1 McTague, The Tax Man Threatens Eviction from HousingShelters; Barney Frank Fixes Responsibility, BARRON'S, January30, 1995, at 47.

2 Mark-to-Market includes FHA-insured Section 236 andSection 221(d)(3) Below Market Interest Rate ("BMIR") projectswith Loan Management Set-Aside ("LMSA") assistance, Section 8 NewConstruction and Substantial Rehabilitation projects and Section8 Property Disposition Set-Aside assistance. It also includesother FHA-insured projects with LMSA assistance. It does notinclude Section 202 and Section 811 projects, Section 8 moderaterehabilitation projects, insured projects without Section 8assistance or Section 8 projects which are not FHA insured.

3 The expirations will begin in Fiscal Year ("FY") 1996. HUD has estimated that of the approximately 1,330,000 apartmentswhich now receive Section 8 project-based assistance, 125,602

THE CLINTON ADMINISTRATION'S PROPOSED REINVENTION OF HUDAND THE MARKING OF MORTGAGES TO MARKET

CANCELLATION OF INDEBTEDNESS INCOME AND OTHER ISSUESFOR SECTION 8 PROJECT OWNERS AND THEIR COUNSEL

Jerrold I. HirschenHirschen & SingerNew York, New York

"OLD TAX SHELTERS NEVER DIE. They morph into financialnightmares.

"This is especially true for the one million persons whosetax-sheltered investments from 1974 to 1986 helped build and

manage 12,000 low-income apartment complexes for the Departmentof Housing and Urban Development's Section 8 program."1

I. Introduction. Mark-to-Market is a proposed United StatesDepartment of Housing and Urban Development ("HUD") initiative thatis directed to low-income housing projects which have receivedproject-based Section 8 assistance and which have been credit-enhanced by Federal Housing Administration ("FHA") mortgageinsurance.2 In projects which are affected by Mark-to-Market:

Ë Section 8 project-based assistance will not be renewed ascontracts expire.3 Current contracts will not be abrogated.4

apartments would be affected in FY 1996, 142,051 in FY 1997,144,488 in FY 1998, 103,322 in FY 1999 and 70,916 in FY 2000. InFY 1996, approximately 2,000 of the affected apartments areproject-based Section 8 and the balance are LMSA.

4 "First, let me be crystal clear: HUD will honor itscommitments and obligations under all existing contracts. Nocontracts will be abrogated." Letter from HUD Secretary Henry G.Cisneros to Senator Christopher S. Bond, June 15, 1995, at 3[hereinafter cited as Bond Letter]. Copies of all letters citedin this paper are on file in the office of Hirschen & Singer. See also Dolber and Fuller, HUD Says It Will Not Break Contractsin Sec. 8 Phaseout, STANDARD & POOR'S CREDIT WEEK MUNICIPAL, July24, 1995, at 98-99.

5 "The success of Mark-to-Market depends on Congressappropriating an annual level of certificates that is sufficientto cover all eligible residents in units which lose project-basedassistance and transition to market -- and to do so over the fulltime frame of the transition." HUD, Mark-to-Market OperatingFramework, Draft of May 26, 1995, at 6 [hereinafter cited as HUDOperating Framework].

On July 29, 1995, the House of Representatives passed theDepartments of Veterans Affairs and Housing and UrbanDevelopment, and Independent Agencies Appropriation Bill, 1996(HR 2099; Report 104-201)[hereinafter cited as HR 2099]. TheBill approved funds for renewal of expiring project-based Section8 contracts for two years. However, it did not require linkagebetween the new vouchers and the project tenants. It provided:

" ... further, That the Secretary of Housing and UrbanDevelopment may reserve amounts available for the renewal ofassistance under Section 8 of the United States Housing Actof 1937 and may use such amounts, upon the termination orexpiration of a contract for assistance under section 8 ofthe United States Housing Act of 1937 (other than a contractfor tenant-based assistance and notwithstanding section 8(v)of such Act for loan management assistance), to providevoucher assistance under Section 8(o) of such Act in themarket area [emphasis added] for a number of eligiblefamilies equal to the number of units covered by theterminated or expired contracts, which assistance shall bein accordance with terms and conditions prescribed by theSecretary ..." HR 2099 at 24.

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Ë Section 8 assistance will be converted to tenant-basedsubsidies in the form of housing certificates. Residents in theaffected projects will receive these certificates.5

Thus, upon the expiration of project-based Section 8subsidies, funds for vouchers equal to the number of expiringunits would be available for use in the market area of theaffected project for eligible families rather than for theexisting low-income families in the project. There is notransition period as was provided for in the HUD OperatingFramework quoted above. It should be noted that this is languagein an appropriations bill which may be amplified upon if there isan authorization bill. If there is not, HUD will havesignificant discretion in its implementation of Mark-to-Market. If the funds are ultimately distributed to the market areas,local public housing authorities may have similar discretion.

Rent levels were set at the lower fair market rent levelsrather than at the existing rent levels, thus triggering theMark-to-Market process. Fair market rents were reduced from the45th to the 40th percentile and Federal preferences weresuspended for one year. However, the very low and low-incometargeting requirements were not changed.

Some observers believe that the Senate is more receptive toa cautious approach to Mark-to-Market. The Senate AppropriationsCommittee mark-up is scheduled to take place during the first twoweeks of September 1995.

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Ë Section 8 contract rents for the tenant-based subsidyprogram will be adjusted (in most instances down) to market levels.

Ë Section 8 assistance will be decoupled from FHA mortgageinsurance.

Ë Project mortgage debt will be restructured to an amountthat can be serviced by the reduced cash flow produced by themarket level rents. The new mortgage will not be insured.

Ë Partial claims will be permitted against the FHAinsurance fund.

According to HUD, Mark-to-Market will:

Ë End the oversubsidization of projects.

Ë End projects' permanent reliance on project-basedassistance and place them on a solid footing.

Ë Promote tenant choice in locating housing.

6 HUD has indicated that Section 8 Certificates will bemade more attractive to owners. The requirements to "take onetake all" tenants and for an "endless lease" will be eliminated. Evictions for cause may result in the loss of certificates. HUDhas reported an 87% national success or acceptance rate forcertificates. In New York City where there is a tight market,the HUD reported acceptance rate is only 80%. HUD expects thatlocal rent control, housing laws and land use restrictions in NewYork City will substantially slow tenant displacements caused byMark-to-Market. Additionally, the same local rent control andhousing laws will inhibit the acceptance rate of certificates bynew landlords.

7 HUD Operating Framework, supra note 5, at 4. Recapitalization Advisors, Inc. estimates that Mark-to-Marketwill affect 450,000 apartments (4,000 properties). Recapitalization Advisors, Inc., Section 8 Mark to MarketBackground and Policy Considerations, Congressional StaffSymposium Briefing, April 18, 1995 at 4. A glossary of Section 8Mark-to-Market Terms which was included in RecapitalizationAdvisors, Inc. congressional staff briefing is annexed to thispaper as Appendix I. A glossary of terms which was included inthe HUD Operating Framework is annexed as Appendix II. NationalHousing Conference ("NHC") estimates that "over one millioninvestor limited partners invested money with the expectation ofreceiving investment returns in the form of tax benefits andincreased residual value". NHC, Proceedings of NHC Task Force onProject-Based Section 8 Housing, March 1994, Appendix I[hereinafter cited as NHC Task Force].

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Ë Strengthen tenant responsibility.6

Ë Reduce long-term costs to the government.

Ë Reintroduce private market competition.

HUD estimates that approximately 9,000 projects will beaffected by Mark-to-Market.7 The mortgage restructurings willresult in significant adverse tax consequences to investors in manyof these projects. However, HUD has chosen not to be an advocatefor the amelioration of these tax consequences.power to move

II. A Brief History of Reinventing HUD and the Emergence ofMark-to-Market.

A. The National Performance Review. As part of theNational Performance Review directed by Vice-President Gore during1993, each cabinet department and 10 Federal agencies established

8 Gore, Report of the National Performance Review: FromRed Tape to Results, Creating a Government that Works Better &Costs Less, September 1993 [hereinafter cited as NationalPerformance Review].

9 Id. at 142.

10 Id. at 142.

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Reinvention Teams. The Review's findings were published inSeptember 1993.8 Its 10 recommendations with respect to HUDincluded:

"HUD02 Improve Multi-Family Asset Management and Disposition

HUD should use public-private partnerships tomanage and sell HUD-held loans and real estate fornon-subsidized housing projects. Congress shouldreduce restrictions on HUD sale of multi-familyproperties, including use of portable subsidies fortenants when the Secretary determines that to bebest for tenant needs."9

"HUD04 Create an Assisted-Housing/Rent Subsidy Demonstrati o nProject

HUD should be authorized to experiment innegotiated restructuring of privately ownedassisted-housing projects to improve management,promote mixed-income housing and save taxpayerfunds."10

B. FHA Multifamily Housing Business Strategic Plan. InNovember 1994, one month before the release of HUD's ReinventionBlueprint, the FHA Office of Multifamily Housing Programs publishedits Business Strategic Plan. The Executive Summary cited fourtopics of "overarching importance", one of which was:

"FHA-Multifamily Housing's existing portfolio of rentalhousing---which currently is often viewed as a source ofconcern---provides us in reality with a tremendousopportunity. It is more than as asset that needs to beprotected, it is a resource that enables us to make a

11 FHA Office of Multifamily Housing Programs, BusinessStrategic Plan, November 1994, at viii.

12 The National Housing Law Project ("NHLP") suggestedthat HUD's proposal might better have been called "Terms forSurrender". NHLP, A Critique of HUD'S REINVENTION BLUEPRINT,December 19, 1994.

13 With a bow to the prevailing political winds, itstated:

"HUD, for its part, has allowed itself to evolve into abureaucracy far more attentive to process than to results,characterized by slavish loyalty to non-performing programsand insufficient trust in the initiatives of local leaders." HUD, Reinvention Blueprint, December 19, 1994, at 1[hereinafter cited as Reinvention Blueprint].

However, in testimony to a Senate committee in early February1995, Nicolas P. Retsinas, Assistant Secretary for Housing -Federal Housing Commissioner, described "the largest multifamilyinsured inventory in the world, approaching 2 million units--three quarters of which have either mortgage subsidies, rentalsubsidies or both" and address "all segments of Americansociety". He noted that the inventory has recently "beenportrayed in a negative light. Yet more than 80% of ourinventory provides decent, safe and sanitary affordable housing." Retsinas, Testimony to Senate Committee on Appropriations,Subcommittee on VA, HUD and Independent Agencies, February 2,1995, at 1-2.

14 In HUD's Reinvention: From Blueprint to Action, issuedon March 15, 1995, HUD noted that its Inspector General hadidentified "up to 240 total HUD activities".

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significant contribution to improving communities throughoutAmerica."11

C. HUD's Reinvention Blueprint. In response to thebudget driven White House and Congressional pressure to eliminateCabinet level Federal departments and many of their programs, HUDintroduced a Reinvention Blueprint12 on December 19, 1994.13 Thereinvention plan had three principal components:

1. Consolidate Programs and Move to Performance-BasedFunding. It proposed to consolidate "HUD's 60 programs"14 intothree "flexible, Performance Based Funds: Housing Certificates for

15 The Affordable Housing Fund would consolidate allcurrent HUD grants for housing production and rehabilitation,including homeowner initiatives, into one production ordevelopment fund which would be distributed to local and stategovernments as is the HOME program presently.

16 The Community Opportunity Fund would consolidatecurrent HUD grant programs for community economic developmentinto one fund which would devolve to and be administered bystates and localities.

17 Reinvention Blueprint, supra note 13, at 3.

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Families and Individuals; the Affordable Housing Fund15; and theCommunity Opportunity Fund.16 These funds would:

"give Mayors and Governors the flexibility to develop localplans for community and housing investment needs that, bytheir nature, vary from jurisdiction to jurisdiction andchange from year to year."17

The Section 8 rental assistance programs and public housingprograms would be consolidated into one fund that provided portableHousing Certificates for Families and Individuals which would beallocated by local and state governments to low-income families whowould then have "the power to move". Owners and managers would besubject "to the discipline of the marketplace".

Ë "The current public and assisted housing system of tyingsubsidies to units rather than people would bephased out over the next three years."

Ë "For assisted housing developments, an FHA "mark tomarket" process [emphasis added] would be carried outbefore conversion of project-based subsidies to tenant-based assistance and allocation of such assistance tostates and localities for administration."

Ë "A new debt restructuring group within the new FHAcorporation would be responsible for restructuring,project-by-project, the debt on the nation's portfolio ofassisted housing in a process known as "marking-to-market." This means the debt would be established basedon the property's true market value, so HUD can stopproviding above-market rent subsidies to keep projectsalive." This restructuring would take place "as Section8 contracts expire" or "at such earlier time as legallypermissible".

18 Reinvention Blueprint, supra note 13, at 7-9, 15-16.

19 Reinvention Blueprint, supra note 13, at 3.

20 Reinvention Blueprint, supra note 13, at 3.

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Ë "Owners could select to prepay their mortgage and nolonger participate in the FHA insurance program or to notcontinue the subsidy."18

2. Transform Public Housing. This would principally beaccomplished by converting operating subsidies for local publichousing agencies or authorities "to rental assistance forresidents, who would be given the choice to stay where they are ormove to apartments in the private rental market. Public housingagencies would then be compelled to compete in the marketplace forlow-income residents."19

3. Create an Entrepreneurial, Government-Owned FHACorporation. This new FHA would be "streamlined, downsized,entrepreneurial and accountable --- using public privatepartnerships and market mechanisms to achieve its publicpurposes."20 It would provide credit enhancement to state and localgovernments.

D. The American Community Partnership Act. In May 1995,HUD distributed proposed legislation to implement the ReinventionBlueprint. The Bill Text of the American Community PartnershipsAct, which has not been introduced as legislation in the Congress,is 397 double spaced typewritten pages; the Section by SectionExplanation and Justification of the Act is 228 double spacedtypewritten pages. It is expected that Congressman Rick Lazio, theChair of the House Subcommittee on Housing and CommunityOpportunity of the Committee on Banking and Financial Services,will introduce authorizing legislation in September 1995 which willincorporate parts of Mark-to-Market.

The Explanation described Mark-to-Market as follows:

"Mark-to-Market addresses the most critical flaw--theinterdependence of subsidies, debt payments and insurance. Byseparating the subsidies and insurance, HUD can reduce costs,provide residence choice, insure real estate based incentivesto owners and improve the quality of the housing. Such aseparation can be done two ways.

"One is to shut off the subsidy, pay mortgage insuranceclaims when the mortgages default, and then dispose of theproperties or notes after the owner disinvests. The second

21 HUD, American Community Partnerships Act: Section bySection Explanation and Justification, May 1995, at 198[hereinafter cited as HUD Explanation].

22 Id. at 199. The National Association of Home Builders("NAHB") and others disagree:

"In fact, according to the Congressional Budget Office(CBO), HUD's proposal would not save the federalgovernment money. CBO recently prepared 25-year costsestimates for both renewals of project-based assistanceand the Department's proposal. The CBO study indicatesthat HUD's disposal proposal would cost $4 billion morethan simply renewing all expiring Section 8 project-based assistance contracts.

"HUD's proposal would produce huge up-front demands onFHA's multifamily insurance fund." NAHB, The Mythsand Costs of Mark-to-Market: The Department of Housingand Urban Development's Proposal to Eliminate thePrivately-Owned, Assisted Multifamily Portfolio, June12, 1995, at 3 [hereinafter cited as Myths and Costs].

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approach is to solve the problem that the real estate is over-leveraged by allowing the market to determine the value byselling the mortgages before disinvestment can take place.Subsequent restructuring of debt will be a function of lenderand borrower workout."21

It set forth HUD's analysis of the budget implications:

"on a present value basis, it would cost over $80 billion tocontinue renewing expiring contracts between now and the year2020. If we simply end project-based subsidies, the cost ofFHA claims and tenant certificates would rise to $82-87billion. By comparison restructuring the FHA portfolio willcost less: $74 billion. Renewing contracts withoutrestructuring is not a solution. It maintainsoversubsidizing, sheltering owners from the market competitionand limiting tenant choices. It is also the most expensivecourse."22

Section 332 of the proposed Act covers Mark-to-Market.

Section 332(a) establishes overall authority for Mark-to-Market and applies it to (a) HUD-insured multifamily mortgages,including insured mortgages that are not in default, and (b) whichare assisted in whole or in part by a Project based contract under

23 HUD intends to utilize partner (contractor) expertisein carrying out Mark-to-Market. "The RTC, FDIC, and theirprivate sector contractors have demonstrated that mark-to-marketcan be successfully applied to restructuring large real estateportfolios. The Department intends to use the expertise ofintermediaries and to build on its success in mortgage sales. Strategies will include the establishment of structures like theRTC/N series which allow third parties to complete the workoutsand mortgage sales which permit transfer without assignment toHUD and which enable the market to effectively evaluate andrestructure debt. (HUD (g)(4) auctions are one example of thistype of sale." HUD Explanation, supra note 21, at 202. "Privatesector participants would be competitively chosen based oncriteria identified in advance of the selection process." HUDOperating Framework, supra note 5, at 6.

HUD field staff training in Mark-to-Market has beenconducted by Deputy Assistant Secretary Helen Dunlap and formerFHA Commissioner Austin Fitts, representing Hamilton Securities,a HUD consultant. CD Publications, 95-31 HOUSING AFFAIRS LETTER,August 4, 1995, at 1. Hamilton Securities was the financialadvisor for HUD's March 28, 1995 successful auction of 177nonperforming unsubsidized Southeast region mortgages whichrealized approximately 710 million dollars for a portfolio withtotal unpaid principal and accrued interest of over 1.1 billiondollars. See the discussion of the auction at page 25 of thispaper.

24 Current law allows partial payments only in connectionwith defaulted mortgages.

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Sections 8 or 23. These projects will be subject to havingassisted rents reestablished at market levels.

Section 332(b) authorizes HUD, either directly or throughthird parties23, to take certain actions in connection with HUD-insured and assisted multifamily projects in order to allow theprojects to operate at market rent levels. These actions,including debt restructuring, may be taken (a) at, or within sixmonths after the expiration of a project-based assistance contractor (b) before the expiration date, by mutual agreement with theowner. For a project in which all contracts expire on or beforeSeptember 30, 1997, such period shall be at or within 12 months ofexpiration.

Section 332(c) sets forth specific actions which may be takenin connection with Mark-to-Market and debt restructuring, includingthe authority to:

1. Make a full or partial payment of claim.24

25 It is not clear whether this is intended to apply toState and local laws and restrictions such as rent control, deedand land use agreement restrictions and covenants, tax abatementagreements and zoning agreements which impose continued lowincome use requirements on the owner. However, some of theserestrictions are subordinate to the FHA-insured mortgages and maybe removed by foreclosures. In these cases, Mark-to-Market maybe responsible for an increase in project value.

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2. Sell mortgages using such procedures as the Secretary maydetermine.

3. Enter into such agreements, incur such costs, or makesuch payments, reasonably necessary to compensate or induce theparticipation of third parties in undertaking the actionsauthorized by Section 332(c).

4. Provide assistance or make advances to pay for projectimprovements from the Housing Resolution Fund(s) established bySection 331 to implement restructuring.

5. Provide up to two years of transitional project-basedassistance for eligible tenants.

6. Remove, at the owner's request or the Secretary'sdetermination, any mortgage restriction, regulatory agreementrestriction, project-based assistance contract or use agreementrestriction if such restriction would prevent the project fromoperating as a market rate rental project.25

7. Reinsure, enter into contracts of reinsurance or enterinto participations or otherwise transfer to third parties economicinterests in contracts of insurance and/or the premiums paid or dueto be paid on such insurance on such terms and conditions as theSecretary may determine.

Section 332(d) authorizes the provision of tenant-basedcertificates from the Housing Certificate Fund to familiesreceiving assistance under a project-based contract at time ofcontract expiration, including transitional project-based contractsunder Section 332(c).

Section 332(e) is a nondiscrimination clause pertaining to therefusal to lease to households holding certificates.

Section 332(f) authorizes the Secretary to transfer servicingrights on any mortgage held by the Secretary.

E. HUD's Mark-to-Market Operating Framework. Since thedistribution of the American Community Partnerships Act, HUD has

26 This would be similar to the process now used by HUD toauction 221(g)(4) mortgages. The mortgagees will have given HUDan election to assign as a result of a default.

27 Eligible bidders would include both the project ownerand the selling mortgagee. "Owner Mortgage Purchase: Owners'concerns would be alleviated to the extent that they are able topurchase their own notes. In fact, HUD's recent sales haveprovided opportunities for owners to bid on their own mortgages,and there is evidence that owners can successfully compete inthis marketplace. The Department will attempt to provide acompetitive environment for all potential participants, includingowners." Bond Letter, supra note 4, at 3-4. But see thediscussion at page 26 of this paper of the rules established forHUD's Southeast region mortgage sale on March 28, 1995 and theresults of that sale.

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released a series of documents explaining the Department's approachto the implementation of Mark-to-Market. The HUD OperatingFramework summarized Mark-to-Market and described the strategiesthat are being considered for its implementation.

HUD proposed alternative strategies for dealing with FHA-insured mortgages on assisted projects whose Section 8 contractswill not be renewed on expiration. Most of these strategiesrequire authorizing legislation and FY 1996 appropriations. Theaction of the House of Representatives on July 29, 1995 withrespect to appropriations is described in Footnote No. 5 at page 2of this paper.

The first strategy, consisting of Reflector Sales and MortgagePartnerships, deals with mortgages after default when the mortgageehas notified HUD of its intent to assign the defaulted mortgage butbefore the mortgage has been taken into the HUD-held inventory.

The second or "proactive" strategy, consisting of JointVentures on the Mortgage Insurance in Force and Acceleration ofMortgage Claims, deals with mortgages before default. The latterstrategy may be especially important to slow down disinvestment inthe portfolio.

In a Reflector Sale, the defaulted insured mortgage would besold from the current mortgagee to a purchaser, without being takeninto the HUD-held inventory.26 HUD's agent would gather theinformation from HUD and the selling mortgagee, such as paymenthistories, financial data and project physical condition, that apotential mortgage purchaser would require to bid for theunassisted mortgage. Bids would be submitted as a percentage ofthe unpaid principal balance of the mortgage.27 At the closing, theselling mortgagee would receive (a) the purchase price from the

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successful bidder and (b) an amount from HUD which represents thedifference between the purchase price and the amount which wouldhave been paid on a mortgage insurance claim under the terms of theproject insurance.

Partnerships for Mortgage Sales would be carried out by thetransfer of defaulted mortgages for which a notice to assign hasbeen sent to HUD to well-capitalized partnership entities withprofessional servicing and distressed asset disposition capacity.The partnerships could conduct Reflector Sales or bulk sales ofindividual assets, rehabilitate the properties before sale, orconvey the mortgages to a state or local agency. A "base value"would be determined for each mortgage and the partnerships wouldbear the downside risk in the event they cannot recover up to thebase value. The partnership would share the upside gain with HUD.

In the case of a Joint Venture for Mortgage Insurance inForce, HUD would transfer to a joint venture entity all or aportion of the economic liability for the insurance in force onmortgages included in Mark-to-Market. The joint venture would besimilar to a Partnership for Mortgage Sales with the joint venturebearing the downside risk and sharing the upside gain with HUD.However, it would be required to proactively work with owners andlenders, before default, on a project-by-project basis. Resolutionmethods could include workouts, mortgage restructuring, mortgagesales and property rehabilitation. The renegotiation of bothsubsidy and mortgage insurance would be permitted.

The second proactive option that HUD is considering formortgages which are not in default is to permit mortgagees to "put"to HUD prior to default mortgages that are likely to default uponthe expiration of a Section 8 contract. The put could take placeup to one year prior to the expiration of the Section 8 contract,provided the mortgage satisfied predefined "likelihood of default"criteria which would be formula-driven and automatic. The criteriamight require that no put be permitted for mortgages below acertain interest rate or that such puts carry a discount. Thesemortgages would also go to a joint venture which would haveperformance targets and would bear some downside risk along withHUD's legal liability under the insurance contract.

HUD diagrams illustrating the four options discussed above areannexed to this paper as Appendix III.

III. The Income Tax Consequences of Mark-to Market - Cancellation of Indebtedness Income.

A. Private Placement Memoranda - Investor Awareness. Areview of Private Placement Memoranda for project-based Section 8New Construction and Substantial Rehabilitation partnershipsyndications reveals a fairly consistent approach by public

28 The National Housing Partnership, Private PlacementMemorandum for NHP-Hampton Associates '79, July 11, 1979, at 36.

29 Id. at 98-99.

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syndicators to the disclosure to their investors that the projectmortgage was for a longer term than the Section 8 contract.

The following Risk Factor is a clear warning to the investor:

Limited Term of Rent Subsidy under Section 8 Program. Underexisting law and agreements, Sandy Springs and Gladys Hamptonwill not receive Housing Assistance Payments under the Section8 Program for more than 20 years ... After the termination ofthe Housing Assistance Payments, it is unlikely that theProject's tenants will be able to pay the rent necessary tosustain the Project. Accordingly, in the absence of someother form of government assistance not currently providedfor, the Project would not be economically viable unlesshigher-income tenants were obtained."28

"... if and when a Partnership sells a Project, it willrecognize taxable gain to the extent that the proceeds ofsale, plus the outstanding amount of the mortgage loan, exceedthe Partnership's tax basis for that Project, which is reducedeach year by the depreciation deductions. If there is aforeclosure or other involuntary conversion, each Partnershipmay recognize taxable gain to the extent its tax basis for aProject (as reduced by depreciation deductions) is less thanthe amount of the mortgage discharged by the foreclosure orother involuntary conversion. Since any foreclosure is likelyto produce substantial taxable gain, such an event would haveserious adverse tax consequences for an Investor. ... aportion of the gain may be treated as ordinary income underthe depreciation recapture rules ... It is possible that netcash proceeds distributed from any sale, foreclosure or otherdisposition of the Projects will not be sufficient to coverthe substantial tax liabilities that may result ..."29

Another Memorandum contained the following Risk Factor:

"The Commitment from HUD for the Section 8 payments runs fora term of 20 years (in the case of Meridian Tower, it is 20years, plus two five-year renewal periods) and is dependentupon continuing Congressional appropriation of funds. Therecan be no assurance that such appropriations are or will beforthcoming, or that Section 8 payments will be availableafter the respective terms of the Section 8 contracts have

30 Wilder Richman Corporation, Private PlacementMemorandum for WRC 1984 Housing Investor Program, April 10, 1984,at 44.

31 Integrated Resources Equity Corporation, PrivatePlacement Memorandum for Alcor Associates, February 15, 1983, at13.

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ended. If the Section 8 payments or their equivalent are notavailable ... such Project may go into default thereunder."30

The following Risk Factor is less direct:

" ... Approval of Rent Increases. So long as the Projectreceives housing assistance payments under the HUD Section 8Program (which will be received for a maximum of 20 yearsfollowing completion of the Project and the termination ofwhich may adversely affect the Project) or the HUD-insuredMortgage Loan is outstanding on the Project, the rents forapartment units in the Project may not be raised without theconsent of HUD. ... Moreover, there can be no assurance thatsufficient HUD Section 8 Program funds will be available withrespect to any increased rents. ...In the event that rentalincome from the Project is insufficient to meet operatingexpenses, including the debt service on the Mortgage Loan ...the mortgage securing the obligation of the Partnership torepay the Mortgage Loan ... may be foreclosed. Foreclosurewould result in the loss by Investors of their investment inthe Interests and would have serious adverse tax consequencesto Investors."31

B. Exit Strategies. Since the 1986 Internal RevenueCode real estate tax reforms which eliminated the deduction ofpassive losses from housing investments against other income, therehas been no tax-based incentive for limited partners to invest inproject improvements. However, the limited partners who usuallyhold up to 99% of the tax benefits of the owning partnership alsohave had no incentive to sell since taxable gain would berecognized not only on any cash actually received but on fundsattributable to the partners' negative capital accounts.

In recent years, prior to the emergence of Mark-to-Market,there has been considerable discussion regarding "exit" strategiesthat would enable the limited partners of a mature low-incomehousing partnership who may be incurring phantom income (taxableincome without cash) to transfer their interests and exit the

32 General partners, usually hold a one percent ownershipinterest and do not share the limited partners' incentive tosell, since they receive property and partnership managementfees.

33 NHC has highlighted the tax issues presented byresidual receipts:

"...Certain housing developments with Section 8 project-based assistance developed after 1979 are required to remitannually to its mortgagee earnings in excess of theallowable distribution amount. Amounts required to beremitted, residual receipts, are held by the mortgagee. Thefunds are to be remitted to HUD upon the expiration of thecontract term.

"An owner may be eligible for a tax deduction when thepayment is made to HUD. However, a project owner is noteligible for a deduction at the time funds are remitted tothe mortgagee since there is a possibility that HUD coulddirect the mortgagee to utilize all or a portion of suchfunds for the benefit of the Section 8 development prior tothe termination of the Section 8 contract. Residualreceipts, and interest thereon, may represent taxable incomefor the owner, even though the owner is not eligible toreceive these funds." NHC Task Force, supra note 7, at 12-13.

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partnership without adverse tax consequences.32 These strategiesincluded:

1. Remedial legislation that would encourage the sale of aproject to a not-for-profit organization, state or local agency,public housing authority or tenant initiated cooperative orcondominium for nominal consideration, ie., one dollar plus theoutstanding mortgage balance. The purchaser would extend the lowincome restrictions for the project for 40 years (or for theremaining economic useful life of the property) and there would bea tax forgiveness for the sellers' non-cash capital gains (negativecapital account). Any remaining suspended passive losses wouldfirst be fully utilized by the Seller. Gain would be recognizedand taxed on any net cash, after all transactional costs had beenpaid, distributed to the seller.

Alternatively, the tax liability would be deferred on gainsattributable to mortgage amortization or interest earned onresidual receipts33 or other accounts.

2. Remedial legislation that would permit present owners toretain or acquire an interest or management role in the new

34 The Report of the President's Commission on Housing,1982, at 26.

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ownership entity provided they agree to extend the low incomerestrictions for the project. The transaction would be exempt fromthe anti-churning provisions of the Internal Revenue Code. Therewould be a tax forgiveness similar to that described in ParagraphNo. 1 above.

3. Remedial legislation that would create a tax credit equalto the amount of the tax incurred on the non-cash portion of thegain, provided the purchaser extends the low income restrictionsfor the project.

4. The "reinvention" of Section 1039 of the Internal RevenueCode, which had provided a roll-over (with no taxable event) forSection 236 and 221(d)(3) BMIR project owners who replaced theirinvestments with new projects, to include Section 8.

C. Mark-to-market Will Result in Cancellation ofIndebtedness Income to the Project Owner.

1. In 1982, the Report of the President's Commission onHousing proposed direct payments to tenants as the ultimate goal ofhousing assistance payment programs. The Report suggested that HUDexplore the possibilities of "recovering funds previously budgetedfor the subsidized production programs" and using these funds fora tenant based Housing Payments Program and the Housing Componentof the Community Development Block Grant program. However, theReport also noted other interests that must be addressed:

"The Commission assumes that any retrieval would requirethe agreement of project sponsor/mortgagors, mortgagees,bondholders, and affected State and local government agencies.Feasibility of retrieving these funds in many cases woulddepend on favorable rulings by the Internal Revenue Service(IRS) concerning the continued treatment of these projects as"low income" for tax purposes if they were marketed withoutregard to tenant income levels. Similar rulings might benecessary from the IRS and from States with regard to projectfinancing obtained through bonds with tax-exempt interestconditioned on the loan's use for a low-income project."34

2. HUD has addressed the tax issues raised by Mark-to-Marketas follows:

"Tax Issues Will Be Resolved by The Principal Parties.Mortgage Restructuring may trigger tax consequences. In amortgage loan sale resolution, winning bidders would determinewith owners how to resolve outstanding tax issues, if any

35 HUD Operating Framework, supra note 5, at 8.

36 Bond Letter, supra note 4, at 4.

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result. The Department is not proposing amendments to the taxcode, recognizing the potential for unintended consequences."35

"Minimizing Adverse Tax Consequences: Mark-to-market is notdesigned to create any direct tax consequences. However, anadverse tax event could occur if debt is forgiven in whole orin part, or if there is a foreclosure. While the taxconsequences will depend on each project's unique financingand restructuring approach, the Department intends to minimizeunnecessary adverse tax consequences, and has retained theservices of accounting and law firms to assist in designingsolutions which minimize adverse tax consequences. It shouldbe noted that, while the Department seeks to minimize anyadverse tax consequences, the Department does not exercisejurisdiction over the tax treatment of real estate investors.Note, also, that the possible adverse tax consequences arethose encountered by any real estate owner who defaults andthen restructures the underlying debt. And, as typical of anyreal estate workout or restructuring negotiation, the taximplications of the transaction will be one of the keyfinancial elements the owner must consider in deciding uponthe most suitable workout solution."36

37 Recapitalization Advisors, Inc., Section 8 Mark toMarket Costs and Benefits to the Federal Government, April 18,1995, at 4.

38 National Leased Housing Association Position on Renewalof Expiring Contracts, undated 1995, at 2. The accrued intereston most uninsured "soft" second mortgages entered into as part ofthe refinancing of New York City and State mortgage debt in 1977now exceeds the principal amount of the second mortgage. See thediscussion in Section IV of this paper at page 20.

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3. The housing industry has responded:

"Principal Issues Affecting Costs and Benefits

... Protecting owners. Owners will make properties work, somake sure that:

- Economic equity after recapitalization. Owners need cashflow to be motivated.- Protection against Federal income taxes. Income onforgiveness of debt should be deferred or suspended."37

"Owners ... must be protected ... Debt forgiven by a lender isgenerally treated as taxable income to the borrower. Acorresponding change in the tax code to waive the tax due onthe foregiven indebtedness would be necessary to preventunintended yet devastating economic consequences to theownership entity. An intermediate step to be undertaken inthe absence of such a tax change should be to convert theexisting debt not being serviced under the "mark to market"underwriting to a "soft" second mortgage. This has thepotential to create an inequity to the owner who may be leftat the end of the renewal term holding an artificially created"soft" second which may be larger than what would have beenremaining under the initial underwriting."38

"NAHB believes that HUD's disposal proposal is, in effect, anaction that would take these properties from their currentowners and investors, selling not only the debt but alsotransferring the current owners' and investors' equity, futurecash flow, resale value, and management and mortgage servicingfees to the purchasers of the mortgages.

"These "takings" would occur because the mortgages would betransferred at full face amount while new market rents wouldbe set at levels that will only support lower debt. Theresulting cash flow deficit would permit the purchasers to

39 Myths and Costs, supra note 22, at 3.

40 Letter from Association of Local Housing FinanceAgencies to Senator Connie Mack, June 13, 1995.

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immediately foreclose and gain control of project equity andother value associated with the properties. Bidders seekingproject equity and other value will pay more than lenders orthe existing owners seeking to purchase only the debt. Thesuccessful purchasers therefore, will be those who willforeclose on the existing owners and investors. Foreclosurewill trigger adverse tax consequences for the current ownersand their investors. [emphasis added] Alternatively, themortgage purchasers could use their leverage to extractequity, cash or both from ownership entities seeking to avoidadverse tax consequences."39

"The HUD proposal will also give unwarranted control tothe investors in how the mortgaged property is to be used.Since the entire mortgage would be purchased, the investorscould force a foreclosure if alternate uses of the propertywere desirable to them, severely disrupting tenants andcompromising the public purpose of the programs.

" ... Retaining a deferred-payment second mortgage forthe shortfall will also (a) shield the owner from potentialadverse Federal Income Tax considerations resulting fromcancellation of indebtedness, and (b) allows HUD to recoversome of its claim if the property later appreciates so that itcan be sold for more than the new mortgage."40

"Owner tax issues need to be taken into account.

"HUD wants to leave owners with economic incentives.However, owners are in a bind. Large residual mortgageeliminates economic incentive vs. forgiveness of debtcauses cancellation of indebtedness income. How wouldnew capital (e.g. FNMA) feel about lending to owners whohave no upside potential?

"How would current ownership structure of many projects--- burnt out limited partnership tax shelters --- affectresponse to mark-to-market. Current limiteds may beunable or uninterested in increasing investment. With nofunds for buy-outs and large tax bills upon sale orforeclosure, delay (and disinvestment) may be their "best

41 Cohen, Section 8 Contract Expirations, Outline for 4thAnnual Conference on Affordable Housing and Community DevelopmentLaw, ABA Forum on Affordable Housing and Community DevelopmentLaw, June 1995, at 5.

42 The Subordinate Mortgage Note form used by the New YorkState Housing Finance Agency provided [in capital letters]:

"NOTWITHSTANDING THE OTHER PROVISIONS OF THIS NOTE, PRIOR TOTHE DATE THE SECRETARY OF HOUSING AND URBAN DEVELOPMENT("SECRETARY") SHALL CEASE TO HOLD OR INSURE THE HUD NOTE ANDMORTGAGE (THE "HUD RELEASE DATE"), FAILURE OF THE MAKER TOPAY INSTALLMENTS OF INTEREST OR PRINCIPAL SHALL NOTCONSTITUTE A DEFAULT HEREUNDER UNLESS SURPLUS CASH ("SURPLUSCASH") AS DEFINED IN A REGULATORY AGREEMENT EXECUTED BY THEMAKER AND THE HUD SECRETARY (THE "REGULATORY AGREEMENT") ANDINCORPORATED BY REFERENCE INTO THE HUD MORTGAGE, IS NOT

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strategy." Discussions concerning tax relief forexisting investors have not been well received."41

IV. Solutions for Cancellation of Indebtedness Income.

A. The "Soft" Second.

1. The HUD implementation of Mark-to-Market couldinclude the creation of a second note and mortgage in an amountequal to the difference between the existing mortgage debt, plusany accrued interest, and the marked down note and mortgage. Thiswould be payable only out of project cash flow. There is precedentfor an administrative ruling by the Internal Revenue Service thatthe principal amount of the second mortgage constitutes bona fidedebt.

In 1977, during fiscal crises involving both the City andState of New York, the New York City Housing DevelopmentCorporation ("HDC") and the New York State Housing Finance Agencyrefinanced part of their portfolios of Section 236 projectmortgages. These projects were owned by limited partnerships as isthe case with the project-based Section 8 projects. The existingproject mortgage debt was modified and recast to create (a) a firstmortgage which was eligible for HUD insurance under Sections 207and 223(f) of the National Housing Act and sold by the mortgagee toan institutional investor to raise cash for the City or State and(b) a subordinate mortgage that was uninsurable. The subordinatemortgage consisted of that portion of the existing mortgage,including accrued and unpaid interest thereon, that exceeded theamount of the new first mortgage. The subordinate mortgage, whichprovided that it was only payable out of "surplus cash", wasretained by the mortgagee.42

APPLIED TO PAYMENTS DUE UNDER THIS NOTE PROVIDED, HOWEVER,THAT ALL UNPAID INTEREST OR PRINCIPAL SHALL BE PAID NO LATERTHAN THE MATURITY DATE. IN THE EVENT PRIOR TO THE HUDRELEASE DATE, SURPLUS CASH IS EITHER NOT AVAILABLE OR TO THEEXTENT AVAILABLE IS INSUFFICIENT TO MAKE PAYMENTS OF ALLPRINCIPAL AND INTEREST HEREUNDER, NO INTEREST OR PENALTIESSHALL ACCRUE ON ANY UNPAID INSTALLMENTS OF INTEREST ORPRINCIPAL. PRIOR TO THE HUD RELEASE DATE, ALL SURPLUS CASHSHALL BE APPLIED SEMI-ANNUALLY TO PAYMENTS DUE UNDER THISNOTE."

The HUD Regulatory Agreement defined surplus cash as:

"any cash remaining after:

(1) the payment of:

(i) All sums due or currently required to be paidunder the terms of any mortgage or noteinsured or held by the Secretary;

(ii) All amounts required to be deposited in the reserve fund for replacements;

(iii) All obligations of the project other than theSubordinate Mortgage unless funds are set aside or deferment of payment has been approved by the Secretary;

(iv) Remittances due to the Secretary as required by Paragraph 4(i) [this referred to rents collected in excess of the approved basic rents]; and

(2) the segregation of:

(i) an amount equal to the aggregate of allspecial funds required to be maintained by the

project;

(ii) That portion of rentals which must beremitted to the Secretary in accordance with

Paragraph 4(i), but not yet due;

(iii) All tenant security deposits held.

43 CCH IRS LETTER RULING REPORTS, 1977 RULINGS, at 7733079[hereinafter cited as 7733079]. A copy of 7733079 is annexed to

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2. In Private Letter Ruling 773307943 which dealt with a

this paper as Appendix IV.

44 Id. at 4.

45 Pub. Law 103-66, 103d Cong,, 1st Sess. (August 10,1993).

46 Hirschfeld, Antacid for the Real Estate Industry: Newly Enacted Debt Discharge Relief, 7TH ANNUAL FUNDAMENTALS OFREAL ESTATE TAXATION, ABA Section of Real Property, Probate andTrust Law, August 6, 1995, at 1, reprinted from THE JOURNAL OFTAXATION (November 1993), Warren, Gorham & Lamont [hereinaftercited as Antacid].

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mortgage held by HDC, the Internal Revenue Service ruled that:

"the basis of the partnership interest of each partner of thearrangement shall include the amount of his share of theoutstanding principal balance of each mortgage debt. ... Apartner's share of such liabilities will be determined bymultiplying his percentage for sharing in the profits of thearrangement by the sum of the unpaid balance of the senior andsubordinate mortgages."44

B. Section 108(c) of the Internal Revenue Code.

1. In limited situations, the provisions of Sections 108(a)(1)(D) and 108(c) of the Internal Revenue Code, which were addedby Title XIII (the Revenue Reconciliation Act of 1993) of theOmnibus Budget Reconciliation Act of 199345, may enable partners toelect to defer cancellation of indebtedness income.

"...Apart from passive loss relief for real estateprofessionals ..., Congress took an important stab atameliorating some of the harsh tax results that can occur ina real estate workout. Thus the 1993 Act added a limitedexclusion for noncorporate taxpayers from recognition ofcancellation of indebtedness ("COD") income in many realestate debt workouts where the amount of the debt is beingreduced but not eliminated. The potential current taxliability that is eliminated by operation of this newexclusion is actually deferred to a subsequent year due to arequired corresponding basis reduction in either the affectedproperty, if it is depreciable, or other depreciable realestate owned by the taxpayer."46

2. In order to be eligible for the benefits of Section

108(c), the debt must be "qualified real property businessindebtedness" ("QRPI"). One of the conditions for QRPI is thatthe debt must have been incurred or assumed in connection with real

47 IRC Section 108(c)(3)(A).

48 Antacid, supra note 46, at 13.

49 Antacid, supra note 46, at 10.

50 For a discussion of limitations on the appraisals oflow-income housing projects, see The Committee on Housing and

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property used in a trade or business.47 This determination is madeat the partnership level. The fact that the investment would bedeemed investment real estate at the partner level is not relevant.

3. There are two principal limitations on the use of Section108(c):

The Basis Limitation:

" ... provides that the amount of potential COD incomeexcluded from taxation may not exceed the aggregate adjustedbases of all depreciable real property held by the taxpayerimmediately before the discharge. For this purpose, theadjusted basis is determined as of the first day of the nexttaxable year or, if earlier, the date of disposition of therelevant property. It is important to note that while thedefinition of QRPI requires that the secured real estate bereal property used in a trade or business, this basislimitation only looks to depreciable real estate, which wouldclearly encompass all rental real estate (other than, ofcourse, land)."48

The Fair Market Value Limitation:

"... provides that the amount of COD income that is notsubject to tax may not exceed the excess of:

(1) the outstanding principal amount of such debt, asdetermined immediately before the discharge, over

(2) the fair market value of the underlying realproperty which is secured by the debt, asdetermined immediately before the discharge. Forthis purpose, the fair market value of the propertyis reduced by the outstanding principal amount ofother QRPI secured by the property immediatelybefore this discharge.49

"... this fair market value limitation will likely necessitatethe need for obtaining an appraisal50 to support the fair

Urban Development, Guidelines for Appraisers with Respect toCertain New York City Legal Issues in Determining PreservationValue under the Low Income Housing Preservation and ResidentialHome Ownership Act of 1990, 48 THE RECORD OF THE ASSOCIATION OFTHE BAR OF THE CITY OF NEW YORK 368, April 1993; Appraisal BoardIssues Guidance on Valuation of Subsidized Properties, 23 HOUSINGAND DEVELOPMENT REPORTER CURRENT DEVELOPMENTS, NO. 12, Warren,Gorham & Lamont, July 31, 1995, at 181.

51 Antacid, supra note 46, at 12-13.

52 Letter from Brownstein Zeidman and Lore to AssistantSecretary Nicolas Retsinas and Deputy Assistant Secretary HelenDunlap, June 25, 1995.

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market value of the property. While the lender and the ownerof the affected property will likely be operating at arm'slength, it will not necessarily be possible to assume, withoutsubstantiation, that the principal amount of the restructureddebt will be equal to or greater than the fair market value ofthe property, which may make this ... limitation not relevant.By contrast, lenders are, in certain cases, willing to let theprincipal amount of the restructured debt fall below the fairmarket value of the property, which gives the owner a currentequity interest in the property. While such actions arelaudable from the perspective of giving borrowers an addedincentive to restructure rather than default, this newlegislation clearly does not permit such equity stake to bereceived tax-free if sufficient COD income would otherwiseexist."51

A proposal has been made to HUD that:

" ... legislation could be enacted to permit continueddeferral of the tax that would result from that portion of thecancellation of indebtedness income not deferred under Section108(c). A special deferred tax account could be created whichwould be triggered upon disposition of the project by thepartnership of which the electing partner is a partner or, ifearlier, disposition of that electing partner's partnershipinterest in the owning entity. Under this approach, thelegislation would not forgive tax but merely postpone it untiltermination of the partner's ownership interest in theproperty. Alternatively, and, we believe, more appropriately,legislation could provide that the tax liability would bereduced on a gradual basis if the owner maintains the firstmortgage in a current status (e.g., the potential taxliability could be reduced by 10% each year for ten years)."52

53 Dolber, Louis and Fuller, Some Section 8s to ReceiveDeveloping Outlooks, STANDARD & POOR'S CREDIT WEEK MUNICIPAL,July 24, 1995, at 1.

54 Id. at 29. See also Interview with Anthony Freedman,Section 8's New Look: Will the U.S. Keep Its Word?, THE BONDBUYER, July 5, 1995, at 6, for a discussion of theconstitutionality of the proposed repeal of Section 142(d). Seealso Bond Letter, supra note 4, at 4-5.

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V. Other Issues Presented by Mark-to-Market.

1. Uninsured State and Local Agency Mortgages. Some Stateand local HFA projects were assisted by project-based HousingAssistance Payment Contracts, but the project mortgages were notinsured. In some cases, the Contract term is shorter than themortgage term. Estimates as to the number of projects involvedvary widely. Standard & Poor's tax-exempt housing group hasannounced that it will begin assigning "developing outlooks" tosome unenhanced State and local Section 8 transactions. Thesetransactions have typically been assigned "stable outlooks".Developing outlooks indicate that a rating could be raised orlowered, but also can be used to indicate a developing conditionthat could result in ratings affirmations. Issues assigned adeveloping outlook are not in imminent danger of default and arenot on Credit Watch.53

Standard & Poor's is concerned that HUD has proposed changesin Section 142(d) of the National Housing Act, a 1987 law thatprohibits cuts in Section 8 contract rents. It is also concernedthat HUD has changed its procedures for rent increases, moving awayfrom annual automatic adjustment factors. It notes the uncertaintyas to how HUD would reduce contract rents, but states that if"legislation is passed and HUD is permitted to reduce rents to meetthese guidelines, it is likely that many projects will be throwninto default".54

2. LMSA Projects. A significant portion of the more than100,000 apartment units in projects which have LMSA Contracts whichexpire in FY 1996 are in Section 236 State or local agency projectswith uninsured mortgages.

3. Voluntary Termination. Will an owner be able to acceptHUD's offer to voluntarily terminate a Section 8 contract where aState or local agency retains some control of the tenants' incomesthrough a regulatory or land use agreement? Some HFA mortgagescannot be prepaid without the consent of the agency.

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4. What Chance Will an Owner Have at a Mortgage Sale? Will"screens" be developed by HUD to identify "good" owners and "good"projects? Should HUD give owners a priority or a right of firstrefusal at mortgage sales? This has not previously been the caseand is not likely to occur. In HUD's March 28, 1995 auction of 177nonperforming Southeast region mortgages, the winning bids were onepool bid from GE Capital for 166 mortgages and 11 bids onindividual mortgages. The winning bids averaged approximately 78cents on the dollar as compared to 23 cents on the dollar that HUDhas been reported to receive when it forecloses on nonperformingloans. Prior to the auction, some property owners had soughtauction rules that would have required pool bidders to set forth aseparate bid for each mortgage in their pool as well as a pool bid.Then, if an owner's or any other individual bid exceeded theseparate bid in the winning pool, that mortgage would be droppedfrom the winning pool. This suggestion was rejected.

5. Previous Participation Clearance and Program Eligibility.What will be the effect of a mortgage foreclosure upon thecontinued participation in HUD programs of project general partnersand management agents? HUD's Previous Participation clearanceprocess involves the disclosure on a Previous ParticipationCertification (Form HUD-2530)(9/94) of:

"2. For the period beginning 10 years prior to the date ofthis certification, and except as shown by me on thecertification.a. No mortgage on a project listed by me has ever beenin default, assigned to the government or foreclosed, norhas mortgage relief by the mortgagee been given;"

Will HUD recognize the special circumstance of its Mark-to-Marketinitiative or will it consider the foreclosure sufficient adverseinformation to warrant withholding or disapproving continuedparticipation?

6. Municipal PILOT Agreements. Some municipalities share inannual increases in Section 8 contract rents pursuant to PILOTagreements. These payments are tied to project-based assistancecontracts which will not be renewed under Mark-to-Market.

In New York City, the initial determination of base ShelterRent Taxes was made by reference to the Section 8 contract rents.The municipal resolutions granting partial tax exemption typicallyprovide that the annual real estate taxes shall not exceed thelesser of either 17% of the contract rent or the amount of localand municipal taxes that would otherwise be due in the absence ofany form of tax exemption or abatement. The City then shared in25% of the annual increase in Section 8 contract rents. Theproject owners agreed not to charge rents in excess of thoseauthorized by HUD during the tax exemption period.

55 See the discussion of the 1996 HUD Appropriations Billin note 5.

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However, the resolutions provided that the tax exemption"shall operate and continue for so long as the federally-aidedand/or assisted mortgage is outstanding ..." Mark-to-Market willeliminate that mortgage as well as the project-based Section 8assistance and the HUD involvement in the project.

7. Other Municipal Agreements. Some land use agreements runwith the land; others are subordinate to the FHA-insured mortgageand will be terminated by foreclosure. These agreements mayprovide for an extended period of low-income use, a limited returnon project equity, restrictions on transfer of ownership withoutmunicipal or agency consent, and recapture of tax abatements.Additionally, State or local laws may affect these issues.

8. Absentee Ownership. If pool bidders are the successfulpurchasers at auctions, local owners will be replaced by strangersto the project community. The new owner will select new managementwhich may also be a stranger to the project community.

VI. What this Paper Has Not Discussed.

A. Tenant Displacement. Significant numbers of tenantsmay be displaced! There is no assurance that Congress willappropriate an annual level of certificates that will cover all ofthe low-income residents in projects which lose their project-basedassistance. There is also no assurance that the certificates willbe sufficiently linked to the project residents.55 NAHB believesthat Mark-to-Market will result in significant displacement:

" ... It is clear that significant reduction of long-termcosts to the federal government from HUD's assistedmultifamily portfolio can only be achieved by reducingthe number of families and individuals receiving federalrental subsidies.

" ... Many residents will be forced from their homesbefore they are prepared to move. Some residents who donot wish to relocate ... will be forced to move fromtheir neighborhoods. Tenants who do not receive rentalassistance will have to either substantially increasetheir rental burden, find lower quality rental units ordouble up with other families. Some will choose not toform households and, unfortunately, some will becomehomeless. Even if ... certificates were provided to alltenants currently in properties ... we estimate that morethan 170,000 households would be displaced because theycould not afford to pay market rents with their

56 Myths and Costs, supra note 22, at 2-3.

57 NYHC, Position Statement on Restructuring FederalHousing Programs and Policies, March 5, 1995, at 2-3.

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certificates or because certain properties will bedemolished. If ... budget pressures lead Congress tocurtail the availability of ... certificates, then nearly400,000 families and individuals ... could bedisplaced."56

B. Loss of Affordable Housing Units. The stock ofaffordable housing units will be reduced. The New York HousingConference ("NYHC") has argued that:

" ... Even with debt service reduced or eliminated, manyprojects are in areas so poor that "market rents" wouldnot cover operations cost. A pattern of gradualattrition will emerge, leaving the poorest tenants inpartially occupied, deteriorating buildings,destabilizing the neighborhoods for which they were oncethe anchor. ... Early indications are that HUD itselfexpects that Mark to Market will result in a loss throughdeterioration or gentrification of as much as 30% of theassisted housing stock, with no plans for replacement.Is this an acceptable outcome of a reinvented Federalhousing policy? [emphasis added]57

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C:ACREL\M2M.895August 16, 1995