Mortgage Recording Tax On Mezzanine Debt, Preferred Equity Again Proposed In N.Y. Senate – Real Estate

Highlights

• Several New York state senators recently introduced S-318,
  which mirrors a previous legislative effort, S-7231, to impose a
  tax on the creation of mezzanine debt and preferred equity on
  borrowers owning real estate.




• The bill would prevent a secured party from enforcing a
  security interest unless a financing statement is filed with the
  state and the county where the property is located and the mortgage
  recording tax was paid.




• As proposed, S-318 also updates the definitions of
  “mezzanine debt” and “preferred equity
  investments.”

Legislation to impose a tax on the creation of mezzanine debt
and preferred equity was reintroduced on Jan. 4, 2023, in the last
two sessions of the New York state legislature, by the same state
senators who proposed it previously. The only change is the bill
number, which is nowS-318 instead of S-7231. Among actions, the
Mezzanine Debt Bill:

• would impose the mortgage recording tax on mezzanine debt and
  preferred equity investments, as well as require that the mezzanine
  lender or preferred equity holder file a Uniform Commercial Code
  financing statement (UCC-1) to perfect its security interest in its
  collateral (i.e., the membership interests or shares of the
  borrower)




• prevents a secured party from enforcing a security interest
  unless the financing statement is filed with the state and the
  county in which the property is located and the mortgage recording
  tax has been paid




• targets real estate transactions, although there is a very real
  possibility that it could be interpreted to include any financing
  transaction that even indirectly involves real estate, which could
  include corporate transactions in which the target company or its
  subsidiaries include real estate utilized in its operations

Defined Terms

The bill amends Section 291-k of New York’s Real Property
Law to define “mezzanine debt” and “preferred equity
investments” as:

“debt carried by a borrower that
may be subordinate to the primary lien and is senior to the common
shares of an entity or the borrower’s equity and reported as
assets for the purposes of financing such primary lien. This shall
include non-traditional financing techniques such as a direct or
indirect investment by a financing source in an entity that owns
the [equity] interests of the underlying mortgage 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 investor[‘]s capital contribution.”

The reference to “non-traditional financing
techniques” should be considered as troubling because it is
open-ended and could allow virtually any relationship to become
subject to the mortgage recording tax.

The Mezzanine Debt Bill also modifies Section 250 of the New
York State Tax Law and Section 9-601 of New York’s UCC to
specify that “whenever a mortgage instrument is recorded in
the office of the recording officer of any county, any mezzanine
debt or preferred equity investment related to the real property
upon which the mortgage instrument is filed shall also be recorded
with such mortgage instrument.” The Mezzanine Debt Bill also
provides that “mezzanine debt and preferred equity
investments” are taxable, and that the tax will be measured by
the amount of “principal debtor obligations” that may be
secured by a security agreement “in relation to real property
upon which a mortgage instrument is filed.” A consequence of
the recording requirement is that counties and cities could also
impose a tax on the recording of the financing statement, which
would make the effective tax rate equal to the mortgage recording
tax rate, which is 2.85 percent of the “debt” secured for
commercial real property located in New York City and having a
value of more than $500,000.

The Mezzanine Debt Bill also amends Section 9-601 of the UCC to
provide a new requirement that recording of a financing statement
in the relevant county records is required to perfect “a
security interest in mezzanine debt and/or a preferred equity
investments.” This is particularly troubling because Section
291-k of the Real Property Law would provide that:

“No remedy otherwise available
to a secured party under article nine of the uniform commercial
code shall be available to enforce a security agreement pertaining
to mezzanine debt financing and/or preferred equity investments in
relation to real property upon which a mortgage instrument is filed
that is evidenced by a financing statement, unless that financing
statement is filed and the tax imposed pursuant to the authority of
subdivision four of section two hundred fifty-three of the tax law,
has been paid.”

Unintended Consequences

Although the Mezzanine Debt Bill targets real estate
transactions, there is a very real possibility that it could be
interpreted to include any financing transaction that even
indirectly involves real estate, which could include corporate
transactions in which the target company or its subsidiaries
include real estate utilized in its operations. There is also the
problem of multistate transactions that either involve parties that
own real estate in New York or elsewhere, which also raises issues
as to which state’s laws would govern real estate in New York
in a transaction having a nexus with another state. In reviewing
the Mezzanine Debt Bill, it is clear that, if enacted, it will make
New York more expensive and is likely to make mezzanine debt and
preferred equity less available than in the other 49 states.

The Sponsor’s Justification demonstrates that
the bill’s author does not fully understandthe roles mezzanine
debt and preferred equity play in real estate finance and treats
mezzanine debt and preferred equity as another form of mortgage
financing, which is the opposite of the role that they play. It is
the availability of mezzanine debt and preferred equity to make
property more financeable by increasing the equity component of the
debt stack and has become a prerequisite for much mortgage
financing, particularly construction financing, which always
carries a great deal of risk. Treating mezzanine debt and preferred
equity as a mortgage could adversely affect its use as additional
equity enabling the borrower to be able to obtain mortgager
financing.

The sponsor also argues that there is something unfair because
homebuyers cannot obtain mezzanine financing, although the
legislature and the state’s banking regulators and Dobbs-Frank
Act would never allow homebuyers to give the equity in their homes
to a third party, nor would the legislature allow a third party to
make decisions regarding the property, which would be necessary for
the lender to protect its collateral. Moreover, considering the
complexity involved in foreclosing a mortgage in New York, the
legislature would never allow a UCC auction to terminate the
homeowner’s rights to their home without years of litigation,
which would defeat the very purpose of mezzanine debt and preferred
equity financing.

Conclusion and Considerations

If enacted, it is anticipated that this legislation would result
in less available funding for construction and other risky
financing, which would create another reason for developers,
investors and lenders to move their business to Florida, Texas or
other low-tax, low-regulatory states. Although it may be aimed in
part at raising revenue, the bill also creates a disincentive for
financing in New York and could result in New York City and the
state actually receiving less revenue, because the mezzanine and
preferred equity funding sources would follow the mortgage
financing to another, more hospitable state.

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