Tax Planning for Debt Relief

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The coronavirus has had an adverse impact on many businesses and affected their ability to meet financial obligations. To relieve financial strain, business owners have various options to discharge debt, modify loans and transfer property to their lenders. Below are some of the tax issues a business should consider when assessing debt relief options. Note this list is not exhaustive, and the options available will vary depending on a business’s particular situation.

Transferring Property to Lender. The tax treatment of a transfer of property to a lender in satisfaction of outstanding debt will vary depending on whether the debt is recourse or nonrecourse. For nonrecourse debt, the outstanding liability is included in the amount realized for determining gain or loss, regardless of the fair market value of the property. Alternatively, gain or loss on the transfer of recourse debt is recognized to the extent of the fair market value of the real property, with any excess treated as cancellation of debt (COD) income. Whether recourse or nonrecourse debt creates a more tax favorable result will depend on the circumstances of a particular taxpayer. As discussed herein, COD income may be subject certain to gross income exclusions.

Insolvency. When a taxpayer is insolvent, COD income is not included in the taxpayer’s gross income. In other words, debt may be discharged tax-free when an individual or entity is insolvent. For corporations, including S-corporations, insolvency is determined at the entity level. For partnerships, insolvency is determined on the partner level. Any partnership considering discharge of debt should consider whether its partners are solvent, and if so, the partnership may recognize income on debt cancellation.

Qualified Real Estate Indebtedness. Certain debts associated with real property may also be discharged tax-free. Specifically, if a debt constitutes “qualified real property business indebtedness (QRPBI),” a taxpayer (with the exception of a C-corporation) may exclude amounts discharged from gross income. QRPBI includes debts incurred in connection with real property used in a trade or business that is secured by such real property, and is used to acquire, improve or construct such real property. A taxpayer must also make an election to treat a liability as QRPBI. Additionally, any amounts excluded as QRPBI must be applied to reduce the taxpayer’s basis in the real property securing the debt. If the QRPBI discharged exceeds the basis in such real property, the taxpayer may depreciate other real property it owns, subject to certain procedures.

Discharge of Deductible Amounts. If the payment of the debt is deductible to the taxpayer, the discharge of those amounts will not be recognized as COD income.

Debt to Equity Conversion. A taxpayer may not recognize COD income if it transfers an equity interest in exchange for discharge of debt. The taxpayer will be treated as settling the debt in an amount equal to the value of the equity interest; therefore, COD income will result only if the interest is worth less than the outstanding liability.

Loan Modification. Loan modifications may result in COD income to the extent a debtor receives a discount on the principal amount. If the principal amount of the debt does not change, the interest rate may decrease and amortization period may increase without resulting in COD income.

Third-Party Purchase of Debt. The tax treatment of a third-party debt purchase will depend on whether the third-party is unrelated or related to the debtor. If the purchaser is related to the debtor, the debtor itself may be treated as receiving a new debt; this can result in COD income if the purchaser obtains the loan at a discount. If the purchaser is not related to the debtor, it may purchase the loan at a discount without triggering COD income for the debtor. Note, however, that if an unrelated third party purchases the loan at a discount, any modifications should be done prior to the purchase. If a modification occurs after the purchase of a discounted loan, the third party will recognize gain based on the difference between the original principal and its discounted price.

Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation. The author has provided the links referenced above for information purposes only and by doing so, does not adopt or incorporate the contents. Any federal tax advice provided in this communication is not intended or written by the author to be used, and cannot be used by the recipient, for the purpose of avoiding penalties which may be imposed on the recipient by the IRS. Please contact the author if you would like to receive written advice in a format which complies with IRS rules and may be relied upon to avoid penalties.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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