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A recent decision by the 3rd U.S. Circuit Court of Appeals will significantly affect when and at what price real estate will be sold in bankruptcy cases in Pennsylvania, New Jersey and Delaware. Transfer taxes may represent a significant component of closing costs in a major real estate transaction. In the city of Philadelphia, for example, state and local transfer taxes on a $5 million sale would be $200,000, or 4 percent of the purchase price. As a result, in a large transaction, the parties may attempt to structure the sale to qualify for applicable exemptions or to minimize or avoid tax liability. Although exemptions are most frequently governed by state or local law, in certain limited circumstances federal law, such as Section 1146(c) of the U.S. Bankruptcy Code, may preclude state and local authorities from imposing transfer taxes on particular transactions. Under Section 1146(c), a transfer of property made “under a plan confirmed” under Section 1129 of the Bankruptcy Code may not be “taxed under any law imposing a stamp tax or similar tax.” Bankruptcy trustees and debtors regularly sell underperforming assets prior to confirmation to generate much needed cash and to staunch operating losses, thereby facilitating the formulation and ultimate confirmation of a plan. Leading bankruptcy courts, including the bankruptcy court in Wilmington, Del., have historically exempted such transactions from transfer tax, holding that transfers in furtherance of a plan ultimately to be confirmed are exempt under Section 1146(c). Despite this widely accepted view and common practice, the 3rd Circuit in Baltimore County v. Hechinger Liquidation Trust (In re Hechinger Inv. Co. of Del. Inc.) recently held that pre-confirmation transfers do not fall within the Section 1146(c) exemption. The 3rd Circuit’s ruling was consistent with a 1999 holding of the 4th Circuit in NVR Homes Inc. v. Clerks of the Circuit Courts (In re NVR, LP). The Hechinger decision highlights that timing is everything. Hechinger’s filed for bankruptcy protection under Chapter 11 of the code in June 1999. Shortly thereafter, it began selling certain assets, with court approval, under the general sale provisions of Sections 363 and 365 of the code. In each instance, Hechinger’s sought a declaration that the sales would not be subject to state or local transfer tax. Fresh from their victory in NVR, the state of Maryland and three additional Maryland counties objected. The bankruptcy court overruled the objections and held that the transfers were exempt from transfer tax under Section 1146(c) even though there was no approved plan in place. The bankruptcy court reasoned that ” . . . a transfer that is essential to or an important component of the plan process, even if it occurs prior to plan confirmation, is ‘under a plan’ within the meaning of Section 1146(c).” The U.S. District Court for the District of Delaware affirmed, concurring with the bankruptcy court, that “Section 1146(c) applies to pre-confirmation transfers essential to a plan that is ultimately confirmed.” In other words, according to both the bankruptcy and district courts, the critical issue is not whether the transfer occurs before or after confirmation of a plan, but whether the transfer facilitates ultimate confirmation of a plan. The decisions of the bankruptcy court and district court in Hechinger turned on the policy considerations underlying the 1146(c) exemption, specifically Congress’ desire “to encourage Chapter 11 plans by providing Chapter 11 debtors with tax relief when they are compelled by business realities to sell certain assets.” The 3rd Circuit unequivocally disagreed with both lower courts, opining that ” . . . a real estate transaction is made ‘under a plan confirmed under Section 1129′ only where the sale is authorized by the terms of a previously confirmed Chapter 11 plan.” The court based its decision on an exhaustive analysis of the meaning of the preposition “under” a plan in Section 1146(c), concluding that the only rational and commonsense construction is that a transfer must be pursuant to an existing plan and not merely pursuant to a plan in prospect or a plan ultimately to be confirmed. This interpretation was required, according to the appeals court, by two important canons of statutory construction. First, that tax exemption provisions are to be narrowly construed, and second, that federal laws which interfere with state tax laws must be construed in favor of the state. Outside of the bankruptcy court arena, courts have typically construed transfer tax exemptions in a rigid, text-based manner. The Hechinger decision is consistent with that approach. It represents a sea change, however, at the bankruptcy court level and will cause both sellers and buyers to rethink the timing and the economics of bankruptcy real estate sales in the 3rd Circuit.

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