Tax consequences of debt modifications.

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 Sec. 731(a), if this reduction in basis (which is treated as a cash distribution under Sec. 752(b)) exceeds the remaining basis in their partnership interests.

Nonrecourse note payable

to financial institution

The Tax Reform Act of 1986 (TRA) subjected real estate to the at-risk rules of Sec. 465 (with certain exceptions). A modification of a pre-1986 nonrecourse real estate mortgage note could result in such note becoming subject to the TRA.

Original issue discount

A substantial modification of a note is considered to be a sale of the old note for a new note. Therefore, the modification of an existing note that results in a "new" note having an issue price less than the outstanding balance of existing debt may create original issue discount (OID) (Prop. Regs. Sec. 1.1274-1(c)).

However, this rule will not apply to a note arising from the sale of property, unless the sale took place after Dec. 31, 1984 (Prop. Regs. Sec. 1.1274-1(e)).

Cancellation of

indebtedness income

If a substantial modification occurs to a note, a portion of the principal of the debt may be deemed to be canceled. (See Sec. 108(e)(11), added by the Revenue Reconciliation Act of 1990.) The cancellation will be equal to the difference between the outstanding debt's principal amount and the issue price of the new debt determined under Secs. 1273 and 1274. (Note: If the taxpayer is insolvent or bankrupt, the discharge is generally not taxable (Sec. 108(a)).)

Example: A $1,000,000 note bearing interest at 12% is replaced with a $1,000,000 note bearing interest at 5%. Debt discharge income could result since the new note does not bear adequate interest. The principal must be recomputed based on the applicable federal rate. If the $1,000,000 note is recomputed to consist of $850,000 of principal and $150,000 of interest, the taxpayer has debt discharge income of $150,000. (This result was suggested by Prop. Reg. Secs. 1.1274-1(c)(2) and 1.1273-2(f)(5).)

Conclusion

While a debt modification may be welcomed for business and economic reasons, the potential adverse tax effects must also be considered. It is not always clear the extent to which a note can be modified before it is considered to have been exchanged for a new debt instrument. It is conceivable that a particular change may result in adverse consequences in one of the areas previously discussed but not in another. For example, a reduction in interest rate generally will not result in a deemed disposition of an installment note receivable. However, a change in interest rate could result in the application of the OID rules or create forgiveness of indebtedness income.