Mortgage Recording Tax on Mezzanine Debt, Preferred Equity Again Proposed in N.Y. Senate

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 now S-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 understand the 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.

For more information, contact the author.

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