Tax Issues In Acquiring Debt

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1 Tax Issues In Acquiring Debt Charles R. Beaudrot Partner, Tax and Real Estate Capital Markets Practices Timothy S. Pollock Partner, Tax, Real Estate and Real Estate Capital Markets Practices

2 INTRODUCTION Tax issues associated with purchasing debt: Purchasing debt at a discount Disposition of purchased debt Post purchase foreclosure Original Issue Discount ( OID ) and market discount rules Dangers of post acquisition debt modifications 2

3 INTRODUCTION (CONT D.) If you have questions during today s Webinar, you may submit them via the Questions button in the top right corner of your screen. We will answer those and any other questions you have during the final minutes of the presentation. If you think of questions after today s Webinar, please contact: Chuck Beaudrot or Tim Pollock or 3

4 ILLUSTRATION FACT PATTERN: Promissory Note face amount: $1,000,000 Secured by shopping center with a FMV: $ 600,000 Outstanding Balance: (principal) $1,000,000 Interest Rate: 5.5% Original Term: 5 Years Remaining Term: 2 Years Acquisition Purchase Price: $ 500,000 4

5 ILLUSTRATION (CONT D.) SIMPLE EXAMPLE: Purchase $1M Note for $500,000 and sell the next day (or allow Borrower to satisfy) for $700,000. Sales Price: $700,000 Basis (Purchase Price): $500,000 Gain: $200,000 Tax (At 40%): 80,000 Net: $120,000 CONCLUSION: NO PROBLEM. Have $700,000 Cash To Pay $80,000 Tax. 5

6 ILLUSTRATION (CONT D.) THE PROBLEM: Phantom Income - Taxable income with no cash (or insufficient cash) to pay taxes. 6

7 ILLUSTRATION (CONT D.) PHANTOM INCOME RISKS: - Purchasing debt at a discount can present many opportunities to produce phantom income. - Mandatory interest income accruals under common law and OID rules can apply without regard to interest payments. - Foreclosure can produce income without cash. - Cottage Savings debt exchange rules can produce income without cash. 7

8 SPECIAL REIT ISSUES Besides the inconvenience of phantom income producing a tax liability without cash,oid, market discount, accrual accounting and debt exchange issues can be particularly important for REITS. 8

9 SPECIAL REIT ISSUES (CONT D.) REMEMBER: - REITS must distribute at least 90% of taxable income (even if there is no cash associated with that income.) - Also, as a practical matter, fund investors may not be happy with loads of phantom income allocations. 9

10 FORECLOSURE PHANTOM INCOME Buy Note for: $500,000 Foreclose 90 days later and receive property with FMV: $600,000 Gain: $100,000 Tax liability at 40%: $ 40,000 Cash: $ 0 FMV of property is subjective and open to debate. Battle of appraisers; but not uncommon to pay less for note to compensate for foreclosure risks (e.g., bankruptcy, legal fights, etc.). 10

11 DISTRESSED DEBT FUND: INTEREST, OID AND MARKET DISCOUNT ACCRUALS HISTORICAL COMMON LAW ANALYSIS: - Under tax common law, must an accrual method taxpayer continue to accrue interest as long as the taxpayer has the legal right to receive that interest from the borrower? - No, a taxpayer can stop accruing interest on a debt it holds if there is no reasonable expectation of collection of the debt. - Rule arose out of Corn Exchange Bank, 37 F2d 34 (2d Cir. 1930) and Jones Lumber Co., 404 F2d 764 (6 th Cir. 1968) cases. - IRS took the view in TAM that this case law does not apply to OID accruals. 11

12 DISTRESSED DEBT FUND: CHARACTERIZATION OF PAYMENTS AT COMMON LAW: - Designations of parties as principal or interest respected. - Undesignated payments prior to maturity treated first as interest to the extent accrued. - Payments at maturity treated first as principal to the extent thereof. 12

13 DISTRESSED DEBT FUND: CHARACTERIZATION OF PAYMENTS (CONT D.) Reg (e) says that all payments are treated first as interest to the extent accrued, then as principal. Regulation has no exception for distressed debt, but unclear that taxpayers have to treat a partial payment on a nonperforming loan as attributable first to interest. Arguable that an unscheduled payment is not under the debt instrument. 13

14 DISTRESSED DEBT FUND: OID INCOME - Generally, OID is the difference between the amount loaned and the higher amount due at a later date. 14

15 DISTRESSED DEBT FUND: OID INCOME (CONT D.) - Original Issue Discount typically arises in two common very similar circumstances: - First, lender loans less than face amount so that amount due at maturity exceeds issue price. EXAMPLE: Lender loans $80,000 without stated interest, and Borrower has to repay $100,000 at maturity five years later. The $20,000 difference is OID and has to be taken into income over the five year term of the loan. 15

16 DISTRESSED DEBT FUND: OID INCOME (CONT D.) - Second, balloon payment that includes accrued but unpaid interest. EXAMPLE: Lender lends $80,000. Interest accrues at the rate of 8%, but only 4% is payable annually and the remaining 4% is payable at maturity on the fifth anniversary. The $16,000 in interest that accrues and is payable at maturity is OID and has to be taken into income over the five year term of the loan. 16

17 DISTRESSED DEBT FUND: OID INCOME (CONT D.) - Original issue discount must be taken into income periodically over term of the loan, regardless of payment stream; analogous to being placed on accrual basis accounting method. - Statutory provisions override common law analysis: parties interest and principal labels are irrelevant. 17

18 DISTRESSED DEBT FUND: OID INCOME (CONT D.) - Purchaser of Note inherits the existing OID income stream. Therefore, based on existing terms of the note, could have interest income without cash payment regardless of ability of the Borrower to pay. 18

19 DISTRESSED DEBT FUND: MARKET DISCOUNT BASIC RULES Market discount is like OID except market discount applies to the purchase of existing debt rather than to the making of the original loan. Market discount is defined as the excess of the face amount of a debt instrument over the taxpayer s basis in the debt. EXAMPLE: If taxpayer purchases $1,000,000 note for $500,000, the market discount is $500,

20 DISTRESSED DEBT FUND: MARKET DISCOUNT APPLICATION TO DISTRESSED DEBT (CONT D.) - Market discount rules are premised on the notion that the discount is an interest equivalent; the statute does not distinguish between market discount that arises from market interest rate increases above the stated note rate versus a reduction in the value of security or doubt as to collectability. 20

21 DISTRESSED DEBT FUND: MARKET DISCOUNT APPLICATION TO DISTRESSED DEBT (CONT D.) Market discount accrues on a straight line basis over remaining life of debt unless the taxpayer elects constant yield accrual (e.g., IRR type calculation assuming compounding of interest). EXAMPLE: So if the market discount is $500,000 per the preceding example, then $250,000 market discount would accrue annually over the remaining 2 year term of the loan. 21

22 DISTRESSED DEBT FUND: MARKET DISCOUNT BASIC RULES (CONT D.) - Unlike OID, accrued market discount generally is taken into income as payments are made. - All payments on the loan are characterized as interest up to the amount of the accrued market discount that has not already been taken into income. If the loan is an amortizing loan: - Market discount is taken into income periodically as amortization payments are made. - Each payment of principal must be treated as ordinary income to the extent of the accrued market discount that has not already been taken into income. - Gain on the sale or retirement of a debt instrument is treated as ordinary income to the extent of the accrued market discount. 22

23 DISTRESSED DEBT FUND: MARKET DISCOUNT BASIC RULES (CONT D.) - Taxpayer can elect to accrue market discount on a constant interest rate basis, applying compounding principles similar to those applicable under the OID rules. - A taxpayer may choose to use the constant rate accrual method so that less of the market discount accrues upfront and more of the market discount is pushed to the back end based on compounding principles. This may reduce the amount of sale proceeds characterized as accrued market discount on a quick sale of the note. 23

24 DISTRESSED DEBT FUND: MARKET DISCOUNT APPLICATION TO DISTRESSED DEBT Literal application of rules can produce harsh timing and character results. Example Debt with face of $1,000,000 purchased for $500,000 with 2 years to maturity. Therefore, $500,000 of market discount accrues at the rate of $250,000 per year for the remaining 2 year term. After 1 year, debtor pays $200,000 labeled as principal. If rules are applied literally, all $200,000 would be ordinary income. 24

25 DISTRESSED DEBT FUND: MARKET DISCOUNT APPLICATION TO DISTRESSED DEBT (CONT D.) - Taxpayer can elect to take market discount into income currently under OID principles. - If do not elect to take into income currently, then cannot deduct interest on any debt incurred to fund the purchase of market discount note until the market discount is taken into income. - Risk of Election: If the taxpayer elects to include the market discount in income currently, the election thereafter applies to all market discount debts acquired by the taxpayer. 25

26 POOL ACCOUNTING VS. INDIVIDUAL LOAN ACCOUNTING Purchase of a Pool of Loans presents accounting complexity. Example Suppose a taxpayer buys a pool of distressed loans for 20% their $10,000,000 of face (i.e., purchase price is $2,000,000 total). A loan with a face amount of $1,000,000 (e.g., 10% of the total $10M face) is settled for $500,000. Does taxpayer have $300,000 of gain (e.g., $500,000 received less $200,000 (10%) of total cost basis), or can it simply reduce basis by $500,000? 26

27 POOL ACCOUNTING VS. INDIVIDUAL LOAN ACCOUNTING (CONT D.) General rule on debt is that each debt stands on its own. But United Mercantile Agencies, 23 T.C. 1105; 1955 U.S. Tax Ct. and the 1997 expansion of section 1272(a)(6) both support pool-wide open transaction treatment. If using pool accounting, what constitutes a pool? 27

28 DISTRESSED DEBT FUND:TAX TRAPS LOAN MODIFICATIONS - Fund formed for the purposes of purchasing non-performing or under performing debt. DANGER! DANGER! DANGER! - Modification of debt after acquisition requires debt exchange analysis. - Significant Modification triggers exchange. - If exchange deemed to occur, Holder of Note deemed to exchange old $1,000,000 Note for new $1,000,000 Note. 28

29 DISTRESSED DEBT FUND: TAX TRAPS LOAN MODIFICATIONS (CONT D.) - Not a problem for the original Lender because its basis in the old Note equals the original loan amount (i.e., the face amount of the old Note). Lender: FMV of New Note $1M Basis in Old Note: $1M Gain $ 0 29

30 DISTRESSED DEBT FUND: TAX TRAPS LOAN MODIFICATIONS (CONT D.) - For the new holder of the Note, however, this could be a big problem. FMV of New Note*: $1,000,000 Basis in Old Note (e.g. Discounted Purchase Price): $ 500,000 Phantom Gain** $ 500,000 * Determined using applicable federal rate and PV calculations, not appraisal. ** Short term capital gain or ordinary income depending on activities of holder of the Note. 30

31 MODIFICATIONS TRIGGERING DEEMED EXCHANGES The Cottage Savings regulations trigger a deemed exchange upon any significant modification. 31

32 MODIFICATIONS TRIGGERING DEEMED EXCHANGES (CONT D.) - While a single modification may not be significant on its own, modifications are looked at collectively and in the aggregate. - There are 10 bright-line tests and safe harbors: 1. Change in yield. Regs (e)(2)(ii); - 25 basis points (.25%) or 5% of the annual yield is deemed significant. 32

33 MODIFICATIONS TRIGGERING DEEMED EXCHANGES (CONT D.) 2. Change in timing of payment. Regs (e)(3)(i); - Payment is deferred more than the lesser of five years or 50% of the original term of the Note. - Apparently extension options in the Note are not considered unless Borrower can unilaterally extend without conditions. 33

34 MODIFICATIONS TRIGGERING DEEMED EXCHANGES (CONT D.) 3. Change in Obligor. Regs (e)(4)(ii); (Note: Not a change for non-recourse obligation, but it is for a recourse obligation); 4. An addition or deletion of a Co-Obligor. Regs (e)(4)(iii); if it affects likelihood of repayment; 34

35 MODIFICATIONS TRIGGERING DEEMED EXCHANGES (CONT D.) 5. Change in security or credit enhancement. Regs (e)(4)(iv); - Generally significant in recourse debt only if changes likelihood of repayment. - Generally significant in case of a non-recourse loan. 6. Change in priority of debt. Regs (e)(4)(v); - Significant if changes likelihood of repayment. 35

36 MODIFICATIONS TRIGGERING DEEMED EXCHANGES (CONT D.) 7. Change from debt to equity. Regs (e)(5)(vi); 8. Change in recourse nature. Regs (e)(5)(vii)(A); - Change from recourse to non-recourse is significant. - Change from non-recourse to recourse is significant. 36

37 MODIFICATIONS TRIGGERING DEEMED EXCHANGES (CONT D.) 9. Change in customary financial covenants. Regs (e)(6); - Generally not significant. 10. Indirect tax exempt bond modifications. Regs (f)(6). 37

38 MODIFICATIONS TRIGGERING DEEMED EXCHANGES (CONT D.) CAREFUL: Two Most Common Modifications: Change in Yield and Deferral of Payments: EXAMPLE: Change in Yield: - Original Note Rate & Yield: 5.5% - Modified Yield: 5.0% Yield has deceased by 50 basis points; also yield has decreased by 9.09% (.5 5.5%). Conclusion is the modification was significant. 38

39 MODIFICATIONS TRIGGERING DEEMED EXCHANGES (CONT D.) EXAMPLE: Modification: Conclusion: Change in Timing Original Term: Remaining Term: 5 Years 2 Years Maturity extended 2 years and next six months of payments deferred to maturity. While extension of maturity by 2 years does not exceed 50% of the original 5 year term, deferring the next six months payments to maturity is more than a 3 year deferral (2 year remaining term plus 2 year extension) which is more than 50% of original term. Therefore, modification is significant. 39

40 MODIFICATIONS TRIGGERING DEEMED EXCHANGES (CONT D.) OTHER: Adding guaranty or additional collateral to non-recourse debt is generally significant. 40

41 DISTRESSED DEBT FUND: TAX TRAPS LOAN MODIFICATIONS Solution: - If possible all modifications should be made by original lender prior to purchase of note. REMEMBER: MODIFY BEFORE YOU BUY 41

42 CHARACTER CONVERSION Risk of ordinary income recognition, followed by loss on disposition: Issue: Capital Loss vs. Ordinary Loss Conclusion:? Worthless Security IRC - Bad Debt IRC

43 CHARACTER ISSUES ARE LOANS CAPITAL ASSETS? The fact that a fund is engaged in a business of buying distressed loans` does not necessarily result in the loans being treated as ordinary assets. Since a Supreme Court decision in Arkansas Best, 485 U.S. 212 (1988), property is treated as a capital asset unless a statutory provision makes it ordinary. 43

44 CHARACTER ISSUES ARE LOANS CAPITAL ASSETS? (CONT D.) Loans are ordinary assets only if - Inventory, stock in trade, held for sale to customers. (Competing Issue: Impact of dealer status on tax exempt investors and UBTI.) Notes or accounts receivable acquired for services or from the sale of other ordinary property. 44

45 CONCLUSIONS Buying debt has tax risks for the purchaser most commonly in the form of phantom income. It is usually better to modify debt before purchase. Purchases of debt raise significant O.I.D. and market discount issues for the purchaser. Accounting issues are complex, especially in connection with the acquisition of a pool of loans. Beware of possible reverse character conversions of ordinary income into capital loss. 45

46 Thank You For Joining Us for Tax Issues In Acquiring Debt Please contact our speakers with any questions after the presentation. Charles R. Beaudrot Partner, Tax and Real Estate Capital Markets Practices Timothy S. Pollock Partner, Tax, Real Estate and Real Estate Capital Markets Practices

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