« Back Avoid Recognition of Taxable Income Upon Cancellation or Modification of Debt

June 11, 2009

In this environment of distressed mortgage loans, many borrowers attempting to work out those distressed loans will be confronted with the added burden of having to recognize “cancellation of indebtedness income” (“COD Income”).  U.S. income tax rules generally require a borrower to recognize COD Income whenever the borrower’s indebtedness is reduced or when the borrower (or certain related parties of the borrower) reacquire the debt at a discount.  The amount of COD Income that must be recognized is generally equal to the amount of the reduction in the principal amount of the debt or the discount for reacquiring the debt.  This COD Income is then included in the borrower’s income at ordinary income tax rates.  For example, if a taxpayer previously borrowed $5 million from a lender and subsequently the lender either agrees to reduce the principal amount of the loan to $3 million or permits the taxpayer to discharge the loan for a payment of only $3 million, the taxpayer will generally be required to recognize COD Income of $2 million.  Fortunately, there are numerous exceptions to the general rule that permit the borrower to avoid recognizing COD Income upon the taxpayer’s debt being reduced or repaid at a discount.  The more significant exceptions are briefly summarized below.  As indicated below, many factors beyond the scope of this article must be considered in planning for and understanding the consequences arising from cancelling and modifying indebtedness, and it is best to consult one of our tax lawyers before entering into a transaction that may involve COD Income.
  • Insolvency and Bankruptcy Exceptions – If the indebtedness is discharged or cancelled while the borrower is insolvent (i.e., the borrower’s liabilities exceed the borrower’s assets), the borrower can generally exclude the COD Income equal to the amount by which the borrower is insolvent.  For purposes of these rules, a borrower is insolvent to the extent that the borrower’s liabilities exceed the fair market value of the borrower’s assets.  COD Income can also be avoided when the indebtedness is cancelled or reduced in connection with a Federal Bankruptcy proceeding.  Under this bankruptcy exception, the entire amount of debt that is extinguished or reduced qualifies for the exception without regard to the extent to which the borrower is insolvent.  Whenever the insolvency or bankruptcy exceptions apply, the borrower is required to reduce certain tax attributes by the amount of COD Income that is excluded.  For example, if the taxpayer has other assets, net operating losses, general business tax credits or capital losses, it will be required to reduce its basis in those assets and/or the amount of those losses or credits by the amount of excluded COD Income.  In the case of debt relating to partnerships and limited liability companies, it is important to remember that these exceptions apply at the partner or member level.  Therefore, the exceptions will apply only if the particular partner or limited liability company member is insolvent or is filing for bankruptcy.  Bankruptcy or insolvency of the partnership or limited liability company entity of which the taxpayer is a partner or member is not sufficient for these exceptions to apply to COD Income arising from debt of the partnership or LLC.
  • Qualified Real Property Business Indebtedness – Another exception applies to the cancellation or reduction of indebtedness that is secured by real property used in a trade or business and that is incurred or assumed to acquire, construct, reconstruct or substantially improve the property.  Debt incurred to refinance such property also qualifies to the extent it does not exceed the principal amount of the refinanced debt.  This exception is elective and applies to property owned by individuals, partnerships, limited liability companies, and S corporations.  It does not apply to entities classified as “C” Corporations.  If utilized, the tax basis of the borrower’s depreciable real property is reduced by the amount of COD Income excluded.
  • Qualified Principal Residence Indebtedness – Another exception permits taxpayers for a limited period to exclude COD Income arising from indebtedness used to acquire (or refinance) the taxpayer’s principal residence, generally up to the amount of $2 million.  As with the Qualified Real Property Business Indebtedness, the amount of COD Income that is excluded reduces the taxpayer’s taxable basis in the residence.  This exception was recently added to help alleviate the burden of COD Income arising from debt forgiveness in connection with the housing crisis.  It applies only to COD Income arising from the cancellation or reduction of indebtedness before January 1, 2010.
  • New Election to Defer COD Income – The American Recovery and Reinvestment Act of 2009 added a new provision that permits taxpayers to elect to defer COD Income arising from a “reacquisition” of the debt in 2009 or 2010.  The COD Income must be included in gross income ratably over a 5-year period beginning generally in the 2014 tax year.  This provision applies only to borrowings made by a C Corporation or otherwise in connection with a trade or business.  The term “reacquisition” includes a complete forgiveness of the debt.  A taxpayer will have to consider many limitations in evaluating whether or not to utilize this deferral election.  For example, COD Income deferred under the election will not qualify for the bankruptcy, insolvency or qualified real property business indebtedness exclusions described above and upon certain events, the deferral may be accelerated (e.g. sale of substantially all of the borrower’s assets, liquidation of the borrower or cessation of the borrower’s business activities).  In the case of partnerships, S corporations and limited liability companies, the election is made at the entity level.  Certain other special rules apply to partnerships and limited liability companies.  Therefore, particular care must be taken when the election is made with respect to indebtedness of a partnership or limited liability company.
  • Purchase Price Adjustments – COD Income can generally be avoided when the indebtedness being cancelled or reduced is debt of the purchaser of the property to the seller of the property (“a seller financed sale”).  In those cases, the amount of COD Income is treated as a purchase price reduction, thereby reducing the buyer’s basis in the purchased property.
  • Deductible Liabilities – No COD Income is required to be recognized to the extent that the borrower’s payment of the discharged liability would give rise to a deduction to the borrower.
  • Capital Contributions – In the case of corporations, a shareholder may contribute debt that the corporation owes to the shareholder and the corporation will not normally be required to recognize COD Income.
  • Satisfaction by Receipt of Corporate Stock or Partnership/LLC Interests – If a corporation, partnership or limited liability company satisfies its debt to a borrower by issuing an equity interest to the borrower, the entity will recognize COD Income only to the extent the debt being extinguished exceeds the fair market value of the equity interests being issued to the lender.  However, in these types of transactions, the lender receiving the stock is not entitled to recognize immediately a loss deduction equal to the COD Income being recognized by the corporation.  Proposed regulations similarly provide that in the partnership/LLC context, the lender will not be entitled to a loss deduction upon receipt of the partnership or LLC membership interest.
  • Foreclosure of Non-recourse Debt – When a borrower conveys property to a lender that secures an indebtedness that is non-recourse to the borrower (either in connection with a foreclosure or in contemplation of a foreclosure action), the borrower does not recognize COD Income.  Instead, the transaction is treated as a sale transaction and the borrower recognizes capital gain (or loss) to the extent of the difference between the principal amount of the indebtedness and the borrower’s tax basis in the property being extinguished.
If you are a borrower facing a foreclosure or other workout situation, be sure to consider the tax consequences of potentially having to recognize COD Income in determining what course of action is best for you.  Taft’s tax attorneys can help you choose the most advantageous structure.

This communication is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein.
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