The real estate market continues to face headwinds as the Federal Reserve tries to battle soaring inflation by raising interest rates more than ten times since March 2022. These rising interest rates have slowed transactions in the real estate market, making it less attractive for buyers to finance new projects. Real estate companies are looking for alternative solutions in this challenging market, including hedging their interest rate exposure through various derivative products. Two common derivative products in the real estate industry are interest rate swaps and interest rate caps. It is essential for real estate companies to understand these products and the implications of termination of these contracts upon sale, refinance or extinguishment.
Interest Rate Swaps for Real Estate Companies
An interest rate swap is a derivative contract to hedge interest rate exposure on floating-rate loans. The borrower typically enters into a floating-rate loan with a financial institution and pays a variable rate over the loan term. The borrower can then contract with a third-party institution (“counterparty”) to fix the floating rate to a specific interest rate that does not fluctuate. The swap would be in an asset position when the borrower pays a fixed rate less than the market floating rate. Alternatively, the swap would be a liability position when the borrower pays a fixed rate more than the market floating rate. The interest rate swap contract is terminated if the borrower exits the swap early, through a sale, refinance or other type of exit. Upon termination, the borrower may be required to make a termination payment if the interest swap contract is in a liability position, or the borrower may receive a termination payment if the contract is in an asset position upon exit.
Interest Rate Caps for Real Estate Companies
An interest rate cap is also used to hedge exposure on floating interest rates and has become increasingly popular, given the significant rise in interest rates. Unlike a swap agreement, where the borrower makes or receives periodic payments to or from a counterparty, the borrower pays the counterparty an upfront payment based on specific variables. These variables include the notional amount, term, current market rate and strike rate. Once the borrower makes the initial payment, generally, there are no additional payment obligations for the borrower and the contract is considered an asset. The borrower receives payments from the counterparty if the floating rate exceeds the strike rate.
Terminating Derivative Loan Contracts
Due to rising interest rates, borrowers may end up with “in-the-money” contracts upon expiration and may receive a large payment included in taxable income. Considering tax consequences associated with the termination payment is essential when unwinding interest rate swaps and caps. Interest rate swaps and caps are considered notional principal contracts (NPC) for tax purposes and are governed by specific IRS codes and regulations.
Per the IRS regulations, a termination payment is made or received to extinguish or assign all or a proportionate part of any party’s remaining rights and obligations under an NPC, including a payment made between the original parties to the contract (an extinguishment), a payment made between one party to the contract and a third-party (an assignment), and any gain or loss realized on the exchange of one NPC for another.
If a taxpayer has a position in an NPC, any gain or loss arising from a termination payment is treated as gain or loss from a termination of the underlying NPC. The character of that gain or loss depends on whether the underlying NPC is a capital asset in the hands of the taxpayer. Although the interest rate cap or swap contract may be attached to a mortgage on real property which may be considered a capital asset, the contract itself is considered separately from the underlying asset when determining whether it is a capital asset. Interest rate swaps and caps are excluded from the capital asset definition because they are considered hedging transactions, including any transaction entered into in the normal course of the taxpayer’s trade or business, primarily to manage the risk of interest or price changes concerning borrowings made.
A hedging instrument related to a mortgage agreement generates ordinary interest deductions, and therefore, any payments on the hedge would have either been reductions or increases to the interest expense. The termination payment is essentially future advances of interest reductions or future payments on increases in the interest expense (depending on whether it is in an asset or liability position at exit). Based on this exception from capital asset treatment, payments received or paid on interest rate swap and cap terminations are generally considered ordinary, which may be taxed at higher income tax rates.
Proper tax planning and understanding the tax implications are essential when unwinding these contracts, as the payments may be larger than initially estimated. Borrowers should make sure to retain documentation of the contract terms and speak to a tax advisor upon execution and termination of interest rate swaps, caps, as well as any other hedging instrument.