By Staford François, Partner, CohnReznick
The recent macro-economic environment has led to significant changes in the private credit space. Most loan operators have seen their share of non-performing loans, which at times has led to foreclosure on the collateral, resulting in Real Estate Owned (REO). This article will provide high-level guidance on the conversion of a loan receivable to an REO which, from both an accounting and tax point of view, is a realizable transaction.
What is a non-performing loan?
The loan operator (advisor), as part of its policies and procedures, will determine when a loan is deemed to be non-performing. In general, once borrowers are no longer making their scheduled recurring payments on a loan, it becomes non-performing. After exhausting all options to bring the loan back to performing status, the advisor may start with the legal proceedings to foreclose on the collateral.
How to account for a foreclosed REO?
The difference between the cost basis of the loan and the fair value of the property received, as discussed below, results in a realized gain or loss as of the conversion date. The realized gain or loss is recorded on the statement of operation of the entity during the period the conversion occurs. The gain or loss from the conversion is a realizable event; as such, the advisor must evaluate its tax impact. The tax gain or loss could be different than book if the cost basis of the loan has been written down for book purposes before the foreclosure. If there is a tax gain on foreclosure, this will give rise to phantom income because no cash is realized until the sale of the REO.
How to determine the cost basis of the non-performing loan at the date of foreclosure?
Once the loan becomes non-performing, the advisor, per Generally Accepted Accounting Principles in the United States (US GAAP), should stop accruing interest on that loan. All legal expenses incurred in perfecting the lien related to the loan along with accrued interest should be included in the cost of the loan. In general, all costs incurred that are directly related to the foreclosure through the date the deed of trust is assigned to the advisor are capitalized as part of the loan cost. The primary question regarding what cost to capitalize is whether the legal cost or other professional services incurred to protect the loan will create future benefit to the entity.
What is the fair value of the REO acquired through the foreclosure?
The advisor determines the fair value of the property received through different valuation methodologies such as sale comparisons, appraisals, letters of intent, and income approach. The advisor must also determine the associated cost to sell the property, including items such as liens that must be settled, any unpaid property taxes, and other costs. The advisor then records the property at its net realizable value, which is its fair value minus cost to sell. This becomes the new cost basis of the acquired property.
Subsequent measurements
At period end, for fair value basis of accounting, the real estate property is recorded on a fair value basis on the entity’s statement of assets and liabilities with changes in fair value recorded on the entity’s statement of operations. Whereas, for historical cost basis of accounting, the advisor would evaluate the property for impairment.
Best practice
As the nonmonetary transaction of converting the loan to an REO via the foreclosure process is a realizable event, it is a best practice to involve your accountant and tax professionals early in the process. This will help to ensure the transaction is appropriately accounted for on a GAAP basis and all tax implications have been appropriately addressed.
Sources:
- ASC 310-30 – Loans and Debt Securities acquired with deteriorated credit quality
- ASC 820-10 – Fair value measurement
- ASC 845-10 – Nonmonetary Transactions
- ASC 970-360 – Real Estate – General
About the Author
CohnReznick Partner, Staford François, has more than 15 years of experience providing audit services on financial statements and internal control over financial reporting. His clients include public and private entities in the alternative investment space.
