Cottage Savings regulations finalized in conjunction with newly issued bad debt regulations.

• Author: Ziegelbauer, John R.

The IRS recently finalized Regs. Sec. 1.1001-3. These regulations, originally proposed Dec. 2, 1992, are often referred to as the Cottage Savings regulations because they implement the Supreme Court's 1991 holding in Cottage Savings Association,, 111 Sup. Ct. 1503.

Personnel involved with debt modifications must understand these final regulations, which were effective Sept. 24, 1996. As illustrated, the modification of debt instruments may, in some cases, result in the recognition of gains or losses. In addition, the significant modification of a debt instrument may result in having to perform complicated original issue discount (OID) computations for the modified debt instrument (MDI).

Although Regs. Sec. 1.1001-3 is effective for the alteration of terms of a debt instrument on or after Sept. 24, 1996, taxpayers may choose to rely on it for alterations that occur after Dec. 2, 1992.

This article summarizes both Regs. Sec. 1.1001-3 and the elated new temporary bad debt regulations, Temp. Regs. Sec. 1.166-3T, and illustrates the potential pitfalls and benefits that exist for banks using a reserve method of accounting for bad debts.

Debt instruments are often altered in the ordinary course of business for a variety of reasons (e.g., debt restructuring, loan workouts necessitated by changing business conditions, etc.). To avoid unanticipated results, it is important to understand the potential tax consequences of modifying a debt instrument.

Regs. Sec. 1.1001-3 provides rules to determine whether an alteration in the terms of a debt instrument will result in the deemed exchange of the debt instrument for tax purposes. There are thee steps in doing so:

1. Determine whether the alteration of a debt instrument is a "modification."

2. If so, determine whether the modification is a "significant modification."

3. If the modification is "significant," a deemed exchange of the debt instrument has occurred and a gain or loss must be recognized at that time.

   When Is an Alteration a Debt Modification?

   An alteration of any legal right or obligation is considered to be a debt modification (Regs. Sec. 1.1001-3(c)). The modification can be made directly between the holder and the issuer or indirectly through third parties.

   Alterations by operation of original terms of the agreement generally are not considered modifications. Regs. Sec. 1.1001-3(c)(1)(u) contains a number of exceptions to this rule. The following alterations, which occur by operation of the original debt instrument terms, are modifications (Regs. Sec. 1.1001-3(c)(2)):

   * Any alteration that results in the substitution of a new obligor, the addition or deletion of a co-obligor or a change in the recourse nature of the debt instrument.

   * Alterations that result from the exercise of unilateral options.

   * Alterations that result from the exercise of holder options that defer or educe any scheduled payment of interest or principal.

   * Generally, alterations that result in an instrument or property right that is not debt for Federal income tax purposes. The conversion of a debt instrument into stock of the issuer, however, is not a modification, if it is done according to conversion rights contained in the original agreement.

   Nonperformance by an issuer does not necessarily result in a modification (Regs. Sec. 1.1001-3(c)(4)). A waiver of an acceleration clause or similar default right is not a modification for two years following the issuer's nonperformance. A longer period is allowed if the parties continue to conduct good faith negotiations or if there are pending bankruptcy proceedings.

   Testing for Significant Debt Modifications

   Regs. Sec. 1.1001-3(e) establishes four specific types of significant debt modifications and adds a general rule for modifications not covered by the four specific categories.

1. Change in yield.

2. Changes in timing of payments.

3. Change in obligor or security.

4. Changes in the nature of the debt instrument.

   A modification is generally tested when the parties agree to a change, even if it is not effective immediately...