Sale or exchange treatment for debt modifications.

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 the final maturity date would be considered significant if it exceeded the lesser of five years or 50% of the instrument's original term;

* A change in a debt's obligor (with exceptions) or collateral; or

* A change in a instrument's nature (such as a change from a fixed to a variable rate).

On the other hand, subordination would not be a significant modification (Prop. Regs. Sec. 1.1001-3(e)(3)(v)).

If a modification results in a deemed exchange under the proposed regulations, the holder and issuer still may not realize gain or loss. For example, the refinancing of a residential mortgage with the same lender or the modification of a small business loan typically will not have tax consequences for either issuers or holders. An issuer's realization of discharge of indebtedness income under Sec. 108(e)(11) will depend on whether the adjusted issue price of the original instrument is less than, or greater than, the new instrument's issue price - determined under Secs. 1273 and 1274. A holder's realization of gain or loss will generally depend on whether the issue price of the new instrument is less than, or greater than, the holder's basis in the original instrument. In addition, even if a gain or loss is realized, certain nonrecognition provisions may apply.

The publication of these proposed regulations was designed to elicit comments on the desirability of providing rules for modifying debt instruments and comments as to what those rules might be. A public hearing on these proposals was held Feb. 17, 1993. Final regulations will apply only to modifications made on or after the date that is 30 days after final regulations are published. The IRS will then declare obsolete those revenue rulings no longer representing the Service's position.