Mezzanine Debt and Preferred Equity: Pending New Mortgage Tax Legislation

Legislation was recently introduced to the New York State Assembly (A3139) and State Senate (S3074), that proposes to make mezzanine debt and preferred equity investments subject to the same recording and taxation requirements applicable to mortgages in the State. Cities and counties in the State of New York are already authorized to impose significant mortgage recording taxes in connection with mortgages encumbering real property located in the State, and this proposed legislation would permit the same taxes to be imposed on certain financing arrangements made upstream in the ownership structure of a property. Similar bills have been proposed to the New York State Assembly and Senate in the past, but were not enacted (e.g., A9041 and S7231).

If enacted, the legislation will:

• Amend the New York real property law (section 291-k) to require that whenever a mortgage instrument is recorded in the county recorder’s office, that any “mezzanine debt” or “preferred equity investment” related to the real property upon which such mortgage instrument is recorded, also be recorded.

• 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,” excluding however, debt on certain common or cooperative shares in a residential dwelling.

• Modify Section 9-601 of the UCC to provide that a security interest in mezzanine debt and/or preferred equity investments related to the real property upon which a mortgage is filed may only be perfected by the (1) filing of a financing statement under the applicable UCC provisions, and (2) payment of any taxes due pursuant to section 291-k of the real property law. The modification will also provide that a secured party under Article 9 of the UCC will not have a remedy to enforce its rights under a security agreement relating to such mezzanine debt or preferred equity investment, if a financing statement is not filed or the applicable tax is not paid.

• Amend the New York tax laws to (i) provide that taxes are imposed on mezzanine debt and preferred equity investments, (ii) prohibit the recording of a mortgage of a property with related mezzanine debt and/or preferred equity investments unless the applicable taxes are paid, and (iii) authorize counties and cities to adopt or amend local laws to impose and collect such a tax in the same manner that they impose and collect mortgage recording taxes.

If passed, the amount of the mortgage recording tax imposed on any mezzanine debt or preferred equity investment, would be calculated on the amount of the principal obligation of such debt or investment, at the same rate imposed on mortgages in the applicable jurisdiction. By way of example, assume an owner has a commercial property located in Queens, New York, valued at $100,000,000. The owner obtains a mortgage loan in the principal amount of $65,000,000 and a mezzanine loan (secured by a pledge of equity interests in the entity that owns the fee interest in the property) in the principal amount of $15,000,000. In the aggregate, the owner obtained $80,000,000 in financing. The current mortgage recording tax rate in Queens, New York, is 2.80%. Under the proposed legislation, the owner will pay mortgage recording taxes of $2,240,000 in the aggregate ($1,820,000 in connection with the recordation of the mortgage loan documents, and $420,000 in connection with the filing of the mezzanine loan documents).

Justification for the bill is primarily focused on (i) increased transparency and regulatory oversight as to mezzanine debt and preferred equity investments, which are generally thought of as “risky”, and (ii) the perspective that these type of financing structures are sufficiently related to mortgage financings (and the real property securing the same), that they should be taxed similarly (to the benefit of the State and local governments). Many questions surround this proposed legislation, however, such as (i) whether the tax will apply only to mezzanine debt that is originated concurrently with or within the initial twelve months of such mortgage debt (as the language suggests), or whether it will apply to mezzanine debt that is originated later in time, and if so, is there an obligation to notify the relevant county and/or city, even if a financing statement related to such financing would be filed with the appropriate Secretary of State (which may not be the New York Secretary of State), (ii) whether this legislation will require the details of preferred equity investments to become public information as a result of the filing/recording requirements embedded in this bill, and (iii) whether this tax can also be imposed on the pledge of equity interests upstream of a mortgaged property in connection with corporate credit facilities (which are not typically reliant on the creditworthiness of the underlying real estate assets). For certain, if passed, this legislation will impose significant new requirements on New York real property borrowers and their upstream constituents.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Jessica Fluehr, an O'Melveny counsel licensed to practice law in California, and Kathryn E. Turner, an O'Melveny associate licensed to practice law in California, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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