What the Bank Giveth, the IRS May (Partially) Take Away An Introduction to the Tax Aspects of Workouts

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1 What the Bank Giveth, the IRS May (Partially) Take Away An Introduction to the Tax Aspects of Workouts February 17, 2009 By: Gregory R. Wilson Many individual and business taxpayers are currently struggling to pay their debts. Often these taxpayers may be relieved of some of their indebtedness through bankruptcy, foreclosure or some other type of restructuring or workout. Such relief often results in the taxpayer realizing taxable income. The outline below is designed to provide a brief introduction of some of the tax provisions which pertain to the taxation of debt relief. Only some of the provisions applicable in this area are mentioned below. This area of the law is very complex with many exceptions and nuances. It is critical that a taxpayer consult with his or her tax advisor before pursuing a transaction which may result in debt relief to determine his or her individual tax consequences. Example Davey Jones has the following assets: Asset Market Value Debt Basis Principal Residence (owned by Davey individually) Rental Apartments (owned by Davey through single member LLC) C Corporation Stock (50% owned by Davey, operates printing business) LLC (50% owned by Davey, sole asset is office building) $1,000,000 $1,500,000 (nonrecourse) $1,700,000 $2,000,000 $2,500,000 (recourse) $1,000,000 $500,000 (corp s assets) $3,000,000 (LLC s office building) $1,000,000 (corp s debt) $5,000,000 (LLC s debt on building, nonrecourse) $200,000 (corp s basis in its assets) $4,000,000 (LLC s basis in building) Per the chart above, Davey is underwater. Given this, he is exploring various alternatives with his lenders to restructure his assets and liabilities. What would be the tax consequences of the restructuring? 1

2 COD Income and Section 1001 Gain Introduction Taxpayers generally realize income if debt they owe is partially or entirely forgiven or cancelled. This is often true whether the debt is recourse or nonrecourse and the resulting income is often referred to as COD income. If property is transferred which is subject to a debt in satisfaction of the debt the transfer may result in COD income and/or Section 1001 gain depending on whether the debt is recourse or nonrecourse. Taxpayers normally realize Section 1001 gain if they transfer property and the amount realized on the transfer exceeds their basis in the property transferred. If nonrecourse debt is extinguished on a transfer of property (such as in a short sale, foreclosure or deed in lieu), the transferor realizes Section 1001 gain to the extent the debt on the property exceeds the taxpayer basis. Taxpayers do not realize any COD income on the transfer of property subject to nonrecourse debt. Section 1001 gain may be taxed as capital gain if the asset transferred was capital in nature in the hands of the transferor. It might also be excludable if the transferred asset was the taxpayer s principal residence and the requirements of Section 121 are met. If recourse debt is extinguished on a transfer of property, the transaction is bifurcated to determine the amount of COD income and Section 1001 gain realized on the transfer. The Section 1001 gain equals the current market value of the property transferred (treated as the amount realized on the transfer) less the transferor s basis in the property. Any additional amount of debt on the property which is cancelled results in COD income. Some workouts generate COD income, others generate Section 1001 gain and some both. The exceptions available to avoid recognizing COD income are different than for Section 1001 gain. Davey s Workout Plan Asset Plan Resulting COD Income Realized Principal Residence Apartments C Corp Stock LLC Lender agrees to reduce mortgage principal to $1,000,000 Lender agrees to take property from Davey in full satisfaction of debt Lender agrees to reduce balance of loan to $500,000 Company related to Davey purchases LLC's debt for $2,000,000 $500,000 $0 Resulting Sec Gain Realized $500,000 $500,000 $500,000 $0 $2,000,000 $0 Whether Davey must recognize the COD income and/or Section 1001 gain realized (as shown above) depends on whether at least one of the several exceptions to the general rule that COD income and Section 1001 gain is taxable applies. 2

3 One of these exceptions is the Qualified Principal Residence Indebtedness ( QPRI ) provision which was added as part of the Mortgage Debt Relief Act of The QDRI exception should apply to the majority of typical taxpayers who purchased their homes over the past few years and are now underwater. This provision permits taxpayers to exclude up to $1,000,000 of COD income ($2,000,000 if married filing jointly) realized in related to the cancellation of a purchase money mortgage (or debt which refinanced a purchase mortgage) on their principal residence (for example if the lender agrees to reduce the principal of their debt). This provision should allow Davey to exclude the $500,000 of COD income realized when his lender reduces his mortgage by $500,000. Insolvency Exception to COD Income COD income is excludable by a taxpayer to the extent the taxpayer is insolvent. Insolvency is determined immediately before the debt discharge and means the excess of the taxpayer s liabilities over the current market value of the taxpayer s assets. The taxpayer must be able to show that he will likely be called upon to pay an obligation such as a guaranty for it to be included as a liability. Nonrecourse loans to the extent they exceed the value of the asset securing the debt generally are not included as a liability (unless it is that liability the excess that is being discharged and excluded under the insolvency exception). If assets are exempt from liabilities they may cause an insolvent taxpayer to be solvent to the extent of the value of the exempt assets. In the case of most partnerships and LLCs, the insolvency test is applied at the partner/member level. Thus, it is irrelevant if the partnership/llc itself is insolvent. The partner/member must be insolvent when the debt is cancelled for the COD income to be excludable. In the case of a C corp or S corp, the insolvency test is applied at the corporate level rather than the shareholder level. Davey s C corp is insolvent its liabilities exceed its assets by $500,000. Thus, it can exclude COD income of up to $500,000 if its debt is cancelled. Considering Davey s other holdings (ignoring nonrecourse debt to the extent it exceeds the value of its collateral), Davey appears to be insolvent to the extent of $500,000. Thus, Davey could exclude the $500,000 of COD income realized on the apartments deed in lieu transaction. This, however, does not prevent Davey from having to recognize the $500,000 of Section 1001 gain from the same transaction. Qualified Real Property Business Indebtedness ( QRPBI ) Another exception to COD income is if the cancelled debt is qualified real property business indebtedness. Generally, the debt is viewed at the entity level to see if this exclusion applies. This exception is often not helpful, however, because of several requirements that are often difficult to satisfy. First, this exclusion applies only if the entity is not insolvent and the discharge does not occur in bankruptcy (Title 11). Most entities obtaining debt relief will be insolvent. Second, the relevant debt must have been used to buy or improve real property used in a trade or business. Thus, property held for investment only will not qualify. Third, there are two calculations that must be applied and which limit the amount of excludable COD income under this exception. These 3

4 calculations are complex and will not be discussed here but often render this COD income exception useless. Davey s LLC might be able to use this exception if all the requirements can be met to avoid recognizing the $2,000,000 COD income realized when the related party purchases the loan at a discount. In this regard, if a party related to a borrower purchases the borrower s debt at a discount, this causes the borrower to realize COD income to the extent of the discount. 1 Stimulus Bill COD Income Deferral Section 1231 of the Stimulus Bill recently signed into law allows the tax payable on COD income realized on the cancellation of debt in 2009 and 2010 to be deferred for 4 or 5 years and then recognized ratably over the subsequent 5 years if certain requirements are met. For example, a partnership/llc may use this provision if its debt was incurred as part of its trade or business. This deferral is very valuable but still only applies to COD income (not Section 1001 gain) and only defers does not exclude the tax payable on COD income realized. If other COD income exclusions are not available to Davey, he can probably elect to utilize this provision to defer the tax due on COD income realized from the cancellation of his debt on his apartments, his C corp and his LLC. Bankruptcy COD income may also generally be excluded if the debt reduction occurs in a Title 11 bankruptcy case. In the case of a partnership or LLC, however, the partners/members must file bankruptcy for this COD income exception to apply. Thus, if the partnership/llc files bankruptcy and its debt is cancelled, the bankruptcy will not prevent the COD income from being taxable to the partners/members. Guarantees and Contingent Liabilities A guarantor typically will not realize COD income if a debt he guaranteed is discharged. Additionally, the cancellation of contingent (and some legitimately disputed) debt generally does not cause COD income. Thus, if a guarantee is removed and such guarantee was still contingent (the primary borrower has yet to default on the loan triggering the guarantee), such removal of the guarantee should not cause the guarantor to realized COD income. Equity Called Debt No COD income is realized if the cancelled debt was actually equity instead of debt. For example, if a corporation could not have obtained a loan from a bank but a shareholder loans the corporation 1 Note not all members of the LLC may be in the same position and desire the LLC to elect to use the QRPBI exception (if available). Some, for example, may be insolvent. This could cause Davey if both a member and the manager of the LLC to have a potential conflict between his personal preference as a member and his duties as a manager to the other members. 4

5 $100,000 and no interest payments are ever made on the loan, the loan should probably be classified as equity. If equity is cancelled or redeemed for a nominal amount, no COD income results. Purchase Price Adjustment If seller carry back financing debt is reduced, it is generally treated as a purchase price adjustment and the basis in the property acquired reduced. COD income in these situations may be excluded. This exception to COD income recognition, however, is not applicable if the taxpayer is insolvent or in bankruptcy at the time of the reduction. Debt Modifications Debt modifications which result in principal reduction clearly produce COD income as debt has been partially cancelled. If other terms are modified, however, a significant modification can result which is treated as if new debt was issued in exchange for the old debt. A significant modification of debt can result in COD income (even if the principal is not reduced). Thus, all debt modifications in a workout context must be analyzed to determine if COD income will result from the modification. If debt is not publically traded, the interest rate of the debt can often be reduced to the minimum Applicable Federal Rate (AFR) in effect at the time of the modification and no significant COD income will result. Currently, a minimum AFR rate for a note of up to nine years is only 1.65%. Thus, an alternative workout Davey could consider is keeping his apartments and negotiating to change the loan to 9 year term, interest only payments due during term at a rate of 1.65%. This might enable him to avoid any COD income and the Section 1001 gain which was caused when he transferred the property to the lender. Attribute Reduction, Elections and Reporting Many of the COD income exclusions discussed above require that certain tax attributes or a taxpayer s basis in certain property be reduced to the extent COD income is excluded. For example, if a corporation excludes COD income because it is insolvent, it is required to reduce its net operating loss carryover and other tax assets to the extent of the exclusion. The result of this may be that the excluded COD income may later, indirectly, be recognized or essentially be converted into Section 1001 gain. Additionally, some of the COD income exclusions require elections to be made by the taxpayer and some require certain forms to be filed reporting the transaction causing the COD income. Gregory R. Wilson is a Certified Taxation Law Specialist by the State Bar of California Board of Legal Specialization and practices law in San Francisco he can be reached at and TAX ADVICE CONTAINED IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN TO BE USED, AND SHALL NOT BE RELIED UPON BY ITS RECIPIENT OR ANY OTHER PERSON, FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED UNDER ANY TAX LAW. 5

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