Troubled debt transactions.

• Author: Ricketts, Robert C.

Inconsistencies in IRS Pronouncements Make It Difficult to Avoid Adverse Tax Consequences, Especially in Restructurings Involving Partnership-Debtors

Over the past few years, the Services has issued a number of pronouncements describing the tax treatment of various transactions involving troubled debt. Unfortunately, the rationale behind these pronouncements has been unclear, inconsistent and often contradictory. Thus, in many cases, it remains unclear what the correct tax treatment should be in certain troubled debt transactions, especially in those involving partnership-debtors. This article will discuss the options commonly considerably by lenders and borrowers in troubled debt transactions; examine the inconsistencies in the IRS's pronouncements; and focus on the difficulties faced by taxpayers when the nominal borrower is a partnership. In the process, a consistent logical framework is applied to suggest the correct tax treatment in a variety of troubled debt transactions involving all types of borrowers.

Options Available to the Lender and Borrower

A variety of options are available to lenders holding nonperforming loans. The most direct actions, of course, is foreclosure of the encumbered property (or other collateral) in satisfaction of the outstanding debt balance. Although the most direct action, this alternative is often not desirable due to the depreciated value of the target property, or the inability of the lender to efficiently manage or dispose of the property. One alternative to foreclosure is to renegotiate the terms of the nonperforming loan. Reducing the interest rate may encourage the borrower to continue (or resume) making payments on the loan. A second alternative may be to allow the borrower to settle the obligation at a discount, in effect renegotiating the principal balance rather than the interest rate. In other cases, when both the value of the encumbered property and the value of the borrower's other remaining assets have declined, the lender may accept an equity interest in the borrower (or the borrower's business) in satisfaction of the debt in the hope that future appreciation will be sufficient to offset the loan loss. As each of these alternatives involves distinctly different economic transaction, the tax consequences associated with each also vary.

* Foreclosure transactions - recourse debts

The tax consequences of foreclosure transactions involving recourse debts are well-settled. The regulations under Sec. 1001(1) provide that a foreclosure is treated as a sale of the encumbered property to the lender, but only to the extent of the lesser of the loan's outstanding balance or the property's fair market value (FMV). To the extent that the loan balance exceeds the FMV of the property, and the lender does not further pursue the borrower for satisfaction, the excess is taxable to the borrower as income from the discharge of indebtedness. The lender should be entitled to a bad debt deduction in the same amount.

Example 1: In 1989, B borrowed $100,000 from L to purchase raw land. The land, purchased at a total cost of $125,000, was pledged as security for the note. B also retained personal liability on the debt. In 1993, when the value of the land had fallen to $75,000, L foreclosed on the property in full satisfaction of the remaining $90,000 principal balance of the loan. B will be treated as selling the property to L for its FMV of $75,000, triggering a $50,000 loss ($75,000 sales proceeds - $125,000 original cost). This loss may or may not be deductible, depending on the nature of B's investment in the land. In addition, B will recognize $15,000 in income from the discharge of indebtedness ($90,000 outstanding loan balance - $ 75,000 FMV transferred in satisfaction of the loan). If B is solvent, this income is fully taxable on B's 1993 tax return. L will be entitled to a $15,000 debt deduction.

* Foreclosure transactions - nonrecourse debts

When foreclosure occurs on a nonrecourse loan, the transactions is treated as a sale in its entirety.(2) Thus, in Example 1, if the loan had been nonrecourse (i.e., if B had not retained personal liability on the debt). B would have realized a $35,000 loss, and would have recognized no income from the discharge of indebtedness.

The difference in the tax consequences of foreclosure on recourse and nonrecourse loans is significant because it establishes the principle that forgiveness of a nonrecourse debt does not trigger forgiveness of indebtedness income. This principle is based on the freeing of assets doctrine: cancellation of indebtedness income (CODI) is recognized for tax purpose only to the extent that forgiveness of an existing debt increase the borrower's equity in remaining assets. Insolvent borrowers have no equity in their remaining assets, even after discharge of the indebtedness, and thus are excepted from income recognition by Sec. 108. Similarly, nonrecourse borrowers do not experience an increase in the equity value of their remaining assets on forgiveness of a nonrecourse loan because they never had personal responsibility for the loan; that is, their remaining assets were never encumbered by the debt.(3) The regulations under Sec. 1001 explicitly except these borrowers from the recognition of CODI when their nonrecourse loans are discharged. As discussed below, however this principle has been discarded in recent IRS pronouncements.

* Changes in the terms of a loan

As noted, one alternative to foreclosure is renegotiation of the terms of the debt. Given the large swing in market interest rates over the past decade, many debtors find themselves holding notes bearing interest at rates above current market levels. At the same time, the decline in real estate values makes foreclosure an unattractive options for many lenders. A better options may be for the lender to agree to lower the interest rate in exchange for a renewed commitment by the borrower to make payments on the loan.

The tax consequences of this type of transaction are relatively straightforward. The Service has taken the position that this transaction constitutes the exchange of one debt instrument for another(4). As such, it triggers CODI to the borrower under Sec. 108(e)(11)(10)(renumbered by the Revenue Reconciliation Act of 1993 (RRA)), and a bad debt deduction to the lender, but only to the extent that the imputed principal balance of the modified debt is less than the outstanding principal balance of the existing note. For debts not publicly traded, the present value, or imputed principal amount, of the modified obligation is determined under Sec. 1274 using the applicable Federal rate as of the date of the modification(5). Thus, so long as the modified note bears interest at a reasonable rate, no CODI should result from a mere modification in the rate of interest or other note term. When the "new" interest rate is below market, however, the transaction will be treated as if the borrower had satisfied the note at a discount. The tax consequences of such treatment are discussed later.

* Settlement at a discount - recourse debts

The tax consequences are much less clear when the lender and the borrower renegotiate the principal balance of an existing note in lieu of foreclosure. Here, the outcome depends on whether the lender is the seller of the encumbered property, and whether the note is recourse or nonrecourse in nature.

When the note is not the result of a seller-financing transaction and is recourse in nature, reduction of the principal balance constitutes forgiveness of a portion of the debt, triggering CODI under Sec. 61(a)(12). Such income is taxable to the extent the borrower is solvent after the discharge. Sec. 108 allows deferral of income recognitions to the extent the borrower is insolvent(6).

Example 2: in 1990, B borrowed $250,000 on a recourse note from L. In 1993, when the outstanding principal balance of the note had fallen to $230,000, B satisfies the note with a payment of $150,000. After payment of the note, B's net worth is $25,000. Thus, applying the freeing of assets doctrine, satisfaction of the note has increased B's net worth by $25,000 (before repayment of the debt, B's assets were $150,000 higher and his liabilities were $230,000 higher; thus, his net worth was negative $55,000). Accordingly, B must recognize $25,000 in income from the discharge of indebtedness. The remaining $55,000 (total discharge was $80,000 [$230,000 principal balance - $150,000 settlement]) is deferred under Sec. 108 and must applied to reduce B's other tax attributes (net operating loss (NOL) and credit carryovers, etc.) or the basis of his remaining property.

* Settlement at a discount - nonrecourse debt

The Services has taken inconsistent positions on the appropriate tax treatment of discharged nonrecourse debt. As noted, the regulations under Sec. 1001 suggest quite strongly that CODI does not result from the forgiveness of nonrecourse debt?(7) The Service extended this principle to cases involving the reduction in debt outside of foreclosure transactions in Letter Ruling (TAM) 7953004(8) and in its arguments before the Tax Court in Gershkowitz(9). In Rev. Rul. 91-31,(10) however, it reversed its position, ruling that repayment of a nonrecourse debt at a discount will trigger CODI just as if the loan were recourse.

As noted above, the recognition of CODI has previously been based on the freeing of assets doctrine, which does not apply to the relief of nonrecourse liabilities (unless the value of the encumbered property exceeds the balance of the nonrecourse loan). Rev. Rul. 91-31 thus marks the first attempt by the Service to trigger CODI in these situations. As will be discussed below, a flurry of ruling issued at the end of 1992 suggests that the Service still has not fully come to grips with this position.

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