As a consequence of the ongoing 2020 recession sparked by the COVID-19 pandemic, borrowers are increasingly carrying underwater loans at historically high interest rates, worsening the financial burden many are already bearing. Many real estate investors are having conversations with lenders to discuss debt negotiations as a form of financial relief. Whatever the agreement they eventually come to, both parties should be aware that debt modifications can have consequences on their respective tax liabilities. This blog outlines the basic debt restructure model and the potential tax implications of debt modification for both the borrower and the lender.

The Basics

The first steps in determining the tax implications of a debt restructure is to analyze whether there is a significant debt modification. There are two questions that must be addressed:

1. What is considered a debt modification?
2. Is it a significant debt modification?

From a tax perspective, a modification of a debt instrument is either an exchange of a new instrument for an existing debt instrument (i.e., a “deemed debt-for-debt exchange”) or an amendment of an existing debt instrument.¹ A significant modification of a debt instrument is that which results in an exchange of the original debt instrument for a modified instrument that differs materially either in kind or in extent.²

Generally, if a significant modification occurs, the existing debt is deemed to be exchanged for a new debt instrument. If, however, a significant modification does not occur, the existing debt is not deemed to be exchanged, thereby limiting any income tax consequences.

According to IRS regulations, a debt modification is a “significant debt modification” if it satisfies any one of five “specific” rules, or, if none of those rules apply, the “general” rule. Thus, a debt modification is considered significant if the new debt differs in any of the ways listed here:

1. General rule – based on all facts and circumstances;
2. Change in yield;
3. Changes 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.³

As you might guess, determining how to characterize a debt modification for tax purposes often requires a fair bit of interpretation and judgment, so make sure you have a CPA well-versed in this area of tax law on your team to ensure your business is not under or overpaying taxes.

Tax Implications

Once it is determined whether there is a significant modification of debt, the next step is to analyze the tax implications for the borrower and the lender. Regardless of which side you are on, it is beneficial to understand the tax consequences for both sides of the transaction to ensure that debt negotiations result in an agreement that appeases all parties involved.

The main tax concern for the borrower is whether debt restructuring would create cancellation of debt income on the deemed debt-for-debt exchange. The main concern for the lender is typically whether the debt restructuring would create an original issue discount and in turn require the recognition of a gain or loss.

Borrower Concerns: Cancellation of Debt Income

Generally speaking, cancellation of debt (COD) income arising from a significant modification will be determined by comparing the issue price of the new debt to the adjusted price of the old debt.⁴ This is likely the case if either the old or new debt is publicly traded; the old debt is treated as being repaid for an amount equal to the issue price of the new debt.

If neither the existing debt nor new debt instrument is publicly traded, debt can be restructured so that no COD income is recognized as long as the interest rate stated on the new debt is at least equal to the prevailing applicable federal rate (AFR) and the principal amount of the debt (including any accrued unpaid interest) remains the same.

• Publicly Traded Debt. The determination of the issue price for a publicly traded debt is based on Regs. Sec. 1.1273-2(C)(1). If there is confusion whether the debt is considered publicly traded, the general guidelines consider whether the debt instrument is traded on an established market or has a sales price or a quote from at least one broker, dealer or pricing service.⁵
• Non-Publicly Traded Debt. Debt instruments that do not meet the definition of a publicly traded debt will determine their issue price under IRC Sec. 1274 which would generally be equal to the stated principal amount of the debt if adequate interest is stated.⁶ An exception to debt that would otherwise be considered publicly traded is the small debt exception where the outstanding principal amount does not exceed $100 million.⁷

Lender Concerns: Original Issue Discount and Recognition of Gain or Loss

If either the old or new debt is publicly traded, the deemed debt-for-debt exchange may trigger the acceleration of original issue discount (OID) income on the old debt and the recognition of a loss to the extent that the new issue price is less than the original tax basis of the old debt. The issuance of the new debt could also create OID income for the lender to recognize as income over the new term of the debt if the FMV is lower than the stated principal amount.

Again, if neither the existing debt nor new debt instrument is publicly traded, debt can be restructured so that the adjusted tax basis of the old debt and the issue price of the new debt are the same as long as adequate interest is stated on the new debt and no gain or loss is recognized upon the deemed exchange.

Closing Thoughts

Debt restructuring conversations can often get complicated the more the terms are modified. The ultimate goal of these discussions is to provide financial relief to the borrower while minimizing any unfavorable tax implications for both the borrower and the lender.

BPM Tax Planning for Real Estate Clients

To compete successfully in our challenging recession environment, you must heed the tax implications of your business decisions. Minimizing risks and maximizing savings are significant goals for all businesses, but these actions can be extremely challenging. The professionals in BPM’s Corporate Tax Services group possess deep expertise in tax law as well as extensive experience working with real estate clients to ensure your business meets all of the rules and regulations it faces while also saving as much as it can. Contact BPM Tax Director Michelle Choy to learn more.