A Few Things to Remember
About Debt Restructuring
Forrest Milder, Nixon Peabody LLP
Roger Yorkshaitis, Gatehouse Group, Inc.,
NH&RA
Fall Developers Forum
Overview -- 1
• The cancellation of a partnership debt is generally
treated as taxable cancellation of indebtedness income under IRC section 61(a)(12).
• Renegotiation of a debt instrument can have the same result.
• Cancellation of indebtedness income may not be taxable due to an exception (typically under IRC
section 108), or it may be considered a taxable gain from the sale/exchange of property under IRC section 61(a)(3).
Overview -- 2
• Section 108(e)(2) -- If payment of the debt would have given the taxpayer a deduction, then the taxpayer does not realize COD income. E.g., when a cash basis
taxpayer's obligation to pay an expense is cancelled.
• The taxability of COD income is determined at the partner level. Each partner's distributive share of COD income and sale or exchange gain is separately stated on his or her Schedule K-1.
Sale of Property Subject to Nonrecourse Debt
• COD income is not realized when property that secures non-recourse debt is sold, foreclosed on, conveyed by deed-in-lieu of foreclosure or abandoned.
• Instead, the property is considered sold for the amount of the non-recourse obligation. See Tufts v. Commissioner, 461 U.S. 300 and section 7701(g)).
• In general, it does not matter that the “real” fair market value of the property is equal to or less than the amount of the debt. But see “qualified real property business indebtedness,” below.
Section 108(e)(10)
• If a debtor issues a new debt instrument in
satisfaction of indebtedness, the debtor is treated as satisfying the indebtedness with an amount of money equal to the issue price of the new debt instrument. • Sometimes, when an existing debt is simply
modified, the revisions are considered to be enough of a change that the debtor is taxed as if it has issued a new debt in satisfaction of the old one.
• Typically, tax advisors review the regulations under section 1001 to see if the change is sufficient to
Modifications under 1.1001-3 Regulations
--1
• These can result in a new debt “issuance” that must
be “tested” to see if there is COD income
--› Change from recourse to nonrecourse or vice versa › Different obligor on a recourse debt
› Different asset securing a nonrecourse debt › Change in “payment expectations”
Modifications under 1.1001-3 Regulations
--2
• More factors that can result in a new debt “issuance”
and must be “tested” to see if there is COD income
--› Change that is 25 basis points or 5% of original rate (up or
down)
› Deferral that is more than 5 years of 50% of original term (if less)
› Cumulate modifications
› Some unilateral modifications, or pursuant to the terms of the debt don’t count.
Illustrations -- 1
• $5M debt pays 3% interest, all due in 2010. Lender
agrees to accept payment with interest continuing to
accrue until payment:
› In 2012 – OKAY (under 5 years)
› In 2016 – Must be tested (more than 5 years)
› In 2012 with 2.8% interest – OKAY (less than 25 basis points)
Illustrations -- 2
• Loan is due in 2012
› Extension to 2016 is okay (under 5 years)
› However, a second extension to 2020 must be tested, even though each extension was under 5 years; together, they are over 5.
› Remember that interest must continue to accrue
• $5M debt is recourse and secured by Property X
› Debt becomes nonrecourse, but still is expected to be repaid – OKAY
Illustrations -- 3
• Suppose a soft $5M loan pays 2% interest, with all principal and interest due in December, 2010.
• Today’s AFR is 4%, and one modification is made -- the loan is extended by ten years. Assume that the loan
continues to bear interest at 2%, with all principal and interest due in 2020.
• So, the borrower is getting a loan that requires it to pay $6,217,000 at 2020, but using a 4% AFR, that payment, ten years from now, is only worth $4,038,000 today.
Illustrations -- 4
• Suppose a soft $5M loan pays 7% interest, with all principal and interest due in December, 2010.
• Today’s AFR is 4%, and two modifications are made -- the loan is extended by ten years, and it now bears interest at 4%, with all principal and interest due in 2020.
• Even though the interest rate has been reduced from 7% to 4%, there is no COD income, because the “new” loan is at AFR.
1274-5(b) Regulations
• If property is taken subject to debt in connection with a sale or exchange, and the terms are modified as part of the sale or exchange, and the modification is an exchange under section 1001, the modification is treated as a separate transaction
taking place immediately before the sale or exchange and is attributed to the seller of the property.
• Only applies if seller knew or had reason to know about the modification.
• The seller and buyer may jointly elect to treat the transaction as one in which the buyer first assumed the original (unmodified) debt instrument and then subsequently modified the debt
Assuming debt as part of a sale -- 1274(c)(4)
• In connection with the sale or exchange of property, an assumption of debt is not taken into account unless the
terms and conditions of such debt instrument are modified (or the nature of the transaction is changed). • What does the phrase “terms and conditions” mean? • Illustration: Property secures $5M debt bearing 3%
interest, and buyer takes subject to this debt. Does the debt have to be revised to be AFR? No.
• Suppose the due date for the debt is extended by 3
Qualified Real Property Business Indebtedness
• Section 108(a)(1)(D) allows an exclusion for
discharges of qualified real property business indebtedness.
› After 1993, must be “acquisition indebtedness” › Doesn’t apply to C corporations
• The amount excluded cannot exceed the excess, if any, of the outstanding principal amount of the
indebtedness immediately before the discharge over the net fair market value of the qualifying real property. • Must reduce basis
Illustration of QRPBI and Nonrecourse Debt
• Assume partnership owns a building subject to $1.5
million non-recourse debt, and lender agrees to accept $1 million in full satisfaction.
› Assume that the value of the building is $1.2M.
› Partnership realizes COD income of $300,000 ($1.5M of debt less $1.2M of property’s FMV) that is eligible for the QRPBI exclusion.
› Partnership realizes taxable COD income of $200,000 ($500,000 Total Debt Canceled less $300,000 Excluded under the QRPBI exception.
Acquisition of Debt by a Related Person
• Section 1.108-2 of the regulations
• If a person “related” to the debtor acquires the debt at a bargain price, then the debtor still has cancellation of indebtedness
• Related is based on Sections 267, 707 (essentially, 50%
related) and 414 (“common control”, generally 80% of vote or value for corporations, and 80% of profits or capital interests for partnerships and LLCs; can be in a “chain” or the same people owing brother/sister entities)
• If parties become related up to 2 years later, the IRS must be notified. Presumption they are related where the relationship develops within 6 months.
“Reacquisition” of debt instrument
• New rule under American Recovery and Reinvestment Act (“ARRA”)
• If borrower buys its own business indebtedness, it can recognize income over 5 years, starting in 2014.
• Also applies to related party acquisitions of debt • Section 108(i)
Section 108(e)(5)
• Adjustment to purchase money debt of a solvent debtor is considered a “purchase price adjustment”
• What is purchase money debt?
› Only if provided by seller? (IRS thinks so - see audit manual) › Only if incurred at time of acquisition?
Writing down unpaid development fees
• Would this affect basis computation?
• Is there cancellation of indebtedness?
• Suppose there’s a GP guarantee? Should it be
enforced?
Renegotiating Below Market Government Loans
• Section 7872 regulations define “below market
loans”. Here are a few exceptions:
› Loans made available by the lender to the general public on the same terms and conditions and which are consistent with the lender's customary business practice;
› Loans subsidized by the Federal, State, or Municipal
government (or any agency or instrumentality), and which are made available under a program of general application to the public;
› Loans made by a private foundation or other organization described in section 170(c), with the primary purpose of
Rev. Rul. 98-34
So, what happens if an excepted loan is renegotiated?
Can it still take advantage of these exceptions?
• Rev. Rul. 98-34 involves an existing $100 HUD loan; pursuant to the “mark to market” program, HUD lends borrower $35 with very soft repayment terms, and borrower uses the $35 to pay down a portion of the existing $100 loan.
• The $65 loan is at AFR; the $35 loan is below AFR.
• IRS rules that the $35 loan qualifies for the exception from Section 7872 as a government loan “under a program of
Don’t forget the “Big Picture”
• Opinion – If no one is seeking an opinion, can the parties
be more aggressive?
• Don’t forget the 6 month/2 year rules under Section 108
• Will there be a new Syndication? – will likely have to
satisfy the new investor that it won’t have COD income
• Do all adjustments to debt before the new investor
Contacts
Forrest David Milder
Nixon Peabody LLP 100 Summer Street Boston, MA 02110
617-345-1055
Roger Yorkshaitis
Gatehouse Group, Inc. 120 Forbes Boulevard
Mansfield, MA 02048 508.337.2500
