PDF DownloadThe Tax Effects of Debt Cancellation—A Primer for Non-Tax Lawyers
By Joseph C. Mandarino

Probate & Property Magazine: March/April, Volume 24, Number 2

Real Property|Trust & Estate

Joseph C. Mandarino is a partner with Stanley, Esrey & Buckley, LLP, in Atlanta, Georgia

With every business cycle there is an inevitable decline. For lawyers such a decline means advising on bankruptcy, workouts, and restructurings. One of the most important tax issues that arises in this context is cancellation of debt (COD) income. This article provides a primer on COD income for the non-tax lawyer, which results from debt forgiveness in real estate workouts. As a primer, various important but hyper-technical issues are ignored in order to provide a more helpful picture of the issues. Be aware that some tax practitioners and commentators may use a variety of terms to refer to COD income, such as "discharge of debt income" or "discharge of indebtedness income."

This article first addresses the threshold question of whether COD income has been triggered. It begins by examining how to measure that income and is followed by a discussion of reporting requirements. Various exclusions and deferrals that may be available to debtors are taken up next, and the article concludes with a discussion of various issues that arise on the creditor side.

Cancellation of Indebtedness Income

Grappling with tax issues in a workout or reorganization typically involves many considerations. A vital first step, however, is to determine whether the proposed arrangement will trigger COD income.

The general rule is straightforward: if a creditor cancels a debt, then the debtor recognizes taxable income. This is a matter of statutory law and a long line of tax cases. Section 61(a)(12) of the Internal Revenue Code of 1986 (IRC); see, e.g., United States v. Kirby Lumber Co., 284 U.S. 1 (1931). Naturally, this general rule is subject to various caveats and exceptions.

COD income is often referred to as "phantom" income because the debtor is deemed to have received it even though there is no matching cash flow. As a result, the taxes due on this "phantom" COD income can represent a significant expense that the debtor may be unable to pay. Although debtors typically incur tax losses as part of the run-up to a debt cancellation, that is not always the case. Even when a debtor has unused tax losses, there may be obstacles to using such losses against the COD income.

Fortunately, many exclusions and deferrals exist in the IRC that can significantly mitigate this tax burden. Determining the existence and amount of COD income, and whether and to what extent tax exclusions or deferrals apply, can be critical in tax planning.

Cancellation of Debt by Creditor

The simplest COD event occurs when a creditor cancels all or part of a debt. In that instance, the debtor recognizes COD income to the extent of the cancelled debt.

Cancellation of Debt by Operation of Law

A closely related COD event occurs when a debt is discharged in bankruptcy or becomes unenforceable because the applicable statute of limitations has lapsed. In either case, the debtor recognizes COD income to the extent of the debt that is discharged or becomes unenforceable.

In all cases, COD income arises only to the extent that the underlying debt is undisputed. See Zarin v. Commissioner, 916 F.2d 110, 115 (3d Cir. 1990) (when the amount of a debt is disputed, "a subsequent settlement of the dispute would be treated as the amount of debt cognizable for tax purposes"); McCormick v. Commissioner, T.C. Memo 2009-239. If the debtor and creditor dispute the amount, then a different result may obtain. For example, assume a lender asserts that a borrower owes $1 million on a revolving real estate loan. The borrower alleges that a different amount is due. The lender and borrower ultimately agree that only $600,000 is due. There is no "cancellation" of indebtedness because the amount owed was in dispute. But, if the borrower subsequently runs into financial problems and the lender agrees to settle the agreed-on $600,000 debt for $250,000, then that would trigger COD income in the amount of $350,000 ($600,000 undisputed portion of the debt less $250,000 paid equals $350,000 of COD income).

It is probably not enough for a taxpayer to assert, after the fact, that a debt was disputed. Documenting the history of back and forth between the debtor and creditor, as well as the debtor's good-faith basis for its claim that the debt is lower than the amount claimed by the lender, is invaluable in establishing the disputed nature of the debt.

Finally, there may be an issue if the basis for the dispute arises from the enforceability of the debt. In Preslar v. Commissioner, 167 F.3d 1323 (10th Cir. 1999), the court held that the disputed debt exception does not apply merely because the enforceability of the debt is in question. Rather, the amount of the borrower's liability must be in dispute. This ruling does not appear to be the law in other circuits, but practitioners should be aware that the IRS generally concurs with the more narrow reading of the disputed debt exception in Preslar. In the example above, if the debtor's basis for disputing the debt was not that the lender's statements incorrectly reflected readvances, but instead that the creditor had violated mortgage lending laws, then the IRS could argue that the amount of the debt was not in dispute even if the debt itself was unenforceable as a result of such violation.

Debtor's Acquisition of Own Debt

If a taxpayer buys back its own debt from a third-party creditor for an amount that is less than the amount of the debt, then COD income is triggered. Note that in this instance the creditor has not formally cancelled the debt but has instead transferred it back to the debtor for a partial payment of the amount due.

Example: A corporation issues $100 million in bonds. The bonds trade on the open market. Years later, the corporation has suffered significant losses and the bonds are trading at an 80% discount to face. If the corporation buys back its bonds at the current trading price of $20 million, then it will have COD income of $80 million ($100 million face value less $20 million purchase price = $80 million COD income).

Note that COD income is triggered regardless of whether the corporation formally cancels or retires the bonds.

Acquisition of Debt by Party Related to Debtor

Similarly, the acquisition of debt by a party that is related to the debtor triggers COD income to the debtor. IRC § 108(e)(4). The rationale is that if the relationship between the purchaser of the debt and the debtor is sufficiently close, then the transaction should be viewed no differently than if the debtor purchased its debt directly.

For this rule to apply, the debtor and the purchasing party must be deemed to be related by the IRS. The test for relatedness is complex, but two entities generally will be treated as related if one owns more than 50% of the other, or if indirect common ownership of the two entities is greater than 50%. Id. § 108(e)(4)(C). To further complicate matters, certain family members are treated as related and this treatment may cause otherwise unrelated entities to be treated as related. Id. § 108(e)(4)(B).

As with a direct acquisition by the debtor, COD income is triggered whether or not the debt is formally cancelled.

Example: A parent owns 65% of OpCo. OpCo has issued $100 million in bonds, but they are now trading at a significant discount. The parent buys all of OpCo's bonds on the open market for $25 million. OpCo has $75 million of COD income.

Note that special rules apply if a party first acquires the debt and then becomes related to the debtor (for example, by acquiring control of, or being acquired by, the debtor). Treas. Reg. § 1.108-2(c).

Finally, it is important to recognize that even if a related party acquires the debt without the debtor's cooperation or knowledge, the acquisition will trigger a COD event and it is the debtor—not the related party—that recognizes the income. This result can have consequences for state tax planning.

Changes to the Terms of a Debt Instrument

If the terms of a debt instrument are changed sufficiently, two immediate tax consequences can result. First, the modified debt instrument may be treated as a new and separate debt instrument from the old debt instrument. Second, the new debt instrument may be treated as issued in full satisfaction of the old debt. Accordingly, the debtor may have COD income as a result of this deemed exchange. Id. §§ 1.1001-1(a), 1.1001-3(b). The sometimes counterintuitive consequences to a creditor in this situation are discussed below.

Whether the modification of a debt instrument triggers COD income depends on answers to the following questions:

  1. Are the changes a "significant modification"?
  2. What happens in this deemed debt exchange?

Significant Modification. The regulations governing debt modifications are complicated. The IRC and Treasury Regulations contain a general rule on what constitutes a significant change and special rules governing specific changes. If a change is covered by a specific rule, then such specific rule, not the general rule, governs. Id. § 1.1001-3(e). If the change is not governed by a specific rule, then the general rule applies. Accordingly, in undertaking this analysis it is necessary to identify all the changes, determine which ones are covered by specific rules, analyze those changes under those specific rules, and then consider all the remaining changes under the general rule.

The General Rule. Under the general rule, a modification is "significant" if, considering all the facts and circumstances, "the legal rights or obligations that are altered and the degree to which they are altered are economically significant." Id. § 1.1001-3(e)(1). This standard is not particularly helpful. Tax practitioners must rely on analogy, private letter rulings, and other indirect authorities.

It is worth reiterating that in determining "significance" all modifications are considered collectively (other than those governed by special rules), and a series of modifications may be significant when considered together even though each modification, if considered alone, would not be significant.

The Specific Rules. The regulations contain five sets of rules governing specific changes.

  1. Change in yield : A frequent workout strategy is to change the interest rate on a debt instrument. A change in yield of at least 0.25% (25 basis points) or 5% of the annual yield of the old instrument, is considered a significant modification. Id. § 1.1001-3(e)(2).

    Example
    : The yield on a loan is 6%. The parties agree to reduce the interest rate so that the yield will be 5.5%. This is a reduction in 50 basis points (6% minus 5.5%). It is also a reduction of 8.3% of the yield (0.5% ÷ 6%). Under either test the change in yield is significant. Thus, regardless of any other change, the old debt instrument will be treated as exchanged for the as-modified debt instrument. (The mechanics of that deemed debt exchange are discussed below.)
  2. Change in timing of payments : It is common in a workout to negotiate a new schedule of debt payments. A change in the timing of payments is a significant modification if it results in the "material deferral" of scheduled payments. Id. § 1.1001-3(e)(3). Although the term "material deferral" would not seem to provide sufficient guidance, a safe-harbor standard accompanies this test. Specifically, a deferral of scheduled payments is not material if the deferral is within a "safe-harbor period" that begins on the original due date of the first scheduled payment that is deferred and extends for a period equal to the lesser of five years or 50% of the original term of the instrument. Id. § 1.1001-3(e)(3)(ii).

    Example: In 2002, parties enter into an eight-year balloon loan that matures in 2010. In 2008, the parties extend the final payment date by four years to 2014. The original term was eight years, so a four-year extension is permitted because it is a period equal to the lesser of five years or 50% of the original term of the instrument.
  3. Change in obligor or security : The tax regulations also contain several rules governing changes in the obligor or the collateral securing the debt. In some cases, these rules turn on whether the underlying debt is recourse or nonrecourse. Although the nature of a debt as recourse or nonrecourse for state law purposes is usually evident from the face of the documents, for tax purposes what appears to be recourse debt may sometimes be treated as nonrecourse debt because of the circumstances surrounding it. Accordingly, a more searching consideration may be necessary as part of this analysis.
    • The substitution of a new obligor on a recourse debt instrument. In general, the substitution of a new obligor on a recourse debt instrument is considered a significant modification. Several exceptions apply in the case of tax-free reorganizations, certain asset acquisitions, tax-exempt bonds, and bankruptcy. Id. § 1.1001-3(e)(4)(i).
    • The substitution of a new obligor on a nonrecourse debt instrument. As would be expected, this type of substitution will not be treated as a significant modification. Id. § 1.1001-3(e)(4)(ii). The rationale is that substituting a new obligor on a debt instrument for which the debtor will not be personally liable does not change the economics of the debt.
    • The addition or deletion of co-obligor. The addition or deletion of a co-obligor will be treated as a significant modification if it results in a change in payment expectations. Id. § 1.1001-3(e)(4)(iii).
    • A change in security or credit enhancement for a recourse debt instrument. A change that releases, adds to, or alters the collateral, a guarantee, or other form of credit enhancement for a recourse debt instrument is a significant modification if the modification results in a change in the creditor's payment expectations. Id. § 1.1001-3(e)(4)(iv)(A).
    • A change in security or credit enhancement for a nonrecourse debt instrument. Unless an exception applies, a change that releases, adds to, or alters the collateral, a guarantee, or other form of credit enhancement for a nonrecourse debt instrument is treated as a significant modification without regard to the "change in payment expectations" standard. Exceptions apply if certain types of fungible collateral are substituted or if a commercially available credit enhancement contract is substituted for other collateral. Id. § 1.1001-3(e)(4)(iv)(B).
    • A change in priority . A change in the priority of a debt instrument relative to other debt of the issuer is a significant modification if it results in a change in the creditor's payment expectations. Id. § 1.1001-3(e)(4)(v).
  4. A change in the nature of a debt instrument: Two situations are covered here. First, a modification of a debt instrument that replaces the obligation with an instrument or property right that is not debt for federal income tax purposes is treated as a significant modification. Id. § 1.1001-3(e)(5)(i). Thus, converting all or part of a debt instrument into equity is a significant modification. Second, a change in the nature of a debt instrument from recourse to nonrecourse (or vice versa) is a significant modification, subject to several technical exceptions. Id. § 1.1001-3(e)(5)(ii).
  5. Accounting or financial covenants : A modification that adds, deletes, or alters customary accounting or financial covenants is not a significant modification. Id. § 1.1001-3(e)(6).

Consequences of the Deemed Debt Exchange. If the changes to a debt instrument result in a "significant modification," then the "new" debt is treated as having been exchanged for the "old" debt. Under the IRC's imputed interest rules, a key factor in determining the consequences of this deemed debt exchange is whether the interest rate is reduced below the applicable federal rate (AFR).

Example: Bigco borrows $100 million from Bank and subsequently has trouble making the payments. Bank agrees to lower the interest rate from 8% to 2%. Assume the AFR is 4.5%. This modification is significant under the rules set forth above for changes in yield. Furthermore, because the new interest rate is lower than the AFR, the issue price of the new debt is re-computed at $92.5 million. As a result, Bigco is treated as having satisfied the old debt instrument, which had a principal amount of $100 million, by substituting a new debt instrument with a "face" amount of $92.5 million, resulting in $7.5 million of COD income.

As addressed below, a significant problem can arise if a creditor acquires the debt at a discount and a deemed debt exchange occurs.

Traps

There are many traps for the unwary in the area of workouts and reorganizations. Though this article will not identify all of these areas of concern, at least three issues come up repeatedly: nonrecourse debt, nonloan arrangements, and cancellation or modification of equity securities.

Nonrecourse Debt . An important distinction arises in the case of a satisfaction of nonrecourse debt as compared to recourse debt. Under the applicable tax rules, a debtor does not have COD income if a creditor forecloses on the underlying collateral in satisfaction of nonrecourse debt. Treas. Reg. § 1.1001-2. Instead, the transaction is treated as a deemed sale.

Example: A borrower obtains a $1 million nonrecourse loan for a real estate project secured only by the underlying land. Later, the borrower is unable to make payments. The borrower transfers the land title to the lender in full satisfaction of the debt. Alternatively, the borrower simply defaults and the lender takes back the land. Assume the fair market value of the land is $500,000, and the borrower's tax basis is $250,000. In this case, the borrower has no COD income because the debt is nonrecourse. Instead, the borrower has gain equal to $750,000 ($1 million of debt less $250,000 tax basis).

Because this transaction gives rise to gain or loss from a sale, rather than COD income, it cannot qualify for exclusion or deferral under the COD rules. Moreover, the gain or loss on the deemed sale may be characterized as ordinary or capital, depending on the circumstances of the debtor's ownership of the underlying property.

Nonloan Arrangements. When parties negotiate about a debt, it is clear that COD income is a potential tax issue. But a taxpayer may realize unanticipated income for tax purposes even if there is no formal loan, mortgage, or note. For example, rent obligations under a lease and amounts due under vendor contracts are also debts for tax purposes. Thus, a modification or cancellation of a lease or other legal arrangement that results in a party being relieved of a legal obligation can trigger COD income.

Example: A tenant is two years behind on rent. The landlord waives the rent arrearage in return for the tenant's agreement to pay monthly rent on time during the balance of the lease. In this case, the past due rent is a debt owed by the tenant to the landlord and the waiver may constitute a COD event.

The exclusion from COD for purchase price adjustments, discussed below, can frequently be used to mitigate the tax consequences in some of these transactions.

Cancellation or Modification of "Equity" Securities. The COD rules apply only to obligations and arrangements treated as debt for tax purposes. Generally, common and preferred stock are not treated as debt, and the cancellation or modification of such instruments will not trigger COD income. Some instruments treated as equity for state law purposes, however, are treated as debt for tax purposes. These instruments include "trust preferred" securities. Accordingly, cancellation or modification of these putative equity instruments can trigger a COD event.

Measuring COD Income

If a COD event has occurred, the next step in the analysis is to determine the amount of potential COD income that has been triggered. In general, the amount of COD income equals the difference between (1) the amount due on the debt and (2) the amount paid (if any) in consideration for the debt's discharge.

Example: A debtor owes $100. The creditor accepts $75 in full payment of the debt. The debtor has $25 of COD income.

This computation becomes more complicated if the debt is satisfied with something other than cash. If a debtor transfers property in consideration of the debt, there are two levels of possible tax liability:

  1. COD income, to the extent the debt exceeds the fair market value of the property, and
  2. gain (or loss), to the extent the fair market value of the property is more (or less) than its tax basis.

This second level of gain could be capital or ordinary depending on the nature of the property.

Example: A debtor owes $100. The creditor accepts transfer of the debtor's coin collection in full satisfaction of the debt. The debtor's coin collection is worth $60, and the debtor has a $30 tax basis in it. The debtor has $40 of COD income ($100 debt less $60 fair market value of consideration = $40 COD income). The debtor also has $30 of gain from the sale of the coin collection ($60 fair market value of collection less $30 tax basis = $30), which may be capital or ordinary depending on the circumstance of his or her ownership of the coin collection.

This second level of taxation is significant because, although several exceptions and exclusions may apply to the COD income, sale gain may be unavoidable.

Finally, in computing the amount of COD income, there is an exclusion for interest and fees that have yet to be deducted. Put differently, in computing COD income a debtor does not include any amount attributable to interest that the debtor has not deducted for tax purposes. IRC § 108(e)(2).

Example: A debtor borrows $100 from a lender. In 2010, the debtor is required to make a $20 interest payment. The debtor falls behind, and the lender reduces the principal on the debt from $100 to $50 and waives the $20 interest arrearage. In this case the amount of COD income is $50, not $70, because the $20 interest that was waived would otherwise be deductible. (As a quid pro quo, the debtor will not be allowed to take the deduction for that unpaid interest.)

Reporting Requirements

It is important to be aware of the information reporting requirements that apply in connection with COD events. In the case of a foreclosure or abandonment, for example, the lender may be required to issue an IRS Form 1099-A. IRC § 6050J(a).

This reporting requirement is triggered if (1) a creditor lends money secured by property and (2) that creditor acquires the security in full or partial satisfaction of the debt (or the creditor has reason to know that the debtor has abandoned the property). Id. It is often very advantageous for the debtor to work out with the creditor ahead of time the timing and amount that will be reported on the 1099-A. There are exceptions to this reporting requirement, however. For example, the IRS Form 1099-A does not need to be filed if the property that secures the debt is not held by the debtor for investment or used in connection with a trade or business.

For other debt discharges, the creditor may be required to issue an IRS Form 1099-C. Treas. Reg. § 1.6050P-1(a). Generally, this requirement arises if (1) the creditor is an "applicable entity" and (2) the discharge is $600 or more. IRC § 6050P(a), (b). For these purposes, an "applicable entity" is generally any federal entity such as the FDIC or the Resolution Trust Corporation; any entity that is regulated as a bank; or any nonregulated entity engaged in the business of lending money. Id. § 6050P(c)(1), (2). If an event would require reporting under both Form 1099-A and Form 1099-C in the same year, the lender need file only Form 1099-C. Treas. Reg. § 1.6050P-1(e)(3).

Under the applicable tax regulations, a debt discharge occurs for purposes of triggering the Form 1099-C reporting requirement if it occurs on any of the following events:

  • on the discharge date provided for in bankruptcy, receivership, foreclosure, and other legal actions;
  • on expiration of a statute of limitation;
  • on voluntary agreement of the parties;
  • on application of a defined policy of the creditor to discontinue collection activity and discharge the debt; and
  • on the expiration of a 36-month period in which no payments are received.

Id. § 1.6050P-1(b).
Note that there are several exceptions to Form 1099-C reporting. The creditor is not required to file a Form 1099-C on the following amounts or events:

  • discharge of nonbusiness debt in bankruptcy;
  • discharge of interest, fees, penalties, and so on;
  • a discharge in the case of foreign debtors (but subject to various limitations);
  • acquisition of related-party debt;
  • release of co-obligors (if remaining debtors are liable); or
  • release of guarantors.

Id. § 1.6050P-1(d). As with the Form 1099-A, it can be very helpful for the debtor and creditor to agree in advance about when the Form 1099-C will be issued and what it will cover.

Exclusions and Deferrals of COD Income

If a COD event occurs and the amount of the discharged debt is known, then the next step is to turn to the various exclusions or deferrals that are available. These appear generally in IRC § 108.

Bankruptcy andInsolvency Exclusions

Bankruptcy. The bankruptcy exclusion is probably the broadest exclusion for COD income. In short, IRC § 108(a)(1)(A) provides that if a taxpayer's debts are discharged in bankruptcy, then the resulting COD income is fully excluded. This rule applies whether the discharge occurs under Chapter 7, 11, 12, or 13 of the Bankruptcy Code. Such bankruptcy debtor, however, will be required to undergo "attribute reduction," as discussed below. An important benefit of this exclusion is that it is not limited by the debtor's insolvency.

Insolvency. The insolvency exclusion is narrower than the bankruptcy exclusion. If a debtor is insolvent, and if the debtor would otherwise realize COD income, then the debtor can exclude a portion of that income equal to the amount of the debtor's insolvency immediately before the discharge. IRC § 108(a)(3).

Example: A debtor has assets of $100 and liabilities of $150, resulting in total insolvency of $50. The debtor and creditors work out a reduction in liabilities to $75. The debtor has $75 of COD income, of which $50 can be excluded. (Note that if the debtor filed for bankruptcy, all the COD income would be excluded.)

As with the bankruptcy exception, the debtor will be required to undergo "attribute reduction."

Attribute Reduction. If a debtor excludes COD income under either the bankruptcy or insolvency exception, then the attribute reduction rules are triggered. Id. § 108(b). Attribute reduction forces the debtor to trade the current exclusion of income for future tax deductions. The debtor will be required to reduce tax attributes, in the following order:

  • net operating loss carryovers,
  • tax credit carryovers,
  • capital loss carryovers,
  • tax basis in assets,
  • passive loss carryovers, and
  • foreign tax credit carryovers.

The debtor can elect to change the order of reductions and draw down on tax basis first. Id. § 108(b)(5). The attribute reduction occurs on the first day of the tax year following the year of discharge. Id. § 108(b)(4)(A). As a result, the debtor can use various planning techniques available to minimize its gain on sales in the year of the debt discharge.

Application to Pass-Through Entities.

Cancellation of Partnership Debt. The bankruptcy and insolvency exceptions apply at the partner level, rather than the partnership level. Id. § 108(d)(6). Therefore, it is difficult for a partnership or LLC to qualify for the bankruptcy exclusion. It is somewhat easier (but still difficult) to qualify for the insolvency exclusion.

Cancellation of S Corporation Debt. The bankruptcy and insolvency exceptions apply at the entity level in the case of an S corporation. Id. § 108(d)(7). Therefore, if an S corporation has debts that are discharged while in bankruptcy, then the COD income is excluded and does not pass through to shareholders. If an S corporation qualifies for the insolvency exception, only the balance of the COD income not excluded by the corporation is passed through to the shareholders. Finally, in general the attribute reduction is applied at the S corporation level and does not travel down to shareholders.

Qualified Real Property Business Indebtedness (QRPBI)

An exclusion commonly used by real estate developers is the exclusion for qualified real property business indebtedness (QRPBI). Id. § 108(a)(1)(D). A chief advantage of the QRPBI exclusion is that it does not require the debtor to be in bankruptcy or insolvent. There are certain disadvantages, however.

First, the debtor cannot be a regular (or "C") corporation. Id. § 108(a)(1)(D). Second, the amount of COD income that is excluded is generally equal to the balance of the debt less the fair market value of the real property underlying the debt. Id. § 108(c)(2)(A). Third, the amount of COD income excluded cannot exceed the total tax basis of all the taxpayer's depreciable real property. Id. § 108(c)(2)(B). Finally, the QRPBI exclusion triggers a basis reduction in the debtor's depreciable real property. Id. § 108(c)(1)(A).

Even with these limitations, the QRPBI exclusion is a frequent target of real estate developers that are attempting loan workouts. To qualify, the debt must be incurred or assumed in connection with—and secured by—real property used in the taxpayer's trade or business. Id. § 108(c)(3). The legislative history makes clear that there is a broad sense of what real property is covered—land, improvements, even mineral interests.

Example: A debtor borrows $1 million from a lender to purchase an apartment complex. The loan is secured solely by the complex. The fair market value of the complex is $800,000, the debtor's tax basis in the complex is $150,000, and the complex is the only depreciable real property the debtor owns. The debtor and lender agree to reduce the principal due on the note to $800,000. This workout results in $200,000 of COD income. Assume the debt qualifies as QRPBI. Because the debt is not reduced below the fair market value of the complex, the fair market value limitation on the exclusion does not apply. The debtor's tax basis, however, is $150,000, so only $150,000 of the $200,000 of COD income is excluded. In addition, under the basis reduction rule, the tax basis of the complex is reduced to $0.

In the case of partnerships and LLCs, the determination of whether debt is QRPBI is made at the entity level, but the basis limitation test and basis reduction occur at the partner level. Id. § 108(d)(6). In contrast, in the case of an S Corporation, the determination of whether debt is QRPBI is made at the entity level, as are basis limitation and basis reduction. Id. § 108(d)(7).

Other Basis Deferral Regimes
(Qualified Farm Indebtedness, Qualified Personal Residence Indebtedness)

In addition to the QRPBI exclusion, two other types of real property can receive special tax treatment in workouts: farms and personal residences may qualify for exclusions from COD income arising from certain types of debt. (It also should be noted that an exclusion exists for certain types of student loan indebtedness.) Id. § 108(f).

If a debt meets the requirements of qualified farm indebtedness (QFI), then COD income from the discharge of that debt can be excluded. Id. § 108(a)(1)(C). QFI is defined as debt incurred directly in connection with the operation of a farm; and the definition of "farm" is broad enough to encompass ranches and timber operations. Id. § 108(g)(2)(A). In addition, at least 50% of the debtor's gross receipts for the prior three years must be from farming. Id. § 108(g)(2)(B). The amount of the QFI exclusion is limited to the sum of the taxpayer's tax attributes plus the basis of assets used in the farm business. Id. § 108(g)(3)(A). As with the bankruptcy and insolvency exclusions, attribute reduction will apply. Id. § 108(b)(1).

In the case of a personal residence, a debtor is able to exclude COD that arises from qualified principal residence indebtedness (QPRI). Id. § 108(a)(1)(E). This provision allows a debtor to exclude COD income from a reduction in the debt secured by a mortgage on the debtor's principal residence. For the debt to qualify, it must be secured by a mortgage given to acquire or refinance the debtor's principal residence, or to finance improvements to such residence. Id. § 108(h)(2).

The QPRI exclusion is subject to several conditions. First, the exclusion only applies to the extent the workout was triggered by a decline in the fair market value of the residence or a deterioration in the debtor's financial condition. Id. § 108(h)(3). Second, if a portion of the debt is not QPRI (for example, if the owners borrowed against their equity but did not spend the loan proceeds on improvements), then the ordering rules permit only the amount of COD income that exceeds the non-QPRI debt to be excluded. Id. § 108(h)(4). Finally, the debtor will be required to reduce his or her basis in the residence to the extent of the amount of COD excluded from income. Id. § 108(h)(1).

Purchase Price Adjustment

In certain cases, a purchase price adjustment is not treated as COD and thereby does not give rise to taxable income. Id. § 108(e)(5). Specifically, if a debt arises from the sale of property, and if the purchaser and seller agree on a reduction of that debt, then what would otherwise be COD income is treated as a nontaxable purchase price adjustment. This exception, however, does not apply if the debtor is insolvent or the purchase price reduction occurs in a bankruptcy case. Id. § 108(e)(5)(B). As a practical matter, the debtor should contemporaneously document the basis for the purchase price adjustment.

Capital Contribution of Debt and Stock for Debt Exchange

Sometimes debtors may issue stock or partnership interests (equity) in satisfaction of debt. In 2004, however, Congress clarified that the no stock-for-debt exception applied to partnerships. The exception was repealed for corporations in 1993. Under current tax rules, if a debtor issues equity in satisfaction of a debt, then the debtor has COD income equal to the difference between the amount of that debt and the fair market value of the equity granted in exchange. Id. § 108(e)(8). Nevertheless, the issuance of equity is marginally better for the taxpayer than the transfer of real estate or other property in return for COD because, generally, neither a corporation nor a partnership will recognize gain on the issuance of equity, whereas the receipt of other property could result in COD income and trigger any inherent gain in the property.

Although not as common as a stock-for-debt exchange, the contribution by a creditor of debt to the capital of the debtor sometimes occurs. In that case, the corporation is treated as satisfying the debt for an amount equal to the creditor's basis in the debt. Id. § 108(e)(6)(B). In many cases (for example, when the creditor is the original lender), this contribution will mean no COD income to the corporation. Although a capital contribution of debt will only be workable under unusual facts, note the difference in results if this approach, rather than the stock-for-debt approach, is used.

COD Deferral Opportunity in 2009 and 2010

Generally, if none of the exclusions discussed above applies, COD income is computed and then included in income in a single event. In 2009, however, Congress created a deferral opportunity that mitigates this result.

Under new IRC § 108(i), the deferral applies only to business debts that are reacquired by the debtor (or a related party) in 2009 or 2010. The term "reacquisition" is defined to include

  • the acquisition of a debt instrument for cash,
  • the exchange of a debt instrument for another debt instrument (including an exchange resulting from a modification of a debt instrument),
  • the exchange of a debt instrument for corporate stock or a partnership interest,
  • the contribution of a debt instrument to capital, and
  • the complete forgiveness of the indebtedness by the holder of a debt instrument.

Id. § 108(i)(4)(B). Thus, despite the unhelpful use of the term "reacquisition," this deferral will apply to almost any type of arrangement that triggers COD income.

If a debt is reacquired in 2009 or 2010, then any COD income is recognized ratably over a five-year period beginning in 2014. Id. § 108(i)(1). It is important to realize that this rule only defers income rather than excluding it. If a taxpayer uses this deferral, the following exclusions are not available: bankruptcy, insolvency, QRPBI, and QFI. Id. § 108(i)(5)(c). As a result, a debtor must evaluate carefully whether to use the exclusion or the deferral.

The language in the final sentence of IRC § 108(i)(4)(B) seems to exclude partial forgiveness: "Such term will also include the complete forgiveness of the indebtedness by the holder of the debt instrument." Yet there appears to be little substantive difference between purchasing a note back from a creditor at a 20% discount and agreeing with the creditor to cancel 20% of the note balance and leaving the rest of the debt "in place." Presumably the IRS will clarify this matter in future regulations or other guidance. In the meantime, it may be reasonable for debtors to structure workouts so that the debtor acquires its indebtedness from the creditor at a discount, rather than agreeing to a partial cancellation of the debt in place.

Considerations for Creditors

For creditors, there are two main questions: (1) what happens if the creditor disposes of a debt instrument and (2) what happens if the creditor retains the debt instrument but the debtor falls behind in payments?

Gain/Loss on Disposition of Debt

A creditor can incur gain or loss on the disposition of a debt instrument, just as it could with any other property. In the case of the original lender, the sale of distressed debt will generally trigger a loss. This is the case whether an actual disposition occurs (that is, a sale of a debt instrument to a new investor or a vulture fund), or a deemed exchange occurs because of a significant modification of the terms of the instrument. If the lender is in the business of making loans, then the loss is probably an ordinary loss.

In the case of a subsequent holder, the result may differ. If a third party acquires distressed debt from the original lender, it generally will take that debt with a tax basis less than the face amount of the debt. If the holder later sells the instrument to a new buyer for more than this tax basis (even though it is less than the face amount), the holder will generally have gain. More importantly, if the new creditor re-negotiates the debt with the obligor, a deemed exchange can occur that may trigger phantom income.

Example: A creditor acquires a debtor's $100 bond for $50. The creditor and debtor re-work the debt and reduce it to $70. The debtor then has $30 of COD income, and the creditor has $20 of phantom income.

Writing Off a Debt

If a debt goes bad and there is no one to sell it to, the lender will have to consider when and how to write off the debt. For tax purposes at least two considerations apply. First, the creditor will need to determine if the more stringent rules applicable to worthless securities apply. Second, if they do not, then the creditor will need to determine whether the instrument constitutes a business or nonbusiness debt in the creditor's hands.

Deduction for Worthless Securities. If a debt is issued by a corporation or a government with interest coupons attached or in registered form, then it is governed by the worthless security rules. IRC § 165(g). These rules are often stricter than the bad debt deduction rules of IRC § 166. For example, if a debt is governed by the worthless security rules, then generally the creditor cannot take a loss deduction until the security becomes completely worthless. The loss will be ordinary or capital, depending on whether the debt was an ordinary or capital asset.

Bad Debt Deduction. If a debt does not qualify as a "security," then it is governed by the bad debt deduction rules. IRC § 166. The amount and timing of that deduction, however, will often hinge on whether the debt is a business or nonbusiness bad debt. Generally, debts created or acquired in connection with the holder's trade or business are business bad debts. Id. § 166(d)(1), (2).

If a debt constitutes a nonbusiness bad debt, then the tax rules are less advantageous. In that case, the debt is deductible as a short-term capital loss. Id. § 166(d)(1). Moreover, if the holder is not a corporation, then a nonbusiness bad debt can be deducted only when completely worthless. In contrast, if the holder is a corporation, then a nonbusiness bad debt can be deducted when partially worthless.

If a debt constitutes a business bad debt, the tax rules are more liberal. First, a business bad debt is deductible as an ordinary deduction. Id. § 166(a)(1). Second, regardless of the status of the holder, a business bad debt can be deducted when partially worthless. Id § 166(a)(2).

Conclusion

Any workout or restructuring of a debt obligation requires legal advice in a variety of subject areas. Phantom tax from COD income, however, can be a particularly vexing problem and can derail an already difficult negotiation. Yet avoiding phantom taxes can be as important to the debtor as the creditor. A well-advised client will need to take all these factors into account.

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