Tax consequences of debt modifications.

• Author: Williford, Jerry S.

Debt instruments are often modified without any consideration of the possible adverse federal income tax consequences. This is especially true in the area of troubled real estate. The tax laws contain several situations in which the modification of a debt instrument can lead to problems.

The modification of a debt instrument may consist of lowering the interest rate, changing the maturity date, deferring the payment of interest, substituting collateral, etc. Some changes will have no tax effects; however, if there is a substantial or material modification, the modification may be treated as an exchange of the old note for a new note, which may have adverse consequences.

Installment note receivable

Sec. 453B states that "[i]f an installment obligation is satisfied at other than its face value or distributed, transmitted, sold, or otherwise disposed of," all or a portion of the deferred gain may be recognized. The IRS and the courts have held that certain modifications of an installment obligation may result in a deemed disposition of the note. For example, in Rev. Rul. 82-188, the Service found that a disposition had occurred when the obligor substantially increased the face amount of its obligation in return for the taxpayer waiving his right to convert the obligation into shares of the obligor's common stock. On the other hand, the IRS had ruled in Rev. Rul. 68-419 that the deferral of payment dates and the increase in the interest rate were not enough to cause a deemed disposition.

It appears that in the installment sale area, the Service is, or has been, more tolerant with debt modifications than in other areas.

Partner nonrecourse loan

Modification of a pre-Mar. 1, 1984 nonrecourse note issued to a partner may produce adverse tax consequences.

In determining the basis of the partners' interest in a partnership, a nonrecourse partner note executed after Feb. 28, 1984 is allocated solely to the partner making the loan (Temp. Regs. Secs. 1,752-1T(d)(3)(i)(B) and -4T(b)). In addition, deductions attributable to the post-Feb. 28, 1984 nonrecourse partner note must also be allocated solely to the lending partner (Temp. Regs. Sec. 1.704-1T(b)(4)(iv)(h)).

However, if a pre-Mar. 1, 1984 partner nonrecourse note is substantially modified, the IRS could treat the note as a new partner nonrecourse note subject to the new rules. In such an event, the nonlending partners could suffer a substantial reduction in basis, possibly resulting in gain under...