OREO Valuations, Pitfalls, and Regulatory & Tax Considerations

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1 OREO Valuations, Pitfalls, and Regulatory & Tax Considerations Monday, June 17, :00 PM 3:15 PM. Presented by: Michael J. Indiveri Principal Michael J. Indiveri, CPA LLC 7 Phyllis Drive Succasunna, NJ P: E: mindiveri@indivericpa.com

2 AGENDA ECONOMIC ENVIRONMENT GAAP / REGULATORY REPORTING OVERVIEW EXAMINATION CONSIDERATIONS TAX CONSIDERATIONS COMMON PITFALLS QUESTONS slide 2 Michael J. Indiveri, CPA LLC

3 ECONOMIC ENVIRONMENT slide 3

4 CURRENT CONDITIONS 1-4 Family Mortgage Market Continues to Improve Commercial Mortgage Market Faces Significant Challenges Economic Improvement is Regional Uncertainty Regarding Effect of Transition to Amortizing HELOC Payments OREO Will Likely Remain on Bank,s Balance Sheets slide 4

5 1-4 FAMILY MARKET Delinquency Rate fell to 7.09% at 12/31/2012, the lowest level since Serious delinquency rate, (percentage of loans 90 days or more past due or in the process of foreclosure) was 6.78 %, a decrease of 25 basis points from last quarter, and a decrease of 95 basis points from the fourth quarter of Mortgage performance has shown large improvement nationally and in almost every state. The foreclosure starts rate decreased by the largest amount ever in the MBA survey and now stands at half of its peak in 2009 The two biggest factors impacting the number of loans in the foreclosure process still are the magnitude of the problem in Florida and the judicial foreclosure systems in some states. slide 5

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11 GAAP / Regulatory Overview ASC establishes the guidance on accounting for and the reporting of foreclosed assets ASC establishes the guidance for the Impairment and Disposal of Long-Lived Assets ASC applies to all transactions in which the seller provides financing to the buyer of real estate 12 USC 29 - Sec. 29. establishes the regulatory authority by which a national banking association may purchase, hold, and convey real estate Most states have laws governing the acquisition and retention of such assets. slide 11

12 REGULATORY OVERVIEW For Regulatory Reporting Purposes, OREO Includes: All real estate, other than bank premises, actually owned or controlled by the bank and its consolidated subsidiaries, including real estate acquired through foreclosure or deed in lieu of foreclosure, even if the bank has not yet received title to the property; Real estate collateral in a bank's possession, regardless of whether formal foreclosure proceedings have been initiated; Foreclosed real estate sold under contract and accounted for under the deposit method of accounting Property originally acquired for future expansion but no longer intended for that purpose; and slide 12

13 REGULATORY OVERVIEW The holding period is generally limited to 5 years. A bank may receive approval to hold OREO for an additional 5 years provided: The bank can demonstrate that it made a good faith effort to dispose of the property, or Disposal within the 5 years would have been detrimental The bank must apply for approval; it is not automatic slide 13

14 Accounting for OREO (ASC ) Foreclosed properties should initially be recorded at the lower of the net amount receivable (cost) or the fair value of the property (fair value less estimated selling costs) The excess of the recorded investment in loan satisfied over the fair value fair value of the property received must be charged against the Allowance for Loan and Lease Losses ( ALLL ) If a property is sold shortly after foreclosure it may be appropriate to substitute the net sale value for the fair value and adjust the ALLL slide 14

15 Accounting for OREO Fair value should generally be determined through external appraisals, current letters of intent, broker price opinions or executed agreements of sale. The determination is made on an individual property basis After foreclosure, each foreclosed real estate parcel must be carried at the lower of: the fair value of the real estate minus the estimated costs to sell the real estate or the cost of the real estate slide 15

16 Accounting for OREO Any subsequent decline in the real estate s fair value, prior to disposal, must be recognized as a valuation allowance against the real estate which is created through a charge to expense The valuation allowance should thereafter be increased or decreased (but not below zero) for changes in the real estate s fair value or estimated selling costs Costs relating to the development and improvement of the OREO properties may be capitalized Operating expense, such as real estate taxes and maintenance are charged to expense as incurred Bank may also elect to treat OREO as Held for Sale and carry it at fair market value slide 16

17 Financed Sales of OREO There are five revenue recognition methods Full Accrual Method Under this method, the disposition is recorded as a sale. Any resulting profit is recognized in full and the sellerfinanced asset is reported as a loan. The following conditions must be met in order to utilize this method. A sale has been consummated, The receivable is not subject to future subordination The usual risks and rewards of ownership have been transferred, and The buyer's initial investment (down payment) and continuing investment (periodic payments) are adequate to demonstrate a commitment to pay for the property. slide 17

18 Initial Investment Guidelines slide 18

19 Financed Sales of OREO Installment Method This method recognizes a sale and corresponding loan Profits are recognized as the bank receives payments Interest income is recognized on an accrual basis, when appropriate The down payment is not adequate to allow for use of the full accrual method, but recovery of the cost of the property is reasonably assured in the event of buyer default slide 19

20 Financed Sales of OREO Cost Recovery Method A sale and corresponding loan and may apply when dispositions do not qualify under the full accrual or installment methods No profit or interest income is recognized until either the aggregate payments exceed the recorded amount of the loan or a change to another accounting method is appropriate The loan is maintained on nonaccrual status while this method is used slide 20

21 Financed Sales of OREO Reduced-Profit Method This method is appropriate in those situations where the bank receives an adequate down payment, but the loan amortization schedule does not meet the requirements of the full accrual method Any profit is recognized as payments are received Profit recognition is based on the present value of the lowest level of periodic payments required under the loan agreement Seldom used in practice because sales with adequate down payments are generally not structured with inadequate loan amortization requirements slide 21

22 Financed Sales of OREO Deposit Method The deposit method is used in situations where a sale of the real estate has not been consummated A sale is not recorded and the asset continues to be reported as OREO No profit or interest income is recognized Payments received from the borrower are reported as a liability until sufficient payments or other events have occurred which allow the use of one of the other methods slide 22

23 Income Tax Overview Charge-offs against the ALLL, due to differences in the property cost at the time of foreclosure and the fair value of the property are generally tax deductible in the same period as the foreclosure OREO valuation expenses and recoveries are generally not tax deductible until the property is sold Certain holding period expense may take on the attributes of capital improvements for tax accounting and will not be recognized until the property is sold Tax basis sales revenue recognition may be different than GAAP basis revenue recognition slide 23

24 Income Tax Overview Tax basis timing differences may generate a deferred tax asset or liability depending on the nature of the difference. It is critical that the bank maintains accurate tax basis records (Tax Books) Tax basis records should be maintained at the property level as individual properties may have different attributes Tax basis records should be reconciled to the GAAP basis records at least quarterly slide 24

25 PITFALLS Pre-acquisition Due Diligence Risks Property Related Risks Legal Risks Tax Risks Appraisal Risks Operational Risks slide 25

26 Pre-acquisition Due Diligence Risks Property Level Risks: Environmental liabilities Property may have high risk tenants (dry cleaners, gas stations, etc.) Past contamination may require expensive remediation Property violations and fines Zoning violations Fire hazards Deferred maintenance Unpaid real estate taxes and other taxes slide 26

27 Pre-acquisition Due Diligence Risks Property Level Risks: Invalid certificate of occupancy Inability to operate property as currently configured May have to vacate tenants, break leases rezone property Special license requirements Assisted living facilities, nursing homes, hospitals Unpaid property and / or other taxes Reputation Risk Schools, houses of worship, not-for-profit agencies, low income housing present special foreclosure challenges slide 27

28 Pre-acquisition Due Diligence Risks Legal Risks: Complex foreclosures require specialized legal experience Inappropriate legal vehicle for holding the property may: Expose the bank assets and shareholders to unnecessary liability Require the bank to be licensed as a bank in a foreign state Cause the bank to be in violation of its regulatory charter slide 28

29 Pre-acquisition Due Diligence Risks Tax Risks: Appropriate tax structure requires careful consideration ( C Corp, LLC, LLP) Inappropriate tax planning can expose the bank to: Higher than required income tax expense Loss of deductions Nexus in jurisdictions in which the bank or parent company does not operate slide 29

30 Pre-acquisition Due Diligence Risks Appraisal Risks: Complex properties require appraisers with specialized skills, construction valuation, environmental studies, etc. Deficient appraisals will likely expose the bank to: Criticism from auditors and regulators Challenges by tax authorities Potential restatements slide 30

31 Operational Risks Board established policies for OREO may not be effective or may not exist Management may not have adequate risk management systems in place to properly identify, classify, and track OREO The board, management and effected personnel may not possess the skills and knowledge necessary to effectively manage and execute the responsibilities related to OREO. slide 31

32 Operational Risks Management may not fully understand the contractual arrangements in place when properties are serviced by other institutions or the fiduciary responsibilities as the lead bank Control systems that safeguard assets and ensure the integrity of accounting data/financial reports may be ineffective Management may lack the skills to properly oversee retained experts (appraisers, contractors, property managers) slide 32

33 GAAP /CALL Report Presentation GAAP / SEC PRESENTATION CALL REPORT PRESENTATION OREO (1) Other Real Estate Owned RC7 Other Real Estate Owned OREO Valuation Allowance (1) Other Real Estate Owned RC7 Other Real Estate Owned Gain on sale of OREO Net Gain (Loss) Sale of OREO RI5.j Net gain (loss) OREO Loss on Sale of OREO Net Gain (Loss) Sale of OREO RI5.j Net gain (loss) OREO Income from operation of OREO properties (rent, fees, etc.) Net Income Expense of OREO RI5,5l, (3) Gross rentals and other income from all real estate reportable in RC7 OREO operating expenses Net Income Expense of OREO RI7,d.2.n Miscellaneous Expenses OREO Valuation Expense (Write downs) Net Income Expense of OREO RI5,j Net gain (loss) OREO (1) If immaterial Other Assets slide 33

34 Conclusion Foreclosure brings all the rights, privileges and liabilities of ownership Thank you Questions slide 34