, to Mr. Ravitch.
You have vast experience in the public sector and working with non-profits, and you have been through a lifetime of experience in seeing things work and seeing things crumble in terms of mismanagement, lack of capacity, and sometimes things a bit more nefarious than that, even scandal.
What would the consequences be to restructuring over the long run if we had serious management difficulties, evidence of a restructuring that clearly shortchanged the Federal Government and/or a situation where there were high levels of abuse?
Mr. RAVITCH. Well, if I understand your question correctly, Mr. Chairman, I think that none of us want to sit here 5 or 6 years from now and look at restructuring efforts which resulted in what many people might construe to be windfall profits to owners, nor would anybody like to see the Government accused of being negligent in permitting this housing supply to physically deteriorate. That is why it is so important to get a sensible solution and why governmental involvement, as you have suggested in your legislation, in the administration of restructuring is so vital.
I point out, many people have referred to economic value and long-term benefit, and I would like to respectfully remind everybody that most of the stuff was built in the 1970's and early 1980's, as you know. The replacement cost today, depending on what part of the country, would be anywhere from 50- to 100-percent higher, and another 10 years from now it would be astronomically higher. So the chances of ever replacing this housing stock at comparable dollar amounts are slim.
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I built the first limited-profit housing project in New York City 30-odd years ago. The unadvertised mortgage per dwelling unit at the end of 25 years was $4,000 a unit. Now, I never dreamed in the neighborhood in which it was located that there would ever be any equity value, but there turns out to be equity value.
And I would respectfully submit that in most of these projects here, because I am an optimist about this society's ability to solve its social problems, there will be equity value here, which is why I advocate a second mortgage with a hefty interest coupon, because I think there will, over the long term, be realizable equity in most of the projects over and above the debt.
Chairman LAZIO. All right. Do you want to add something briefly?
Mr. SMITH. Yes. Going back to the beginning of the question, it is imperative that any mark-to-market legislation or any restructuring make a point of culling from the system two categories of things. One is those properties which are fundamentally flawed; and, unfortunately, there are a few of them. And those are the situations in which, as Mr. Ravitch's article indicated, you talk about enhanced vouchers, because you are not serving the residents of the community by preserving it.
The second category is people or organizations who have abused the public trust. Your legislation, the Senate's legislation, both list a broad variety of owners who would be ineligible for restructuring. And I think that is an important principle, because we want only to admit through the screen good housing, run by good owners and managers that is serving the public need. If we are going to do a restructuring, let us at least make sure we are saving only that which is worth saving.
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Chairman LAZIO. Thank you.
I would only add that it is not just about good owners, but good propery is also important.
I want to thank the panel. I appreciate very much your commitment to the issue and look forward to more dialog with you. Thank you.
This hearing is in recess.
[Whereupon, at 4:12 p.m., the hearing was adjourned.]