Proposed Tax on Mezzanine Financing Extends its Reach to Preferred Equity
In our March 2020 Note from The Real Estate Group, we summarized the proposed New York State legislation seeking to extend the mortgage recording tax to mezzanine debt financing. As highlighted in that Note, if the proposed legislation was enacted into law, it would increase the cost of mezzanine debt financing significantly, and in turn, have a material impact on the real estate finance market for properties in New York. We also noted that the legislation was vague with respect to whether the tax could be imposed on other types of financing, such as preferred equity investments. The legislation, as subsequently amended, died in the legislature once the 2019-2020 Senate and Assembly sessions adjourned.
Unfortunately for the commercial real estate finance market in New York, the concept of raising tax revenue from an expanded mortgage tax has not permanently ended. This winter, similar bills have been reintroduced in the New York State Senate (S3074) and Assembly (A3139) seeking, once again, to extend the mortgage recording tax to mezzanine debt financing. Moreover, in this newly proposed legislation, the extension of the tax to preferred equity investments has been expressly included.
The new legislation states that “debt carried by a borrower that may be subordinate to the primary lien and/or common shares and reported as assets for the purposes of financing such primary lien” is subject to the mortgage recording tax. Unlike the 2020 legislation, this legislation provides that the type of debt to be taxed specifically includes “non-traditional financing techniques such as direct or indirect investment by a financing source in an entity that owns the equity interests of the underlying mortgagor, where the financing source has special rights or preferred rights such as: (I) the right to receive a special or preferred rate of return on its capital investment; and (II) the right to an accelerated repayment of the investors capital contribution.” Accordingly, real estate preferred equity investments, as commonly structured, may be subject to the mortgage tax.
The new legislation provides for the following tax rates for mezzanine debt and preferred equity investments:
- mezzanine debt/preferred equity of less than $500,000.00 will be taxed at $1.00 per $100.00;
- mezzanine debt/preferred equity affecting one, two, or three-family houses and individual residential condominium units, in the amount of $500,000.00 or more will be taxed at $1.125 per $100.00; and
- mezzanine debt/preferred equity of all other real estate will be taxed at $1.75 per $100.00.
Under the new legislation, counties and cities in New York will also be authorized to impose an additional tax on the mezzanine debt and preferred equity investments.
As was the case with the 2020 legislation, the new legislation also lacks clarity and leaves many questions unanswered. In particular, the legislations appears (although it is ambiguous) to provide that the tax is to be extended to only mezzanine debt financings and preferred equity investments that occur simultaneously with a mortgage being placed on the affected real property. In addition, there is no clear guidance as to what type of “special rights or preferred rights” under a preferred equity investment would trigger the imposition of the mortgage tax.
In the event the proposed legislation is enacted into law, borrowers will invariably be faced with either accepting loans and preferred equity subject to mortgage taxes or, in the alternative, raising more equity that is not subject to the tax; both at higher costs.
As the proposed bills proceed through the legislative process, we anticipate that the details will be clarified, and we will provide updates on the status of these pending bills as they become available.
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