When Restructuring Debt Be Sure to Be Aware of Potential Tax Consequences

(Last Updated On: January 24, 2017)

Much has been written over the past year and a half about the epidemic of home foreclosures.

Much attention has been given to how lenders can cooperate with borrowers to reduce their debt, modify their mortgages and in some cases even cancel their indebtedness altogether. For borrowers, such workouts represent a second chance, while lenders improve their odds of receiving at least some repayment on loans.

As part of this coverage, much has been made of borrowers who are “under water” meaning that the debt on their homes exceeds its fair market value. In some cases, borrowers have simply walked away from the debt deeming it economically unfeasible to continue to service it under the circumstances.

Often overlooked is the fact that a reduction, modification or cancellation of indebtedness can have significant consequences under federal tax law. Too often, 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.

At the outset, it should be noted that there are many additional rules that can apply to, for example, debt workouts for business entities, which will not be dealt with here.

General Rule

The essential tax rule that applies to the cancellation of debt is straightforward. Under § 61 of the Internal Revenue Code, a taxpayer generally must recognize cancelled debt as gross income. In most cases, income from cancellation of debt—called “COD income” in tax shorthand—is taxed as ordinary income (while the creditor is generally permitted to claim a corresponding bad debt deduction under § 166).

Note: there are a number of statutory exclusions for COD income set forth in § 108, the two most important being for bankrupt and insolvent taxpayers. The debtor pays a price for these exclusions in the form of reductions in debtor “tax attributes” (such as the basis of assets and specified tax credits). This discussion will be outside the business context and the exclusions for bankrupt and insolvent individuals.

Foreclosures and Repossessions. Most debt workouts do not involve simple cancellation of debt. More often, 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 may foreclose on or repossess the collateral.

Either of these actions amounts, for tax purposes, to a sale of the property, so the debtor may have some mix of cancellation of debt income and capital gain. The mix of COD income and sale or exchange gained depends on whether the debt is recourse or nonrecourse.

Recourse Loans

A recourse debt is one 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 on the difference between the fair market value of the property and the debtor’s basis (original cost reduced by depreciation and increased by capital improvements–generally, no depreciation deductions are taken on residential property).

If the fair market value of the property exceeds the debt, there is no COD income. If, however, the fair market value is less than the debt, the debtor may realize COD income to the extent that the cancelled debt exceeds the fair market value, in addition to any capital gain or loss.

If there is an auction or foreclosure, the bid price is presumed to equal fair market value in the absence of clear and convincing evidence to the contrary. Debtors should be aware of this presumption since a distress sale may yield very little, and the debtor should be prepared to rebut the presumption with an appraisal.

Note also that a capital loss on residential real estate is not deductible.

Example: A home is subject to a $300,000 recourse mortgage. A foreclosure sale yields only $50,000. If the debtor basis exceeds $50,000, then there is a nondeductible capital loss on the foreclosure. Further, the debtor has $250,000 of ordinary COD income (which would be reduced by an appraisal over $50,000). Note: The debtor may prefer COD income to capital gain if the debtor qualifies for one of the COD exclusions mentioned above, such as in the case of bankruptcy or insolvency.

Nonrecourse Debt

Nonrecourse debt bars a creditor from attaching assets of a debtor beyond the original collateral. In this case, there can be no COD income.

As with recourse debt, a voluntary conveyance or foreclosure in satisfaction of the debt is treated as a sale or exchange of the transferred property. The debtor realizes a capital gain or loss equal to the difference between the principal amount of the debt and the basis of the property.

Example: Debtor has a debt of $1 million. The debt is secured solely by the debtor’s home with a fair market value of $700,000. The debtor’s basis in the property is $600,000. Upon foreclosure, there is no COD income, but there is a capital gain of $400,000.

If the debt had been recourse, the foreclosure or involuntary conveyance would result in a capital gain of $100,000 and COD income of $200,000 (the remaining debt). Again, if the debtor is able to exclude the COD income under § 108, recourse debt might actually be preferable.

Modification of Debt

A creditor may agree to modify the terms of a loan, often by reducing the interest rate or by extending the maturity date. The tax consequences of this are not so clear and depend upon whether the modification is treated as “significant” under IRS regulations. Generally, a modification is “significant” if the legal rights or obligations are altered in an economic manner to a degree that changes the character of the debt in a major way.

For example, a modification that changes the timing of payments is significant if it results in the “material” deferral of scheduled payments. This will be the case if the payment period is extended more than 5 years or more than half of the original term of the loan, whichever is less.

If the debt modification is not significant under the regulations, it has no tax effect. If the modification is significant, the debt is deemed to be exchange for new debt in a taxable exchange and 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.

Again, the true economic impact of a cancellation or modification of debt can be severely affected by its tax consequences. These must be considered before a taxpayer opts for foreclosure or voluntary conveyance in satisfaction of a debt.

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