A Road Map of Tax Consequences of Modifying Debt

The economy is still struggling to emerge from the “great recession.” According to a congressional panel overseeing Treasury’s Troubled Asset Relief Program (TARP), about $1.4 trillion worth of commercial real estate loans will come due in the next four years. Nearly half of the commercial real estate assets secured by these loans are now worth less than the outstanding debt.1 Outside of some key U.S. markets (e.g., New York City, Washington, D.C.), the U.S. commercial real estate market has been sluggish, mirroring job growth.

For many borrowers who purchased real estate in the 2006–2008 period, the sale of the real estate asset is not economically feasible since the property is most likely still underwater. Often, distressed borrowers with liquidity issues cannot generate enough cash to service their debt, or they do not have enough equity in the property to refinance. Many of these borrowers rely on a debt restructuring transaction, in the form of debt modifications, to help them de-lever the property and work out existing debt.

On the other side of the market from distressed borrowers are the purchasers of distressed debt. There was much discussion and speculation last year about “green shoots” in the economy and the opportunities in the emerging asset class of “distressed debt.” A flurry of activity is starting to hit the marketplace now as these investments have become a viable asset class as evidenced by new “distressed debt funds” being raised in the market.

Debt restructurings are not limited only to owners of real estate loans, but they are also occurring across all industry lines and all types of taxpayers. When the market was at its peak, there were many leveraged buyouts (LBOs) of companies where excessive use of leverage was quite common. Other types of typical financing transactions include loans such as syndicated bank loans and any unsecured debt in general. The recession, coupled with steep declines in revenue, has required a portion of the debt to be restructured to avoid liquidity issues.

This article examines the potential tax consequences to lenders, borrowers, and purchasers of debt in connection with modifications of debt instruments, as well as a discussion of recent proposed and final regulations in the area of debt modifications.

A modification of a debt instrument may result in a deemed taxable exchange of the old debt instrument for a new debt instrument. Deemed exchanges could, in turn, trigger the recognition of cancellation of debt (COD)2 income and the accrual of original issue discount (OID)3 deductions over the remaining term of the debt to the borrower and immediate gain/loss recognition and OID income to the lender. Interest limitations may also affect the deductibility of the OID. A two-step analysis determines whether a deemed exchange has occurred. First, were the terms of the debt instrument modified? Second, was the modification significant? If the modification was significant, what are the tax consequences to the borrower and lender?

A road map of these steps in debt modification is provided in the exhibit.

The IRS issued the current debt modification regulations under Regs. Sec. 1.1001-3 in 1996 in response to the Supreme Court’s decision in Cottage Savings.4 In Cottage Savings, a savings and loan institution sold interests in an underlying pool of mortgages and purchased comparable interests in a different pool of mortgages from a different lender. The purchased mortgages were relatively close in value to those in the original pool, but had different obligors and collateral. The institution recognized a loss on the exchange for tax purposes, but not for financial purposes. The IRS challenged the institution’s claimed loss.

The Court held that the exchange of mortgage portfolios by two savings and loan companies was a taxable event even though the overall portfolios had virtually identical economic characteristics. The Court said the mortgage loans were materially different because they had different obligors and were secured by different properties. Regs. Sec. 1.1001-3, which was amended in 2011, lays out the rules under which the alteration of terms of the old debt instrument will be deemed a taxable exchange.

With some careful planning and a full understanding of the debt modification rules, the tax adviser can plan for and optimize the tax consequences of debt restructurings.

Two-Part Test

Step One: Has a Modification Occurred?

“Modification” is broadly defined in the regulations. In general, a modification means any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt instrument, whether the alteration is evidenced by an express agreement (oral or written), conduct of the parties, or otherwise. A modification can occur from amending the terms of a debt instrument or through exchanging one debt instrument for another.5

There are three main exceptions to the broad definition of a modification:

Terms of a debt instrument: An alteration of a legal right or obligation that occurs by operation of the terms of a debt instrument is not a modification (e.g., an annual resetting of the interest rate based on the value of an index).6 Certain alterations, however, would constitute a modification, even if the alterations occur by operation of the terms of a debt instrument.

One example is a change in obligor or the addition or deletion of a co-obligor. Another example is a change in the nature of the debt instrument (i.e., an alteration that results in a change from recourse to nonrecourse or vice versa).7 An alteration that results from the exercise of an option provided to an issuer or a holder to change a term of a debt instrument is a modification unless the option is unilateral and, in the case of an option exercisable by a holder, the exercise of the option does not result in a deferral of, or a reduction in, any scheduled payment of interest or principal.8

Failure to perform: The failure of an issuer to perform its obligations under a debt instrument is not a modification. Although the issuer’s nonperformance is not a modification, the agreement of the holder not to exercise its remedies under the debt instrument may be a modification.

Absent a written or oral agreement to alter other terms of the debt instrument, an agreement by the holder to stay collection or temporarily waive an acceleration clause or similar default right (including such a waiver following the exercise of a right to demand payment in full) is not a modification unless and until the forbearance remains in effect for a period that exceeds two years following the issuer’s initial failure to perform and any additional period during which the parties conduct good-faith negotiations or during which the issuer is in bankruptcy.9

Failure to exercise an option: If a party to a debt instrument has an option to change a term of the instrument, the failure of the party to exercise that option is not a modification.10

Step Two: Was the Modification Significant?

Assuming a modification occurred, the next question is whether the modification is significant. The regulations provide six rules for addressing whether a modification is significant:

1. General test—facts and circumstances;
2. Change in yield;
3. Change in timing of payments;
4. Change in obligor or security;
5. Changes in the nature of a debt instrument; or
6. Changes to accounting or financial covenants.

Whether a modification of any term is a significant modification is determined under each applicable rule and, if not specifically addressed in those rules, under the general facts-and-circumstances test.11 For instance, a deferral of payments that changes the yield of a fixed-rate debt instrument must be tested under both the change-in-yield test and the change-in-timing-of-payments test.12

General test: Under the general test, a modification is a significant modification only if, based on all facts and circumstances, the legal rights or obligations are altered to a degree that is economically significant. In making a determination under the facts-and-circumstances test, all modifications to the debt instrument are considered collectively, so that a series of such modifications may be significant when considered together although each modification, if considered alone, would not be significant.13 The general test does not apply if there is a specific rule that applies to the particular modification.14

Change-in-yield test: This test applies to debt instruments that provide only for fixed payments, debt instruments with alternative payment schedules subject to Regs. Sec. 1.1272-1(c) (instruments subject to contingencies), debt instruments that provide for a fixed yield subject to Regs. Sec. 1.1272-1(d) (such as certain demand loans), and variable-rate debt instruments. If a debt instrument does not fall within one of these categories (e.g., a contingent payment debt instrument), then whether a change in the yield of the debt instrument is a significant modification is determined under the general facts-and-circumstances test.15

In general, a change in the yield of a debt instrument is a significant modification if the yield varies from the annual yield on the unmodified instrument (determined as of the date of the modification) by more than the greater of: (1) one-quarter of 1% (25 basis points) or (2) 5% of the annual yield of the unmodified debt instrument (0.05 × annual yield).16

A reduction in principal reduces the total payments on the modified instrument and would result in a reduced yield on the instrument, often resulting in a significant modification. As such, the regulations give the same effect to changes in principal amounts as to changes in interest rates.

Example 1: A debt instrument issued at par has an original term of 10 years and provides for the payment of $100,000 at maturity with annual interest payments at a rate of 10%. At the end of the fifth year, and after the annual payment of interest, the issuer and holder agree to reduce the amount payable at maturity to $80,000. The annual interest rate remains at 10% but is payable on the reduced principal.

In applying the change-in-yield rule, the yield of the instrument after the modification (measured from the date that the parties agree to the modification to its final maturity date) is computed using the adjusted issue price of $100,000. With four annual payments of $8,000, and a payment of $88,000 at maturity, the yield on the instrument after the modification for purposes of determining if there has been a significant modification is 4.332%. Thus, the reduction in principal is a significant modification.17

Change in timing of payments: In general, a modification that changes the timing of payments (including any resulting change in the amount of payments) due under a debt instrument is a significant modification if it results in the material deferral of scheduled payments. Examples would include either an extension of the final maturity date or a deferral of payments due prior to maturity (such as a deferral of interest payments). There are many facts and circumstances to consider including the length of the deferral, the original term of the debt instrument, the amounts of the payments that are deferred, and the time period between the modification and the actual deferral of payments.18

The regulations provide for a safe harbor where the modification will not be significant if the deferred payments are required to be paid within the lesser of five years or one-half the original term of the instrument. For purposes of the safe-harbor rule, the term of an instrument is determined without regard to any option to extend the original maturity, and deferrals of de minimis payments are ignored. Deferrals are tested on a cumulative basis so that, when payments are deferred for less than the full safe-harbor period, the unused portion of the period remains for any subsequent deferrals.19

Example 2: A zero-coupon bond has an original maturity of 10 years. At the end of the fifth year, the parties agree to extend the maturity for a period of two years without increasing the amount payable at maturity.

The safe-harbor period starts with the date the payment that is being deferred is due (the original maturity date) and ends five years from this date. Thus, the deferral of the payment at maturity for a period of two years is not a material deferral under the safe-harbor rule and thus is not a significant modification. Although this extension of maturity is not a significant modification, the modification also decreases the yield of the bond and must also be tested under the change-of-yield rules.20

Change in obligor or security: The substitution of a new obligor on a nonrecourse debt instrument is not a significant modification.21 Conversely, a substitution of a new obligor on a recourse debt instrument is generally a significant modification.22 There are a few possible exceptions for substitutions of obligors on a recourse debt instrument. These exceptions include the following:

1. The new obligor is an acquiring corporation to which Sec. 381(a) applies;
2. The new obligor acquires substantially all of the assets of the obligor; and
3. The change in obligor is a result of either a Sec. 338 election or the filing of a bankruptcy petition.23

Moreover, for an exception to apply, the change in obligor must not result in a change in payment expectations or a significant alteration (an alteration that would be a significant modification but for the fact that the alteration occurs by operation of the terms of the instrument).24 In general, a change in payment expectations occurs if, as a result of a transaction, there is a substantial enhancement or impairment of the obligor’s capacity to meet the payment obligations after the modification as compared to before the modification. In the case of an enhancement, the test is based on whether the obligor’s capacity to meet its obligations under the debt instrument was primarily speculative before the modification and adequate after the modification, and, in the case of an impairment, on whether the obligor’s capacity to meet its obligations under the debt instrument was adequate before the modification and is primarily speculative after the modification.25

Example 3: A recourse debt instrument is secured by a building. In connection with the sale of the building, the purchaser of the building assumes the debt and is substituted as the new obligor on the debt instrument. The purchaser does not acquire substantially all of the assets of the original obligor.

The transaction does not satisfy exception (1) or (2) listed above. Thus, the substitution of the purchaser as the obligor is a significant modification.26

The addition or deletion of a co-obligor on a debt instrument is a significant modification if the addition or deletion of the co-obligor results in a change in payment expectations.27 For recourse debt instruments, a modification that releases, substitutes, adds, or otherwise alters the collateral for, a guarantee on, or other form of credit enhancement for a recourse debt instrument is a significant modification if the modification results in a change in payment expectations.28

For nonrecourse debt instruments, a modification that releases, substitutes, adds, or otherwise alters a substantial amount of the collateral for, a guarantee on, or other form of credit enhancement for a nonrecourse debt instrument is a significant modification. A substitution of collateral on a nonrecourse debt instrument is not a significant modification, however, if the collateral is fungible or otherwise of a type where the particular units pledged are unimportant, such as government securities or financial instruments of a particular type and rating. In addition, the substitution of a similar commercially available credit enhancement contract is not a significant modification, and an improvement to the property securing a nonrecourse debt instrument does not result in a significant modification.29

Example 4: A parcel of land and its improvements (a shopping center) secure a nonrecourse debt instrument. The obligor expands the shopping center with the construction of an additional building on the same parcel of land. After the construction, the improvements that secure the nonrecourse debt include the new building.

The building is an improvement to the property securing the nonrecourse debt instrument and its inclusion in the collateral securing the debt is not a significant modification.30 If the priority of a debt instrument changes relative to other debt of the issuer and results in a change of payment expectations, the modification would be significant.31

Change in the nature of a debt instrument: In general, a change in the nature of a debt instrument from recourse to nonrecourse, or vice versa, is a significant modification. There are two exceptions to this rule. First, a defeasance of tax-exempt bonds is not a significant modification if the defeasance occurs by operation of the terms of the original bond and the issuer places in trust government securities or tax-exempt government bonds that are reasonably expected to provide interest and principal payments sufficient to satisfy the payment obligations under the bond.32

Second, a modification that changes a recourse debt instrument to a nonrecourse debt instrument is not a significant modification if the instrument continues to be secured only by the original collateral and the modification does not result in a change in payment expectations. For this purpose, if the original collateral is fungible or otherwise of a type where the particular units pledged are unimportant (for example, government securities or financial instruments of a particular type and rating), replacement of some or all units of the original collateral with other units of the same or similar type and aggregate value is not considered a change in the original collateral.33

A modification of a debt instrument that results in an instrument that is not debt for federal income tax purposes is a significant modification.34 For purposes of this rule, any deterioration in the financial condition of the obligor between the issue date of the unmodified instrument and the date of modification (as it relates to the obligor’s ability to repay the debt) is not taken into account unless, in connection with the modification, there is a substitution of a new obligor or the addition or deletion of a co-obligor.35

Recently finalized regulations on issuer’s financial condition: Recently, the IRS issued regulations that address whether a deterioration in the issuer’s creditworthiness is taken into account in determining whether a modified debt instrument is still classified as debt for tax purposes. The IRS issued proposed regulations in June 201036 that were finalized on Jan. 7, 2011,37 clarifying that, when determining whether a modified debt instrument is still classified as debt for tax purposes, the deterioration of the issuer’s creditworthiness is not taken into account. What precipitated the new regulations was the apparent limitation of the rule disregarding a deterioration in the issuer’s creditworthiness only for purposes of determining whether a debt instrument has been significantly modified and not for purposes of determining whether the modified debt instrument continued to be debt for all tax purposes.

Taxpayers requested clarification of when the credit quality of the issuer would be considered in determining the nature of the instrument resulting from an alteration or modification of a debt instrument. Absent the clarification, the concern was that the new instrument could be treated as equity due to the lack of certainty of repayment or a lack of sufficient collateral. The preamble to the proposed regulations clarifies that any decrease in the fair market value (FMV) of a debt instrument (regardless of whether it is publicly traded or not) between the issue date of the debt instrument and the date of the modification is not taken into account for purposes of determining whether the modified debt instrument continues to be debt for all tax purposes to the extent the decrease in FMV is attributable to the deterioration in the financial condition of the issuer and not to a modification of the terms of the debt instrument.

If the debt is modified and the resulting instrument is not characterized as debt for tax purposes (and is instead treated as equity for tax purposes), the transaction would be treated as an exchange of the old debt instrument for equity of the issuer. Whether this exchange results in COD income to the issuer is controlled by Sec. 108(e)(8).38

The final regulations remove a potential concern in workouts of debt of financially troubled debtors since the modified debt would still be treated as debt for tax purposes, provided there is no change in obligor, and provided there is no change in the terms of the debt that would be inconsistent with debt treatment (such as eliminating a maturity date). If the debt is not publicly traded, the modification often would take place without the debtor having to recognize COD income, so long as the principal amount is not reduced and the debt has adequate stated interest. In contrast, if the debt is publicly traded, the debtor’s creditworthiness would affect the value of the debt, and the debtor would likely have COD income even if the debt was respected as debt for tax purposes. The tax consequences of modifying non–publicly traded debt and publicly traded debt are discussed in more detail later in this article.

Changes in financial and accounting covenants: A modification that adds, deletes, or alters customary accounting or financial covenants is not a significant modification.39 Nonetheless, the issuer may make a payment to the lender in consideration for agreeing to the modification. The payment would be taken into account in applying the change-in-yield test.40 Therefore, a modification to a debt instrument’s covenants can result in a significant modification if the lender receives a payment for agreeing to the modification.

Tax Consequences of the Deemed Exchange

Once the determination has been made that a modification of a debt instrument is significant, the tax adviser must analyze the tax consequences to the borrower and the holder. The borrower’s tax consequences are determined by comparing the issue price of the new debt to the adjusted issue price of the old debt.41 Generally speaking, the adjusted issue price is the principal amount if the debt was not issued at a discount and provided for current payments of interest at a fixed or variable rate. Gain or loss to the holder/lender is measured by the difference between the issue price of the new debt and the tax basis of the old debt. The holder can have a different tax basis than the adjusted issue price. For instance, the holder could have bought the debt from the original lender at a discount.

To determine the issue price of the new debt, a determination must be made if the debt is publicly traded (discussed below) or not. For this purpose, either the old debt or the new debt (or both) can be publicly traded. If the debt is publicly traded, the issue price is equal to the FMV of the debt instrument.42 The rules address publicly traded debt issued for property and non–publicly traded debt issued for publicly traded property. The property is the old debt instrument that is being exchanged for the new debt instrument. If the debt is not publicly traded, the issue price is equal to the principal amount of the debt instrument if the instrument has adequate stated interest.43 An instrument has adequate stated interest if the stated principal amount is less than or equal to the imputed principal amount.44 As a general rule, a debt instrument has adequate stated interest if it bears interest at least equal to the applicable federal rate (AFR) under Sec. 1274(d).

The following examples illustrate various scenarios and outcomes depending on whether the debt is publicly traded or not.45

Example 5: Debt is not publicly traded: The original terms of the loan provide for a 10% interest rate. The $100 principal amount of the loan is equal to the amount of cash that was loaned. The lender is the original lender (and, consequently, has a $100 basis in the loan). The lender agrees to reduce the rate to 6%, which is above the current AFR. Assume that all accrued interest has been paid as of the date of the modification, and no accrued interest is being forgiven.

Impact to lender: Although the modification is significant, no loss is recognized since the issue price of the new debt is $100 (the principal amount) and the lender’s tax basis is $100.

Impact to borrower: No COD income is recognized because the issue price of $100 is the same as the adjusted issue price of $100.

Example 6: Debt is publicly traded: The original terms of the loan provide for a 10% interest rate. The $100 principal amount of the loan is equal to the amount of cash that was loaned. The lender agrees to reduce the rate to 6%. Assume that all accrued interest has been paid as of the date of the modification, and no accrued interest is being forgiven. The debt is publicly traded and has an FMV of $80.

Impact to borrower: $20 of COD income is recognized equal to the difference between the new issue price of $80 and the original amount borrowed of $100. The exchange also creates $20 of OID, resulting in interest deductions to the borrower over the remaining term of the new debt.46 The modified loan has OID because it is treated as a new loan for tax purposes, with an issue price of $80 and a stated redemption price at maturity of $100. Consideration should be given to any interest limitation that would affect the deductibility of the OID, including Sec. 163(e)(5) (applying to corporate debt with a high yield that meets certain requirements provided in Sec. 163(i)).

Impact to lender: $20 of loss47 is recognized in this deemed debt-for-debt exchange because the lender’s amount realized is the new issue price of $80 less the lender’s original tax basis of $100. The exchange also creates OID income of $20 to be taken into income as interest over the remaining term of the new debt.

Example 7: Debt is not publicly traded: The original lender sells the debt to a third party for $80, which is less than the principal amount of the debt. After the transfer, interest terms are renegotiated from 10% to 6%, which is above the current AFR.

Impact to borrower: None.

Impact to original lender: $20 loss is recognized from the sale of the loan for $80.

Impact to third-party buyer: $20 gain due to the receipt of the new debt instrument with an issue price of $100 in exchange for the old loan in which he had a tax basis of $80.48

Example 8: Debt is publicly traded: The original lender sells the debt to a third party for $80, which is the current FMV of the debt. Immediately after the transfer, interest terms are renegotiated from 10% to 6%.

Impact to borrower: COD of $20 and OID deductions of $20 over the life of debt instrument.

Impact to original lender: Loss of $20 is recognized.

Impact to third-party buyer: OID income of $20 over the life of debt instrument. (If the terms of the debt had not been renegotiated, the $20 discount would not have been treated as OID. Instead, it would represent market discount to the third-party purchaser. Market discount is not required to be included in income as it accrues. Instead, accrued market discount is recognized when principal payments are made or when the debt is sold.49 Because a significant modification occurred, the modified debt is treated as newly issued for tax purposes. Therefore, the modified debt is being issued at $80, resulting in $20 of OID, which must be included in income as it accrues.)

As evidenced by the examples above, depending on the facts and circumstances, there could be adverse tax consequences to the borrower, lender, or purchaser of debt if there is a significant modification of the debt instrument.

The ultimate effect of these trans-actions depends on the parties’ tax positions. For example, if a corporation has significant net operating losses that are expiring, it may be beneficial to trigger gain in the exchange (and generate future OID deductions). Moreover, a borrower with COD could use the various exclusions of such COD income under Sec. 108 for some or all of that COD.50

When Is Debt Considered “Publicly Traded”?

In January 2011, the IRS issued proposed regulations (REG-131947-10) addressing when property is considered to be traded on an established market (publicly traded) for purposes of determining the issue price of a debt instrument. Under the current regulations, issue price is generally determined in the following order:

1. The amount of money paid for the debt instrument;
2. If the debt instrument is publicly traded and is not issued for money, the FMV of the debt instrument;
3. If the debt instrument is not publicly traded and not issued for money but is issued for property that is publicly traded (including a debt-for-debt exchange where the old debt is publicly traded), then the issue price of the debt instrument is the FMV of the publicly traded property; or
4. If none of the above, Sec. 1274 applies and the issue price will be the stated principal amount where there is adequate stated interest.51

Under the current regulations, property (including a debt instrument) is considered traded on an established market if it is described in Regs. Sec. 1.1273-2(f) at any time during the 60-day period ending 30 days after the issue date of the debt instrument. Property described in Regs. Sec. 1.1273-2(f) is (1) exchange listed property, (2) market-traded property (i.e., property traded on a board of trade or in an interbank market), (3) property appearing on a quotation medium, and (4) readily quotable debt instruments.52

Few debt instruments are listed on an exchange. For most debt instruments, the important questions are whether the instruments appear on a quotation medium or are readily quotable. A quotation medium is defined as a system of general circulation that provides a reasonable basis to determine FMV by disseminating either recent price quotations of one or more identified brokers, dealers, or traders, or actual prices of recent sales transactions.53 For example, trade information appearing in the Trade Reporting and Compliance Engine (TRACE) database maintained by the Financial Industry Regulatory Authority would likely cause the instrument to be publicly traded.

A debt instrument is considered readily quotable if price quotations are readily available from dealers, brokers, or traders.54 Determining whether a debt instrument is readily quotable requires fact gathering, and tax practitioners may differ on what types of facts would cause a debt instrument to be considered readily quotable.

In issuing the proposed regulations, the IRS explained that commentators had criticized the definition of “established market” as difficult to apply in practice and noted that the current regulations were outdated. Due to the increased amount of debt workouts in recent years, the issue has turned into a hot topic. Generally, not many debt instruments are listed on an exchange, as they are typically traded in privately negotiated transactions between a securities dealer or broker and a customer. A dealer or broker may quote a firm price that enables a customer to buy or sell at that firm price subject to volume limitations, which is referred to as a “firm quote.” A dealer, broker, or listing service may also quote a price that indicates a willingness to buy or sell a specific debt instrument but not necessarily at the specified price (referred to as an “indicative quote”).

The preamble explained that commentators struggled to apply the definition of an established securities market to the informal marketplace in which most debt instruments changed hands. The proposed regulations were intended to simplify, clarify, and generally expand the determination of when property is traded on an established market.

The proposed regulations identify four ways for property (including a debt instrument) to be traded on an established market. In each case, the time period for determining whether the property is publicly traded is the 31-day period ending 15 days after the issue date of the debt instrument.

The following are the four categories that the proposed regulations identify:

1. Property is listed on an exchange;
2. A sales price for the property is reasonably available;
3. A firm (or executable) price quote to buy or sell the property is available; or
4. One or more indicative quotes (i.e., price quotes other than firm quotes) are available from a dealer, broker, or pricing service (an indicative quote).

For the second category, a sales price is considered reasonably available if the sales price (or information sufficient to calculate the sales price) appears in a medium that is made available to persons that regularly purchase debt instruments (including a price provided only to certain customers or subscribers) or to persons that broker such transactions.

The proposed regulations provide that the FMV of property described in Regs. Sec. 1.1273-2(f) will be presumed to be equal to its trading price, sales price, or quoted price, whichever is applicable. If there is more than one price or quote, a taxpayer may use any reasonable method, consistently applied, to determine the price. When there is only an indicative quote, a taxpayer can use any method that provides a reasonable basis to determine the FMV if the taxpayer determines that the quote (or average quotes) materially misrepresents the FMV, provided the taxpayer can establish that the method chosen more accurately reflects the value of the property. The regulations, as proposed, would apply to debt instruments issued on or after the publication date of the Treasury decision adopting the rules as final regulations.

The proposed regulations would resolve a number of uncertainties regarding whether debt is publicly traded. Unfortunately, for some troubled debtors, these proposed regulations would be biased toward treating certain debt instruments as publicly traded. Given that the FMV of these troubled loans is significantly less than their principal amount, a significant amount of COD income may be realized if there is a significant modification to the debt instrument that results in a debt-for-debt exchange. Tax advisers should be aware of these potential consequences, assuming the rules in the proposed regulations are finalized, and try to mitigate any adverse tax effects through careful planning.

Conclusion

A tax adviser needs a working knowledge of the tax consequences of modifying debt. This knowledge is critical to avoiding unpleasant surprises when advising a client engaging in a debt workout. A tax adviser needs to know not only when a debt-for-debt exchange is deemed to take place, but also the resulting tax consequences. Additionally, a tax adviser should be aware of recent developments in the area, including regulations addressing whether a deterioration in the issuer’s creditworthiness should cause a debt instrument to be reclassified as equity. These developments also include proposed regulations that would expand the definition of “publicly traded” to cover a broader range of debt instruments.

Author’s note: The author would like to thank Richard Fox, a principal in the Real Estate Tax Group at Ernst & Young LLP, for his insightful comments and contributions to this article.

Footnotes

¹ Congressional Oversight Panel, Commercial Real Estate Losses and the Risk to Financial Stability (Feb. 10, 2010).

² COD income results from the cancellation or reduction of indebtedness (see Sec. 108).

³ OID means the excess of a debt instrument’s stated redemption price at maturity over its issue price (Sec. 1273(a)(1)).

⁴ Cottage Savings Ass’n, 499 U.S. 554 (1991).

⁵ Regs. Sec. 1.1001-3(c)(1)(i).

⁶ Regs. Sec. 1.1001-3(c)(1)(ii).

⁷ Regs. Sec. 1.1001-3(c)(2)(i).

⁸ Regs. Sec. 1.1001-3(c)(2)(iii). The regulations provide a definition of a “unilateral option” in Regs. Sec. 1.1001-3(c)(3).

⁹ Regs. Sec. 1.1001-3(c)(4)(ii).

¹⁰ Regs. Sec. 1.1001-3(c)(5).

¹¹ Regs. Sec. 1.1001-3(e)(1).

¹² Regs. Sec. 1.1001-3(f)(1).

¹³ Regs. Sec. 1.1001-3(e)(1).

¹⁴ Regs. Sec. 1.1001-3(f)(1).

¹⁵ Regs. Sec. 1.1001-3(e)(2)(i).

¹⁶ Regs. Sec. 1.1001-3(e)(2)(ii).

¹⁷ Regs. Sec. 1.1001-3(g), Example (3).

¹⁸ Regs. Sec. 1.1001-3(e)(3)(i).

¹⁹ Regs. Sec. 1.1001-3(e)(3)(ii).

²⁰ Regs. Sec. 1.1001-3(g), Example (2).

²¹ Regs. Sec. 1.1001-3(e)(4)(ii).

²² Regs. Sec. 1.1001-3(e)(4)(i)(A).

²³ Regs. Secs. 1.1001-3(e)(4)(i)(B), (C), (D), (F), and (G).

²⁴ Regs. Sec. 1.1001-3(e)(4)(i)(E). The requirement that a significant alteration not occur does not apply if the transaction falls under Sec. 368(a)(1)(F) (a change in form or place of incorporation).

²⁵ Regs. Sec. 1.1001-3(e)(4)(vi).

²⁶ Regs. Sec. 1.1001-3(g), Example (6).

²⁷ Regs. Sec. 1.1001-3(e)(4)(iii).

²⁸ Regs. Sec. 1.1001-3(e)(4)(iv)(A).

²⁹ Temp. Regs. Sec. 1.1001-3T(e)(4)(iv).

³⁰ Regs. Sec. 1.1001-3(g), Example (9).

³¹ Regs. Sec. 1.1001-3(e)(4)(v).

³² Regs. Sec. 1.1001-3(e)(5)(ii)(B)(1).

³³ Temp. Regs. Sec. 1.1001-3T(e)(5)(ii)(B)(2).

³⁴ Regs. Sec. 1.1001-3(e)(5)(i).

³⁵ Id.; Regs. Sec. 1.1001-3(f)(7)(ii).

³⁶ REG-106750-10.

³⁷ T.D. 9513 (Regs. Secs. 1.1001-3(c)(2)(ii), (e)(5), and (f)(7)).

³⁸ Many other tax consequences can result from this exchange of debt for equity of the issuer including: (1) converting a single-member disregarded entity into a partnership for tax purposes, (2) a distribution under Sec. 752 due to a reduction of debt (and possible gain recognition to the partners), (3) a change in the treatment of the investment for the Secs. 856(c)(2)–(4) income and asset tests for REITs, (4) a change in the character and sourcing of income, (5) a change in the withholding tax treatment under Secs. 1441–1446, and (6) the cessation of interest accruals and the nonapplication of Sec. 166.

³⁹ Regs. Sec. 1.1001-3(e)(6).

⁴⁰ Regs. Sec. 1.1001-3(e)(2)(iii)(A).

⁴¹ Sec. 108(e)(10); Regs. Sec. 1.61-12(c).

⁴² Sec. 1273(b)(3); Regs. Secs. 1.1273-2(b) and (c).

⁴³ Sec. 1273(b)(4); Sec. 1274(a); Regs. Sec. 1.1274-2(b).

⁴⁴ Sec. 1274(c)(2). The imputed principal amount is generally the present value of all payments under the instrument.

⁴⁵ These examples assume that the debt instruments in question are not “securities” for purposes of Sec. 368(a)(1)(E) and that the installment method will not be applied.

⁴⁶ The various tax issues related to COD income along with COD exclusions or deferrals under Sec. 108 are beyond the scope of this article. The measurement and taxation of OID is also beyond the scope of this article.

⁴⁷ The loss could be ordinary if the lender is in the trade or business of lending, or capital if the debt was a capital asset in the lender’s hands. If the exchange of the old loan for a new loan qualifies as a recapitalization under Sec. 368(a)(1)(E), the loss is not recognized.

⁴⁸ A portion of the $20 gain may be treated as ordinary income under the market discount rules of Sec. 1276 depending on how long the buyer held the debt instrument before the modification.

⁴⁹ Sec. 1276(b).

⁵⁰ Sec. 108(a). Usually, the exclusion of COD from income results in a corresponding reduction of tax attributes under Sec. 1017.

⁵¹ Regs. Sec. 1.1273-2.

⁵² Regs. Secs. 1.1273-2(f)(2)–(5).

⁵³ Regs. Sec. 1.1273-2(f)(4).

⁵⁴ Regs. Sec. 1.1273-2(f)(5). Several safe harbors are provided to exclude debt instruments from being considered readily quotable, including issuances having an original principal amount of no more than $25 million and situations where the borrower does not have any other debt that would fall within the other categories of publicly traded under Regs. Secs. 1.1273-2(f)(2)–(4).