Under Sec. 1001, gain or loss in recognized on "the sale or other disposition of property." (Emphasis added.) For an exchange of property to qualify as a disposition, the property received must differ materially either in kind or extent from the property that was transferred (Regs. Sec. 1.1001-1(a)).
The U.S. Supreme Court held in Cottage Savings Association, 111 Sup. Ct. 1503 (1991), that an exchange of participation interests in residential mortgages among savings and loan associations led to deductible losses under Regs. Sec. 1.1001-1(a). The Court indicated that the interests exchanged by the taxpayers were materially different because they were derived from loans made to different obligors and secured by different properties.
As a result of this decision, many questions have arisen on the materially different standard and its application to debt modifications.
In response, Regs. Sec. 1.1001-3 was proposed Dec. 2, 1992 to specify when a debt modification would be deemed an exchange of the original instrument for a modified instrument; only significant debt modifications, as defined therein, would produce exchange treatment.
The proposed regulations apply a two-prong test. First, in must be determined whether the original instrument was modified. A modification generally is any alteration in any legal right or obligation of the issuer or holder of a debt instrument (Prop. Regs. Sec. 1.1001-3(c)(1)). However, an alteration that occurs through the terms of the original instrument generally would not be a modification (Prop. Regs. Sec. 1.1001-3 (c)(2)(i)). Additionally, a temporary failure of the issuer to perform it obligations under an instrument, including a payment delay, would not be considered a modification (Prop. Regs. Sec. 1.1001-3(c)(2)(ii)).
Second, the modification must be significant. Prop. Regs. Sec. 1.1001-3(e) generally provides that a modification would be considered significant if any of the following occur:
* A more than 1/4% change in the annual rate for computing current interest payments;
* A change in the timing and/or amounts of payments that materially defers payments due under an instrument. An extension of...