The Bad-Debt Blues
It’s crucial to take federal taxes into account when restructuring debt
Posted Nov 1, 2009 10:10 PM CST
By Michael R. Ford and Lisa M. Zarlenga
Note: Register for this month's CLE, "Current Developments in Tax Law," from 1-2 p.m. ET on Wednesday, Nov. 18.
Despite recent murmurs that the recession may be easing its grip on the United States, debt continues to sap the financial strength of millions of families and businesses around the country.
Home foreclosure is one of debt’s most wrenching symptoms. In August, according to RealtyTrac, foreclosure filings were reported on 358,471 properties. That number amounts to one of every 357 housing units in the country.
There was a smidge of good news. Filings were down 1 percent from July. Still, there were 18 percent more than in August 2008.
Meanwhile, August consumer bankruptcy filings totaled 119,874, an increase of 24 percent over the number of filings in August 2008,according to the American Bankruptcy Institute, a nonpartisan organization that analyzes issues relating to insolvency. Here, too, there was a little bit of good news: The number of bankruptcy filings in August 2009 fell by 5 percent from July.
In the face of these numbers—and the very real personal turmoil they represent—more attention is being given to how lenders can cooperate with borrowers to reduce their debt, modify their mortgages and other obligations, and, in some cases, even cancel their indebtedness. For borrowers, such loan workouts represent another chance, while lenders improve their odds of receiving at least some repayment on loans.
A reduction, modification or cancellation of indebtedness can have significant consequences under federal tax law. Too often, however, debtors fail to take tax considerations into account when they restructure debt, especially as many of them try to navigate their way through the process without legal counsel.
This article gives an overview of the federal tax rules that apply to debt workouts, with a primary focus on how individual debtors are affected. (In many cases, additional rules apply to debt workouts for business entities.)
The essential tax rule that applies to cancellation of debt is fairly straightforward. Under section 61(a)(12) of the Internal Revenue Code of 1986, as amended, a taxpayer generally must recognize canceled debt as gross income. In most cases, income from cancellation of debt—called COD in tax shorthand—is taxed as ordinary income. (The creditor, meanwhile, is generally permitted to claim a corresponding bad-debt deduction under IRC section 166.)
There are a number of statutory exclusions for COD income set forth in IRC section 108 (discussed below). But the debtor pays a price for those exclusions in the form of reductions in debtor “tax attributes” (such as basis of assets and specified tax credits). These reductions can offset some benefits of excluding COD income from gross income.
Foreclosures and Repossessions
Most debt workouts, however, don’t involve simple cancellation of debt. A creditor may agree to accept a voluntary conveyance of the loan collateral in complete satisfaction of the debt—say, a house in the case of a mortgage—or the creditor can foreclose on or repossess the collateral.
Either of these actions, in effect, amounts to a sale of the property, so the debtor will have some mix of cancellation of debt income and capital gain under IRC section 1001. The mix of COD income and sale or exchange gain depends on whether the debt is recourse or nonrecourse.
In the case of a recourse debt—which allows the creditor to recover other debtor assets in addition to the original collateral—the conveyance of or foreclosure on the collateral is split between COD income and capital gain.
First, the transaction results in a capital gain or loss, which depends on the difference between the fair market value of the property and the debtor’s adjusted basis (original cost of the property reduced by depreciation and increased by capital improvements). Generally, the tax rate on capital gain is 15 percent.
If the fair market value of the property exceeds the amount of the debt, there is no COD income. If, however, the fair market value is less than the debt, then the debtor may realize COD income in the amount that the canceled debt exceeds the fair market value—in addition to any capital gain or loss. The debtor can avoid COD income if the creditor accepts a deficiency note to cover any shortfall between the value of the property conveyed and the amount of the debt.
If there is an auction or foreclosure proceeding, the bid price is presumed to equal the fair market value of the property in the absence of clear and convincing proof to the contrary. But a debtor should be wary of this presumption if a distressed sale yields very little, and should be prepared to rebut the presumption with an appraisal.
Example: A debtor’s house is subject to a $200,000 recourse mortgage, but the distressed sale yields only $25,000. If the debtor’s basis in the house exceeds $25,000, then the debtor realizes a nondeductible capital loss on the foreclosure, but has $175,000 of ordinary COD income. Any appraisal over $25,000 would reduce the amount of COD income. (Note, however, that the debtor may prefer COD income to sale or exchange gain if the debtor qualifies for one of the COD exclusions, discussed in more detail below.)
In the case of a nonrecourse debt—which bars a creditor from attaching assets of a debtor beyond the original collateral—cancellation of debt income is removed from the tax equation.
A voluntary conveyance or foreclosure of property in satisfaction of a nonrecourse debt is treated as a sale or exchange of the transferred property. The debtor simply realizes a capital gain or loss equal to the difference between the principal amount of the debt and the adjusted basis of the property.
Example: Let’s say a debtor has debt of $1 million secured by a house—a capital asset—with a fair market value of $800,000, and that the debtor’s adjusted basis in the property is $700,000. If the debt is nonrecourse, the foreclosure or voluntary conveyance is treated this way for debtor’s taxes:
Amount realized - $1,000,000
Taxpayer’s basis - 700,000
Capital gain - 300,000
If the debt is recourse, the foreclosure or voluntary conveyance is treated this way for debtor’s taxes:
Amount realized - $800,000
Taxpayer’s basis - 700,000
Capital gain - 100,000
COD income - $200,000 (remainder of debt)
If the debtor is able to exclude the COD income by reason of the bankruptcy or insolvency exclusions under IRC section 108, recourse debt might actually be preferable.
Modification of Debt
A creditor may agree to modify the terms of a loan or other debt, usually by reducing the interest rate or extending the maturity date. The tax consequences of such a modification depend on whether it is defined as “significant” under Treasury regulation section 1.1001-3.
Generally, a modification is significant under the regulation only if, based on all the facts and circumstances, the legal rights or obligations are altered in an economic manner and to a degree that changes the character of the debt in a major way.
A modification that changes the timing of payments, for instance, is significant if it results in the “material” deferral of scheduled payments. A deferral will be material if it extends a payment period more than five years or more than half of the original term of the loan, whichever is less. Other significant modifications in a debt may be indicated by changes in its yield to the creditor; the substitution of a new obligor replacing the original debtor on a recourse debt; a change in the collateral or guarantee on a nonrecourse debt; or changing the debt instrument from recourse to nonrecourse, or vice versa.
If the debt modification is not significant under the definition of the Treasury regulations, or if it was contemplated or provided for in the original debt instrument, then it generally has no tax effect.
If the modification is significant, however, the debt is deemed to be exchanged for new debt in a taxable exchange under IRC section 1001. In that case, the debtor will generally be treated as having satisfied the old debt with an amount of money equal to the issue price of the new debt.
Exceptions and Attribute Reduction
Illustration by Victor Koen
Exclusions From COD Income
As discussed above, the general rule is that cancellation-of-debt income is treated for federal tax purposes as ordinary income to the debtor.
But COD income may be excluded if the debtor falls within certain exceptions enumerated in Internal Revenue Code section 108. (In the case of debtors that are partnerships, the exclusions are applied at the partner level; for S corporations, the exclusions are applied at the corporate level.)
The two most important exclusions are for bankruptcy and insolvency.
COD income is not recognized for tax purposes if the discharge of the debt occurs in a federal bankruptcy proceeding pursuant to a plan approved by the court—whether filed under chapters 7, 11 or 13. Under the bankruptcy exclusion, there is no limit on the amount of COD income that may be excluded.
The insolvency exclusion, however, applies only when, and to the extent, a debtor’s liabilities exceed the fair market value of assets determined immediately before the discharge, and income may only be excluded to the extent of the insolvency.
Assets exempt from the claims of creditors must be counted in determining whether the debtor qualifies for the insolvency exclusion. This could be a factor as to whether the debtor seeks to use the insolvency exclusion or, instead, restructure in a formal bankruptcy proceeding.
Contingent liability is another factor in the insolvency computation. In 1999, the 9th U.S. Circuit Court of Appeals based in San Francisco ruled in Merkel v. Commissioner that a contingent liability should be counted toward insolvency only if the debtor proves by a preponderance of the evidence that he or she will be called upon to pay that liability. This is an all-or-nothing test that makes it more difficult for debtors to establish that contingent liabilities should be taken into account to establish insolvency.
There are other exclusions from cancellation of debt income that may be available to debtors under IRC section 108:
Qualified Farm Indebtedness. A debtor may exclude COD income resulting from the cancellation of “qualified farm indebtedness,” which is debt incurred directly in connection with farming operations, if 50 percent or more of the debtor’s aggregate gross receipts for the three taxable years preceding the taxable year in which the discharge occurs is attributable to the trade or business of farming. The excluded amount may not exceed the sum of the adjusted tax attributes of the debtor and the aggregate adjusted bases of property held or used in a trade or business, or for production of income.
Student Loans. This exclusion applies to certain student loans, but the discharge of the loan must be pursuant to a provision of the loan under which all or part of the indebtedness is discharged if the individual works for a certain period of time in certain professions for any of a broad class of employers.
Qualified Real Property Business Indebtedness. This is debt incurred or assumed to acquire, construct or substantially improve real property used in trade or business, and that is secured by the property. But this exclusion, which is available only to noncorporate debtors, may not be used if the cancellation of debt occurs in the course of a bankruptcy proceeding or if the debtor is insolvent. The amount excluded generally may not exceed the amount by which the principal amount of the discharged debt exceeds the fair market value of the property securing the debt.
Qualified Principal Residence Indebtedness. Under the Mortgage Forgiveness Debt Relief Act of 2007, this exclusion applies only to the discharge of this kind of debt if it occurs on or after Jan. 1, 2006, and before Jan. 1, 2013. The indebtedness must be incurred to acquire, construct or substantially improve any qualified principal residence, and be secured by that property. The exclusion is limited to $2 million of COD income for a married couple filing jointly ($1 million for single filers and married persons filing separately), and it must be used to reduce the basis of the principal residence.
If the indebtedness exceeds the monetary limits, or if a portion is used for a nonqualified purpose, those portions of the indebtedness will be deemed to have been canceled first and must therefore be treated as COD income.
As mentioned earlier, the price for excluding COD income is that certain specified tax attributes of the debtor then must be reduced.
When COD income is excluded by a debtor in conjunction with bankruptcy, insolvency or qualified farm indebtedness, the debtor’s tax attributes must be reduced in the following order: (1) net operating losses; (2) general business credits; (3) alternative minimum tax credits; (4) capital loss carryovers; (5) basis of assets; (6) passive activity loss and credit carryovers; and (7) foreign tax credit carryovers.
The credits are reduced at the rate of 331⁄3 cents for each dollar of excluded COD income. The other attributes are reduced on a dollar-for-dollar basis.
The reduction in attributes is made after the determination of taxes for the taxable year of the debt discharge. That means attributes arising in or carried to the year of the discharge may be used to reduce income or tax for the year of the discharge, and the remaining attributes themselves are reduced for the following year.
Flexibility in the rules for reducing attributes allows a debtor, with careful planning, to apply the rules to best advantage. Instead of reducing attributes in the order prescribed above, the debtor may elect, pursuant to IRC section 1017, to first reduce the basis of its depreciable property. In that way, the debtor may choose to preserve net operating losses for future years.
The exclusions from COD income for qualified principal residence debt and qualified real property business debt specifically provide for a reduction in the basis of the property securing the debt instead of following the ordering rules for attribute reductions.
Temporary Deferral of COD Income:
Congress provided additional—albeit temporary—relief to beleaguered debtors when it included a temporary deferral rule in the American Recovery and Reinvestment Act that became law earlier this year.
A couple of definitions will help explain the temporary deferral rule: An applicable debt instrument is one issued by an individual, corporation or other entity in connection with the conduct of a trade or business. This is broadly defined to include any bond, debenture note, certificate, or other instrument or contractual arrangement constituting indebtedness within the meaning of IRC section 1275.
A reacquisition of an applicable debt instrument may be made by the issuing debtor in one of the following ways: (1) acquisition for cash or other property; (2) exchange of the debt instrument for another debt instrument (including an exchange that results in a significant modification); (3) exchange of the debt instrument for corporate stock or a partnership interest; (4) contribution of a debt instrument to capital; or (5) complete forgiveness of a debt instrument by the holder.
Now, the rule: An eligible debtor may elect to defer COD income arising from its reacquisition of an applicable debt instrument during calendar years 2009 or 2010, in accordance with IRC section 108(i). The debtor may include the income ratably over a five-year period beginning in the fifth tax year following a reacquisition that occurs in 2009 and the fourth tax year for a reacquisition occurring in 2010. (See IRS Revenue Procedure 2009-37 for additional guidance.)
The debtor may make a deferral election separately for each applicable debt instrument that is reacquired. The election may apply to all or only a portion of the COD income that results from each instrument. Once made, a deferral election is irrevocable. Debtors who are not sure whether they will be deemed to have realized COD income in 2009 or 2010 may file protective elections under section 108(i).
If the debtor elects to defer, then the other exclusions from COD income are not applicable. But because the deferral election may apply to only a portion of COD income, the debtor has the flexibility to exclude some of it and defer other COD income. An insolvent debtor, for example, might elect to exclude COD income and reduce tax attributes to the extent of the debtor’s insolvency, but defer any COD income in excess of its insolvency.
Any COD income that is deferred under section 108(i) will be accelerated and added to income in the tax year in which the taxpayer dies, liquidates, sells substantially all assets or ceases to do business.
Consequences for Creditors
In most cases, a creditor that cancels debt, either by reducing the principal or accepting property worth less than the amount of the debt in full satisfaction, will be entitled to an ordinary bad-debt deduction under IRC section 166.
But except for C corporations, the rules governing deductibility depend on whether the bad debt is of a business or nonbusiness variety.
The creditor may deduct a nonbusiness bad debt as a short-term capital loss, while a business bad debt is entitled to an ordinary deduction from income. The difference matters. Although an ordinary deduction may be taken in full, a short-term capital loss may only offset capital gains, plus, in the case of individual taxpayers, $3,000 of other income.
To claim the deduction for a business bad debt, the creditor must establish that the debt became worthless during the taxable year in which it is being claimed—in other words, there is, in the creditor’s sound business judgment, no reasonable hope for recovery. That shouldn’t be too difficult to establish in the case of many debts during the current economic woes.
If, however, a creditor claims a bad-debt deduction and later recovers all or a portion of the bad debt, part of the recovered amount may be includable in the creditor’s income for the year in which it was recovered.
Sale or Exchange
To the extent that the creditor receives something in exchange for the debt—such as the underlying collateral, a modified debt instrument or an equity interest—the creditor will recognize gain or loss under IRC section 1001 equal to the difference between the value of what was received and the creditor’s adjusted basis in the debt.
The character of the gain or loss is determined by the character of the debt instrument in the creditor’s hands. If the creditor repossesses the underlying property, it takes a basis in the property equal to the amount of the debt satisfied plus any gain recognized.
Special rules (described in IRC section 1038) govern repossession of seller-financed real property, which can occur directly or through purchase in a foreclosure sale. In such cases, the seller does not recognize loss, nor is it entitled to a bad-debt deduction. But any gain is limited to the amount of cash (or the fair market value of other property) received prior to the repossession with respect to the sale of the property, less the amount of gain on the sale of the property already included in income, and any repossession costs.
If, after applying the value of the property to the unpaid debt, there still remains unsatisfied debt, the creditor may deduct that amount as bad debt.
The creditor must be sure to file the appropriate tax forms when it cancels debt or acquires an interest in property in a foreclosure or repossession. The creditor must send copies of any required informational forms to the debtor.
For a couple facing foreclosure or the owner of a small business struggling to make ends meet, the need to take tax consequences into account when trying to restructure debt might seem like adding insult to injury. But the reality is that there are few, if any, financial transactions that do not have tax consequences.
Ignoring them is not an appropriate strategy.
The only viable approach is to understand the applicable tax rules so that debt can be restructured in a way that minimizes the debtor’s tax liabilities.
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ETHICS PITFALLS FOR PRACTITIONERS—COMING IN DECEMBER
For Business Only
At least one key form of debt restructuring—an equity-for-debt exchange—is pretty much the exclusive province of business. And so are the tax rules that apply. If a debtor is a business entity, the creditor may agree to accept stock or a partnership interest in exchange for the debt instrument.
If the debtor is a corporation, IRC section 108(e)(8) provides that the debtor will realize cancellation-of-debt income equal to the difference between the adjusted issue price of the debt and the fair market value of the stock transferred to the creditor. Generally, the creditor will recognize gain or loss equal to the difference between the fair market value of the stock received and the creditor’s adjusted basis in the old debt. (If the debt is considered a security for tax purposes, then the exchange may qualify as a tax-free reorganization under IRC section 368.)
The American Jobs Creation Act of 2004 extended the equity-for-debt rule to include discharges of partnership indebtedness in exchange for a capital or profits interest in the debtor partnership. Accordingly, section 108(e)(8) provides that a debtor partnership has cancellation-of-debt income equal to the difference between the adjusted issue price of the debt and the fair market value of the partnership interest.
If the creditor already is a shareholder of the debtor corporation, the creditor might contribute the debt to the capital of the debtor without receiving stock in exchange. The debtor would realize COD income equal to the difference between the adjusted issue price of the debt and the shareholder’s basis in the debt, in accordance with IRC section 108(e)(6). If the shareholder’s basis in the debt is equal to the adjusted issue price, there would be no COD income. The shareholder would just increase its basis in the stock of the debtor corporation by the adjusted issue price of the debt.
The tax consequences can be significantly different depending on whether the debtor corporation issues stock in exchange for the debt or a shareholder-creditor contributes the debt to the corporation’s capital without receiving stock in exchange.
Say Debtor Corp. is indebted to Shareholder in the amount of $100,000, and it issues stock worth $20,000 to satisfy the debt. Debtor Corp. realizes COD income equal to the excess of the face amount of the debt over the fair market value of the stock, or $80,000. Shareholder recognizes a loss equal to the difference between the adjusted issue price of the old debt and the fair market value of the stock received, or $80,000.
But if Shareholder instead contributes the debt to Debtor Corp.’s capital, Debtor Corp. realizes COD income equal to the excess of the face amount of the debt over Shareholder’s basis in the debt, or $0. Shareholder would increase its basis in Debtor stock by the $100,000 adjusted issue price of the debt contributed.
Michael R. Ford is director of the Oklahoma City office of Fellers, Snider, Blankenship, Bailey & Tippens. Lisa M. Zarlenga is a partner at Steptoe & Johnson in Washington, D.C. Ford chairs the Professional Services Committee in the ABA Section of Taxation, and Zarlenga serves as a vice-chair of the committee.