As the economy worsens and the recession deepens, more and more people
are renegotiating the loans on their
homes and businesses.
But, whether you are the borrower or the
lender, there’s a lot to it. There are hosts of
tax laws, regulations, benefits and consequences that you’ll need to be keenly aware
of in the event of a loan modification.
“There are many considerations that
come with a loan modification,” says Jay
Nathanson, an officer in the corporate and
tax departments at Greensfelder, Hemker &
Gale, P.C. “If you find yourself facing a loan
modification, it is in your best interest to
know what those considerations are.”
Smart Business talked to Nathanson
about the different tax consequences
borrowers and lenders may face in these
difficult times.
If a lender reduces the principal amount of a
loan to help a troubled borrower, what are
the tax consequences to the borrower?
In general, the borrower would have
income known as cancellation of indebtedness income. The income would be ordinary income measured generally by the difference between the principal amount owed
before the forgiveness and the amount the
borrower still owed following the forgiveness. The forgiven obligation would be
income to the borrower.
The rule is the result of United States v.
Kirby Lumber Co., where the U.S. Supreme
Court ruled that when the Kirby Lumber Co.
redeemed its debentures, or outstanding
notes, for a discount, that discount was recognized as income to the corporation. The
rule is also codified in the Internal Revenue
Code.
A similar rule would apply if someone
who is a related party of the borrower buys
the borrower’s debt at a discount from an
unrelated lender to avoid an end run around
the general rule.
If a lender agrees to otherwise alter the loan
instrument, what are the income tax consequences to the borrower and lender?
This is known as a significant modification
of a loan instrument, and when this happens, the instrument is treated as being paid
off for the issue price of the new instrument.
There are circumstances where the modification of a loan instrument can give rise to
ordinary income if the issue price of the new
instrument is less than the principal amount
owed under the old instrument. The term
significant modification is very broad and
can be triggered by things such as certain
changes of the interest rate, certain changes
of the timing for payments and changing of
the obligors.
There can be a tax problem for the borrower if the interest rate is lowered below
the applicable federal rate. If the interest
rate on the new debt instrument is below
the applicable federal rate, it is called an
original issue discount and the issue price
would be deemed to be lower than the face
amount of the note, which could give rise to
cancellation of indebtedness income to the
borrower. This is a mere modification of the
debt instrument as opposed to an out-andout forgiveness of the principal.
The lender could also have income, particularly if the lender purchased the debt
instrument from a prior lender at a discount. At the point the old debt is deemed
satisfied, since the new lender has purchased the debt at a discount with a low
basis in the debt, the new lender might recognize gain on the modification of the loan,
too. Mere modification of a debt instrument
is something that must be looked at closely
to make sure it doesn’t give rise to adverse
tax consequences.
Are there exceptions to the rules in response
to the first two questions?
There are many exceptions, but there are
five primary ones, applicable to borrowers,
which are all set forth in Section 108 of the
Internal Revenue Code. One, if the discount
occurs at a time that the borrower is subject
to a federal bankruptcy proceeding, the cancellation of the indebtedness income is not
recognized as income. Second, if the discharge occurs at a time when the borrower
is insolvent, the discharge income is not recognized to the extent of the insolvency. The
third exception is in the case of qualified
farm indebtedness, which is meant to help
out people in the farming industry. The
fourth is in the case of qualified real property business indebtedness, which applies
only to certain real property used for businesses. The fifth is a qualified principal residence indebtedness designed to help homeowners. There is a $2 million limit of indebtedness and the rule is temporary.
In connection with these exceptions, it’s
also important to note that some of them
require an election; they don’t happen automatically. Some of them also require what is
known as attribute reduction, which means
that to the extent that borrowers are permitted to exclude cancellation of debt from
income, they must give up other favorable
tax attributes such as loss carryovers and
basis in assets that they retain so that they
might give up these benefits at a later date.
Finally, it should be noted that the stimulus package now under consideration contains provisions that would defer the recognition of cancellation of debt income from
certain repurchases of debt until later
years.
JAY NATHANSON is an officer in the corporate and tax departments at Greensfelder, Hemker & Gale, P.C. Reach him at (314) 241-9090
or [email protected].
