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[Tax Counsellor]

TAX CONSEQUENCES OF DEBT MODIFICATION

By: Karrie L. Bercik, JD, LLM

A change in the terms of a debt instrument may create income for the debtor or the creditor. This result may occur if the debt is either replaced by a new debt or if the terms of the debt are materially modified.

Replacement of Existing Debt.

(a) Debtor Issues.

If a debtor replaces an existing debt with a new debt, the debtor will be treated as having satisfied the old indebtedness with an amount of money equal to the issue price (determined under complex rules contained in Internal Revenue Code Sections 1273 and 1274) of the new debt.1 Therefore, if the issue price of the new debt is less than the adjusted issue price of the old debt, the debtor will realize cancellation of indebtedness ("COD") income. The new debt instrument may also contain original issue discount ("OID") that would provide the debtor with interest deductions, however, the deductions will be spread over the term of the debt instrument. Because of the time value of money, the OID deductions will not fully offset any recognized COD income.

(b) Creditor Issues.

The debt exchange may also cause a creditor to recognize gain if the creditor has taken a worthless debt deduction or purchased the debt at a discount from a previous holder. In such case, the creditor's basis in the debt will in most cases be less than the issue price of the new debt (usually the face amount). If the creditor recognizes income ("phantom income") on the exchange, the creditor may:

a. Take a partially worthless debt deduction;

b. Report the gain on the installment method; or

c. Argue the doubt as to collectibility doctrine applies.

Modification of Existing Debt.

If the terms of an existing debt are materially modified in kind or extent, the debtor will be treated as having sold the original debt for a new debt.2 If the debt modification is treated as a deemed sale, the tax consequences are the same as if the debt was actually replaced. If the modification is not deemed to be material, there will be no tax consequences to the borrower or lender. The Service recently finalized regulations defining when a modification is material. The final regulations are effective September 24, 1996. The common law debt modification rules are much more flexible than the recently finalized regulations.

(a) When Modification of a Debt is Material.

Treasury Regulations § 1.1001 3 were issued in response to the Supreme Court decision in Cottage Savings Association v. Commissioner.3 The regulations expand the scope of circumstances under which COD income may be triggered in a negotiated workout. Under Treasury Regulations § 1.1001 3, any "significant modification" in the terms of a debt instrument will be considered an exchange (sale). A modification of a debt instrument is defined as any alteration in any legal right or obligation of the issuer or holder unless the modification occurs by operation of the original terms of the instrument.4

The final Regulations state that the following modifications are considered "significant":

(a) General Rule. A modification is significant only if, based upon all the facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant5;

(b) A change in the yield to maturity of more than 25 basis points or 5% of the annual yield of the unmodified instrument6;

(c) An extension of the final maturity of more than the lesser of five years or 50% of the original term if the extension results in the material deferral of scheduled payments7;

(d) Changes in the obligor, security, or guarantor of recourse debt and in some cases change of collateral securing nonrecourse debt8;

(e) A change in priority of the debt if it results in a change in payment expectation9;

(f) A change from recourse to nonrecourse or vice versa10.

There is language in the final Regulations that may require retesting for debt-equity purposes whenever debt is substantially modified.11 With so much real estate under water this could make lenders partners or owners of real estate when even under-water debt is modified, with disastrous tax consequences to the owners and lender.

Because the lender may be able to intentionally trigger gains, the lender may use this new debt modification rule to his or her advantage. Suppose the lender has an expiring capital loss. If the lender modifies a debt and causes gain recognition, the gain can offset the expiring loss. Because the lender now has basis in the debt, the lender may later take a partially worthless debt deduction and "renew" the expiring loss.

Example: Lender has a capital loss of $60,000 that will expire in 1996. Lender holds a note with a face amount of $150,000 for which he has a basis of $90,000. The fair market value of the note is roughly $90,000. In order to "renew" his loss, Lender materially modifies the debt causing a gain of $60,000. The gain offsets the loss and the Lender pays no tax. In 1997, Lender takes a partially worthless debt deduction of $60,000 and charges off part of the loan from his books.

FOOTNOTES

1 Section 108(e)(10).

2 Treas. Reg. §1.1001 1(a).

3 499 U.S. 554, 111 S.Ct. 1503, (1991).

4 Treas. Reg. §1.1001-3(c).

5 Treas. Reg. §1.1001-3(e)(1).

6 Treas. Reg. §1.1001-3(e)(2).

7 Treas. Reg. §1.1001-3(e)(3).

8 Treas. Reg. §1.1001-3(e)(4)(i-iv).

9 Treas. Reg. §1.1001-3(e)(4)(v).

10 Treas. Reg. §1.1001-3(e)(5)(ii).

11 Treas. Reg. §1.1001-3(e)(5)(i).