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RPTE eReport

Winter 2023

2022 Developments in Real Estate Finance

Brook Boyd


  • This piece provides an overview of recent developments in the real estate finance arena.
  • In each case specified there is no guarantee that the debtor actually owns the digital asset, or that the securities intermediary will get title to the digital asset free from other property claims.
  • It is necessary to clearly distinguish “business interest” from other types of interest.
2022 Developments in Real Estate Finance
fotoyy via Getty Images

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1. The Impact of Technology on Real Estate Finance

1.1 Current Status of eDocuments Authorized By E-SIGN Act, UETA & UCC

1.11. E-SIGN Act

The federal Electronic Signatures in Global and National Commerce Act (“E-SIGN Act”), enacted in 2000, authorized a new type of electronic document, called a “transferable record.” Pursuant to the E-SIGN Act, a “transferable record” must meet the following conditions: (1) it must be an electronic equivalent to a “note” under Article 3 of the UCC, (2) the “issuer of the electronic record expressly has agreed [it] is a transferable record” pursuant to the E-SIGN Act, and (3) the transferable record must relate “to a loan secured by real property.”

1.1.2. UETA

The Uniform Electronic Transactions Act (“UETA”) contains similar rules regarding “transferable records.” UETA was introduced in 1999, and has been adopted by all states except New York.

1.1.3. UCC

The 1999 version of the Uniform Commercial Code (“UCC”) defined “record” to include “information . . . which is stored in an electronic or other medium and is retrievable in perceivable form.” The 2010 amendments to the Uniform Commercial Code (“UCC”) (1) authorized electronic signatures, (2) enabled secured parties to have “control” of “electronic chattel paper” if a “system” was used to store the related electronic “records,” (3) protected buyers of intangible collateral who gave value and were unaware of claims by secured parties, and (4) authorized electronic notices of UCC sales.

1.1.4. Control of e-Notes by Holder in Due Course

The E-SIGN Act provides that a person (including a lender) has “control” of an electronic note (“eNote”) if “a system employed for evidencing the transfer of interests in the [eNote] reliably establishes that person as the person to which the [eNote] was issued or transferred.” The person with “control” of such eNote is generally deemed to be the “holder” of it. Such person will also qualify as a “holder in due course” or “purchaser,” as applicable, if the relevant requirements are satisfied under the UCC, except that delivery, possession and endorsement are not required. Similar rules apply under the Uniform Electronic Transactions Act (“UETA”).

1.1.5. Current Fannie Mae Rules for Its Purchases of eNotes and eMortgages

Registration of eNotes & eMortgages: The Federal National Mortgage Association (“Fannie Mae”) has issued detailed rules for its purchases of eNotes and eMortgages. For example, Fannie Mae’s rules provide that “Lenders must . . . ensure eNotes are registered in the MERS eRegistry as soon as possible after the tamper-evident seal has been applied [to the eNote], but no later than one (1) business day of signing. All eMortgages delivered to Fannie Mae must also be registered on the MERS Residential System prior to delivery to Fannie Mae.” This registry is intended to comply with the requirements under UETA and the E-SIGN Act for a central registration system.

Transmitting eNotes to Fannie Mae through MERS eDelivery: A lender that is selling an eNote to Fannie Mae must actually deliver it to Fannie Mae through MERS eDelivery, and then must transmit a request to the MERS eRegistry to begin the process of transferring “Control” and “Location” of the eNote to Fannie Mae.

1.1.6. Recording of Paper Mortgages & Other Documents May Still Be Required

Even if an originating lender or a loan purchaser would prefer to accept only electronic documents, however, in some jurisdictions only paper mortgages (and other related recordable paper loan documents) are accepted for recording.

1.2. Impact of Cryptocurrencies & Other Digital Assets on Finance

Cryptocurrencies and other digital assets are held by many investors, and may be required by lenders as additional collateral, even if the primary collateral is real estate or another traditional form of security. As of January 1, 2023, several U.S. states have enacted various types of laws governing security interests in, as well as purchase or sale of, cryptocurrencies and other digital assets. However, there are also many bills, under consideration by various U.S. state legislatures, that, if enacted, would provide ground rules, and a regulatory structure, for such assets.

1.2.1. Current Practices for Loans Secured by Digital Collateral.

The following practices are customary in jurisdictions in which the proposed 2022 UCC amendments (or similar provisions) have not yet been enacted. In such jurisdictions, secured parties that are relying on digital assets, at least in part, will generally follow at least one of the following procedures:

(1) (a) the transfer of such digital assets to a securities intermediary, (b) the securities intermediary consents to hold the digital assets as financial assets, which are credited to the debtor’s securities account, creating a security entitlement and (c) control by the secured party of the security entitlement pursuant to Article 8 of the UCC, perfecting the secured party’s security interest in the securities account; or

(2) (a) delivery by the debtor to the secured party of a private key for a blockchain asset, (b) the secured party transfers such asset to the secured party’s crypto wallet, and (c) perfection of the secured party’s security interest by filing the applicable financing statements.

However, in each case specified in (1) and (2) above, there is no guarantee that the debtor actually owns the digital asset, or that the securities intermediary will get title to the digital asset free from other property claims.

1.2.2. Proposed 2022 UCC Amendments for Cryptocurrencies & Other Digital Assets.

The American Law Institute and the Uniform Law Commission approved in 2022, and recommended for adoption by all U.S. states, various proposed amendments to the UCC covering cryptocurrencies and other digital assets (the “2022 UCC Amendments”). These proposed amendments include changes to the existing Articles 1-9 of the UCC, as well as a new Article 12 of the UCC. However, as of January 1, 2023, according to the “Enactment Map” appearing on the website of the Uniform Law Commission, no state has adopted these amendments.

The following are new or revised types of assets that are covered in the 2022 UCC Amendments:

Controllable Electronic Records (CERs): The proposed 2022 UCC Amendments define various new types of digital assets that are covered by such 2022 UCC amendments. Probably the most important new type of digital assets are “controllable electronic records (‘CERs’).” According to the 2022 UCC Amendments, a CER “is a record that is stored in an electronic medium [such as the blockchain] and that can be subjected to control.” The comments in the 2022 UCC Amendments say, “think of bitcoin and other virtual currencies as prototypical controllable electronic records.” Another example is that J.P. Morgan has proposed “adapting decentralized finance (DeFi) protocols in the finance industry using tokenized real-world assets. DeFi protocols are self-executing applications on a blockchain that can automate financial services such as lending and borrowing, trading, and asset management while reducing manual involvement from intermediaries.”

Controllable Assets: CERs “also provide a mechanism for evidencing certain rights to payment—controllable accounts and controllable payment intangibles. An account debtor (obligor) on such a right to payment agrees to make payments to the person that has control of the [CER] that evidences the right to payment.”

Payment Intangible: “Payment intangibles” were defined in the 1999 UCC as “a general intangible under which the account debtor’s principal obligation is a monetary obligation.” The 2022 UCC Amendments add the following to such definition: “The term includes a controllable payment intangible.” Courts have ruled, for example, that payment intangibles include (1) payment streams that are stripped from equipment leases, and (2) settled tort claims.

Account: “Account” is a traditional UCC category that similarly has been broadened by inclusion of “controllable account” under the 2022 UCC Amendments. “Account” includes, for example, “a right to payment of a monetary obligation, whether or not earned by performance, (i) for property that has been or is to be sold, leased, licensed, assigned, or otherwise disposed of, (ii) for services rendered or to be rendered,” and certain other rights of payment, subject to various exclusions.

Controllable Account and Controllable Payment Intangible: A “controllable account” or “controllable payment intangible” means, respectively, an account (in the case of a controllable account), or a payment intangible (in the case of a controllable payment intangible) “evidenced by a controllable electronic record that provides that the account debtor undertakes to pay the person that has control under Section 12-105 of the controllable electronic record.”

Advantages of Control: If a party (1) acquires a CER by purchase, for value, in good faith and without notice of a competing claim of a property right in the CER, and (2) has control of the CER, then such party will be a “qualifying purchaser” of the CER. “Article 12 confers an attribute of negotiability on controllable electronic records because a qualifying purchaser takes its interest free of conflicting property claims to the record.”

Recommendations for Lenders Secured by Digital Assets: A lender that intends to be secured, in whole or in part, by digital assets, pursuant to the proposed 2022 UCC Amendments, should (1) design closing procedures, with the borrower’s acknowledgment and consent, in order to enable the lender to have “control” over such assets from the closing date (or such other date that is designated by the lender) until the lender is repaid, (2) require the borrower not only to pay the lender (or the person designated by the lender), but also to acknowledge that the lender is the person in “control” (as defined in the proposed 2022 UCC Amendments) of the digital asset, (3) include a ”choice of law” provision in each CER, and (4) obtain the consents of trading parties, and the borrower, to provide further assurances to the lender confirming that the lender is a first priority perfected secured party with control over the digital assets and other related collateral.

1.2.3 Regulatory & Other Legal Issues Relating to Cryptocurrencies & Other Digital Assets.

Bank Secrecy Act/Anti-Money Laundering (BSA/AML) & Combating the Financing of Terrorism (CFT). Because money laundering has been facilitated, and other crimes and terrorism have been funded, by cryptocurrencies and other digital assets, therefore the U.S. Treasury Department is devoting substantial resources to preventing this in the future. Accordingly, parties should expect a high level of regulatory scrutiny, if they are involved in transactions involving significant amounts of cryptocurrencies and other digital assets.

U.S. SEC & CFTC. The U.S. Securities and Exchange Commission (“SEC”) and the U.S. Commodity Futures Trading Commission (“CFTC”) have aggressively asserted their jurisdiction over cryptocurrencies. For example, the SEC charged that BlockFi Lending LLC both (1) failed to register, with the SEC, BlockFi’s offers and sales of its interest accounts under the Securities Act of 1933, and (2) failed to register as an investment company under the Investment Company Act of 1940. BlockFi then paid a $50 million penalty to the SEC. Also, the CFTC charged BitMEX with (1) illegally operating a cryptocurrency derivatives trading platform and (2) anti-money laundering (AML) violations. BitMEX then entered into a consent order, pursuant to which it paid a $100 million penalty to the CFTC and a $50 million penalty to FinCEN.

U.S. IRS & Other State Tax Agencies. The U.S. Internal Revenue Service (“IRS”) states that, in the case of the typical owner of virtual currency such as bitcoin (who purchases the virtual currency as a long-term investment and is not a dealer), the sale by such owner of such virtual currency results in long or short term capital gain. Therefore, spending bitcoin is not like spending U.S. currency, which is tax-free. Similarly, if you receive bitcoin for services rendered, that must be reported to the IRS as income.

Money Transmitter Licenses. The District of Columbia now requires a money transmitter license to be obtained by any person who engages in any money transmission involving bitcoin or other virtual currency “used as a medium of exchange, method of payment or store of value in the District.”

2. Benefits for Property Owners Under the Inflation Reduction Act of 2022

You, or some of your clients, may be entitled to benefits under the federal Inflation Reduction Act of 2022 (the “IRA”). Here are some examples of the available programs that apply to residential property, but there are many other benefits that apply to commercial property as well.

The IRA extends, through 2032, the existing tax credit to individuals for residential energy property costs. The IRA also increases the rate of such credit for individuals to 30%, and permits a credit of up to $1,200 per annum for various “energy” improvements, except that such credit will be: (1) up to $2,000 per annum with respect to certain heat pump and heat pump water heaters, and biomass stoves and boilers, and (2) up to $150, for home energy audits.

The IRA extends, through 2034, the residential clean energy tax credit, revises the phased reduction of such credit, and extends the credit to include qualified battery storage technology expenditures.

The IRA continues the new “energy efficient home tax credit” through 2032, and permits (1) a $2,500 credit for new homes that meet various Energy Star efficiency standards and (2) a $5,000 credit for new homes that are certified as zero-energy ready homes. The IRA also authorizes a credit for energy efficient multifamily dwellings.

The IRA appropriates funds for the U.S. Department of Energy (“DOE”) for a HOMES rebate program that provides grants to state energy offices. States must then provide rebates to homeowners, aggregators, and contractors, for certain whole-house energy saving retrofits, inclding enhanced rebates for low-income and moderate-income households. A rebate provided under this program may not be combined with any other federal grant or rebate for the same single upgrade.

Also, the IRA funds a DOE high-efficiency electric home rebate program that awards grants to state energy offices and Indian tribes. Pursuant to this program, rebates are available for qualified electrification projects in low-income or moderate-income households. Qualified electrification projects include the purchase and installation of certain heat pumps, electric stoves, electric ovens, electric load service centers, insulation, materials to improve ventilation, or electric wiring.

3. Tax Code Limits on Business Interest, and Exceptions Thereto

As interest rates rise, and as the aggregate amount of business interest continues to increase, borrowers and their attorneys should carefully monitor the amount of each borrower’s “business interest.” For taxable years beginning after December 31, 2017, “business interest” means any “interest paid or accrued on indebtedness properly allocable to a trade or business.” However, a deduction for “business interest” shall not exceed the sum of—

  1. the business interest income of such taxpayer for such taxable year,
  2. 30% of the adjusted taxable income of such taxpayer for such taxable year, plus
  3. the floor plan financing interest (e.g., loans to finance the acquisition of motor vehicles) of such taxpayer for such taxable year.

Any disallowed business interest deduction is carried forward to the next tax year. However, the above limit on deduction of business interest is not applicable to a corporation or partnership with average annual gross receipts not exceeding $25 million. Further, a “trade or business” does not include “any electing real property trade or business.”

It is necessary to clearly distinguish “business interest” from other types of interest. For example, “business interest” does not include investment interest. “Investment interest” includes interest that “is paid or accrued on indebtedness properly allocable to property held for investment.” However, “investment interest” excludes both (A) “qualified residence interest” and “any interest which is taken into account under Section 469 in computing income or loss from a passive activity of the taxpayer.” Deduction of investment interest is limited to the extent of net investment income, which is calculated in a less generous way to taxpayers than the above deduction for business interest.

The line between a “trade or business,” and an “investment,” is not always clear-cut. It may be possible for taxpayers in some transactions to achieve a preferred tax result based on how the transaction is structured and sized.

Other provisions of the Internal Revenue Code that may restrict excessive leverage in real estate financings include (1) restrictions on “excess business losses” (which are not allowed and are instead treated as part of the taxpayer’s net operating loss carryforward in subsequent taxable years) for taxpayers other than corporations, and (2) a requirement that net operating loss deductions cannot exceed 80% of taxable income.

4. When Real Estate Lenders Should Be REITs

What is the most efficient deal structure for a real estate investor that collects interest? This becomes more and more relevant as interest rates continue to increase.

In some cases, a real estate investment trust (“REIT”) should be used (rather than a partnership or C corporation) to provide financing for income-producing real estate by purchasing or originating residential and commercial mortgage loans, and mortgage-backed securities (“MBS”). A mortgage REIT can be formed as a corporation under Subchapter M of the U.S. Tax Code, or as an unincorporated entity that has made a “check-the-box election” to be taxed as a corporation. A mortgage REIT, unlike a C corporation, generally does not pay entity tax on its net earnings if it distributes all of its current-year taxable income to its shareholders, since a mortgage REIT is entitled to a deduction for dividends paid. Further, under Sec. 199A of the U.S. Tax Code, a U.S. individual can claim a 20% deduction for dividends received from a mortgage REIT that collects interest income. In contrast, interest income allocated to a U.S. individual partner is not eligible for this deduction.

5. When a Loan Will Be Recharacterized as Equity for Tax Purposes

In the Tribune Media case, Tribune Media Co. (“Tribune”), was the publisher of the Chicago Tribune, and the owner of the Chicago Cubs. Both were controlled by Sam Zell.

In 2009, the Tribune, and the Ricketts family (the founders of TD Ameritrade), formed Chicago Baseball Holdings, LLC (the “LLC”). The LLC obtained 2 loans, (1) a senior loan funded by a commercial lender, and (2) a subordinate loan (“sub loan”) funded by the Ricketts. Tribune guaranteed collection of the loans.

The Tax Court ruled that the “sub loan” was actually not bona fide debt for tax purposes, and would be recharacterized as equity. The Tax Court stated that the main factors, indicating that the “sub loan” was actually equity, were: (1) there was no fixed maturity date for repayment of the “sub loan,” (2) the terms of the “sub loan,” and the subordination agreement, prevented any meaningful right to enforce payments of the “sub loan” as they became due, (3) the intent of the parties was to treat the “sub loan” as equity, (4) because of the interests of the Ricketts family in both the LLC and the sub lender, it was unlikely that the “sub loan” would ever be enforced, (5) the LLC did not meet its burden of proving that it could have obtained a similar loan from an unrelated third party, (6) the “sub loan” proceeds were used by the Ricketts family to purchase their equity interest (rather than funding operating expenses), and (7) repayment of the “sub loan” was uncertain.

6. Enforceability of Make-Whole Premiums in Bankruptcy

When Ultra Petroleum Corp. and its affiliates (collectively “Ultra”) obtained various loans, it agreed, if it prepaid the loans, to pay a “make-whole” premium to each lender equal to the present value of the interest payments such lender would have received if its loan had been paid at its maturity. However, when natural gas prices plummeted, Ultra became insolvent, and it filed for bankruptcy. But during the Ultra bankruptcy proceeding, natural gas prices roared back, and Ultra became solvent again. Nonetheless, Ultra proposed a plan that would not pay its lenders the agreed make-whole premium. Instead, Ultra proposed, pursuant to Section 502(b)(2) of the Bankruptcy Code (which disallows payment of unmatured interest), to pay only the sum of (1) the outstanding principal owed to its lenders, (2) all interest that had accrued before Ultra’s bankruptcy, and (3) interest on both such amounts at the Federal Judgment Rate (which was much lower than the contractual interest rate) only for the duration of the bankruptcy proceeding. The lenders objected, because Ultra’s proposed payments were $387 million less than their calculation of the contractually required payments.

The Fifth Circuit recently ruled that Ultra’s lenders are entitled to their full make-whole premiums, at the agreed contractual rate, based upon existing case law to the effect that solvent debtors in bankruptcy must nonetheless pay interest at the rate they originally agreed to pay to their lenders. The Fifth Circuit decision is in accord with decisions by the U.S. Supreme Court and some other federal courts, but technically conflicts with the literal provisions of the Bankruptcy Code.

Similarly, in an unrelated case involving Pacific Gas & Electric Company (“PG&E”), the Ninth Circuit held that since PG&E had a net worth of almost $20 billion, and clearly was solvent, therefore PG&E was obligated to pay post-petition interest to its unsecured trade creditors, at the applicable contractual or legal rate, even though PG&E had filed under Chapter 11 of the Bankruptcy Code.

7. Structuring of Bankruptcy Remote Entities

The ABA Committee on Securitization and Structured Finance has published an article, summarizing the issues involved in structuring a borrowing entity, in order to enable it to be “bankruptcy remote” (i.e., it will be unlikely to file for bankruptcy). Such article includes discussions of topics including “special purpose vehicles,” “substantive consolidation,” “true sale,” and related case law. This ABA committee has also proposed a model form of “Delaware Limited Liability Company Agreement,” which is extensively annotated with comments. For new lawyers, or those who have not been closely following the cases in this area, these ABA articles will be invaluable. Lawyers should also be familiar with the specific requirements of the rating agencies (regarding the borrower’s structure and powers), which are available online.

This article should not be construed as legal advice, and readers should not act upon information in this article without legal counsel.