Real Estate Debt Modifications
| Publication year | 2010 |
| Pages | 81 |
| Citation | Vol. 39 No. 8 Pg. 81 |
2010, August, Pg. 81. Real Estate Debt Modifications
August 2010
Vol. 39, No. 8 [Page 81]
Real Estate Law articles are sponsored by the CBA Real Estate Law Section.
Lenders and investors that modify real estate debt may experience federal income tax consequences by reason of the modification, including recognition of income, creation of original issue discount, and market discount.
The federal income tax consequences of debt restructuring, particularly to the lender, can be counterintuitive. Banks and other regular lenders may be affected by these issues, but investors are more likely to feel the impact. In workout transactions, both sides can recognize taxable income without the receipt of cash. This article explores the federal income tax issues that can be important to lenders and debt purchasers.
When debt is modified or restructured, the borrower should be concerned with cancellation of debt income (CODI). A borrower may recognize CODI in a variety of transactional contexts, and CODI recognized by a borrower may have important consequences for the lender, as well.
OID and Debt Modifications
In 1996, the U.S. Treasury Department issued regulations specifying when the modification of an existing debt instrument would be considered to be the issuance of a new debt instrument in exchange for the original debt instrument.(fn1) Under these regulations, if there is a "significant modification," such as a change in the yield to maturity by more than 25 basis points, the modified debt instrument is treated as a new debt instrument, the holder of the original debt instrument is treated as if it received the new debt instrument in exchange for the original debt instrument in a taxable transaction, and the borrower is treated as if it exchanged the original debt instrument for the new debt instrument. In many cases, the deemed exchange has minimal tax consequences for the debt holder, particularly if the loan has not been transferred. However, in some cases, this deemed exchange can result in phantom income, gain, or original issue discount (OID) for the lender or debt holder and CODI for the borrower. In any event, the deemed exchange does not qualify for tax-free treatment under IRC § 1031.(fn2)
In a workout, a lender may grant an interest payment moratorium or forgive past accrued interest. When a modified debt instrument defers interest or provides for principal payments in excess of the issue price of the debt, the deferred interest is considered OID.(fn3) With exceptions for certain kinds of obligations, a portion of the OID generally must be included in the income of the holder of the debt instrument each year, even though a payment is not to be received until a later year (for example, zero coupon Treasury bonds are issued at a discount to face but the holder has to report interest income each year, even though no payment is made until maturity).(fn4)
The Internal Revenue Service (IRS) position appears to be that even when the debt may not be fully collectible, the accrued interest resulting from OID must be reported as taxable income each year, whether the holder of the debt is on the cash or accrual method of accounting.(fn5)
Illustrative Examples
This article uses examples to illustrate certain tax issues that may arise in common restructuring situations. The first example involves a restructuring between the original secured lender and the borrower. The second example deals with some of the issues that can arise when debt is purchased at a discount.
Example 1: Transactions Involving the Original Lender and Borrower
Real Estate LLC purchased a small office building (property) for $2 million in cash on January 1, 1998. On July 1, 2007, when the property appraised for $6 million, Real Estate LLC borrowed $5 million from Fund X, a limited partnership, secured by the property. The loan terms provided for monthly payments of interest only at 7 percent with the principal due at the maturity date of July 1, 2014. Real Estate LLC stopped making interest payments on the loan beginning with the September 1, 2008 payment.
Payment default, but no action taken. Suppose Fund X takes no immediate action.
* Accrual of interest after default. If Fund X uses the accrual method of accounting, the interest payment default, by itself, may not be sufficient cause for Fund X to stop accruing the interest income. If it is "reasonably certain" that interest will not be collected, Fund X may stop accruing interest.(fn6)
* Deemed exchange of debt. When a debt remains in default for more than two years without a good faith attempt to renegotiate the debt, there is a deemed exchange of the original debt for a modified debt instrument.(fn7) Even if there is an exchange by Fund X of the original debt for the new debt, there generally should not be adverse tax consequences on the exchange itself, because Fund X's basis in the debt is the amount loaned and there would be no gain or loss.(fn8)
Foreclosure and deed in lieu of foreclosure Suppose Fund X forecloses or takes a deed in lieu of foreclosure and acquires the property on November 1, 2009. The property is worth $3 million. The loan balance remains $5 million. At that time, assuming Real Estate LLC missed the interest payments from September 1, 2008 to November 1, 2009 the accrued interest (assuming no compounding, fees, or late charges) would be $437,500.(fn11) Fund X uses the cash method of accounting, and any deficiency on Real Estate LLC's debt is not collectible* Possible creation of OID. In two years, there would be at least $700,000 of unpaid stated interest (assuming no compounding, fees, or penalty interest).(fn9) Should an exchange be deemed to have occurred, the question arises as to how to treat the accrued and unpaid interest. If the facts and circumstances indicate that Fund X has allowed Real Estate LLC to defer the payment of the interest, the "new" debt instrument could have OID of $700,000, if this amount is now part of the $5.7 million "redemption price" of the modified debt that exceeds the $5 million amount loaned. Given that the loan is in default, determining the due date of the modified debt (and the accrued and unpaid interest) may be difficult and will depend on the facts and circumstances. If the facts and circumstances indicate that the due date for both principal and deferred interest remains the note's due date of July 1, 2014, the OID may have to be reported as interest income by Fund X on a constant yield to maturity basis from September 1, 2010 (the date of the deemed modification) until July 1, 2014.(fn10)
* Deed in lieu of foreclosure-bad debt loss. If Real Estate LLC gives Fund X a deed in lieu of foreclosure, Fund X will have a bad debt loss equal to $2 million, which is the difference between its $5 million basis for the debt and the $3 million fair market value of the...
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