A road map of tax consequences of modifying debt.

• Author: Ro, Howard

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., NewYork City, Washington, D.C.), the U.S. commercial real estate market has been sluggish, mirroring job growth.

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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

on page 392.

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)

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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...