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 firstname.lastname@example.org.