News stories addressing the lack of liquidity in the credit markets now focus almost exclusively on how to provide incentives for lenders to buy and sell distressed debt. But a normally functioning real estate lending market also encourages borrowers and lenders to look for ways to restructure loans. One of the biggest obstacles to doing so, from the borrower’s perspective, is the adverse tax cost to the borrower arising from discharge of indebtedness income (DOI).
This article discusses how certain provisions in The American Recovery and Reinvestment Act of 2009 (or, the Stimulus Act) seek to mitigate this obstacle. The Stimulus Act contains provisions that are intended to provide relief to borrowers with DOI resulting from restructuring a loan during 2009 or 2010. These deferral rules will have important effects on the restructuring of real estate loans and loans to partnerships.
Discharge of Indebtedness Income
Generally, a borrower will recognize DOI with respect to an existing loan when a borrower (or a related party) is treated as “acquiring” the existing loan for less than the loan’s “adjusted issue price” for consideration, including cash and/or property. The adjusted issue price of an existing loan equals the original amount “lent” for the loan, increased by any accrued original issue discount, and decreased by any payments other than stated interest (e.g., principal payments).
The property used to “acquire” an existing loan can include any type of property, including new debt, corporate stock or partnership interests, and the value of such property will equal its fair market value for purposes of calculating any DOI. For purposes of the foregoing, “new debt” will be deemed to result from the “substantial modification” of the terms of an existing loan. Substantial modifications may include changes to the existing loan’s interest rate, term and/or collateral. Therefore, the restructuring of the terms of an existing loan often will be characterized for tax purposes as the exchange of the existing loan for a new loan.
In the case of a recourse real property loan, DOI will result from a foreclosure or delivery of a deed-in-lieu of foreclosure. (Other rules apply to non-recourse loans secured by real property.) If an existing loan is written off for no consideration, then the entire amount of the adjusted issue price of the existing loan is treated as DOI. DOI also will arise if an existing loan is contributed to the capital of the borrower, in which case the DOI equals the adjusted issue price of the existing loan over the lender’s tax basis in the existing loan.
Existing Tax Law
The existing tax law (which continues in effect, but has been modified by the Stimulus Act, as described below) already contains certain exceptions to the requirement that a borrower recognize DOI as income. For example, a borrower may exclude DOI as income if the borrower is bankrupt or insolvent (to the extent of the insolvency). However, a borrower using these existing rules to exclude DOI income is required to reduce its tax attributes, including its net operating losses, tax credits, capital loss carryovers, the tax basis of its properties and passive activity losses.
In addition, currently, there are additional special rules for a solvent borrower that has DOI related to “qualified real property business indebtedness.” In such circumstances, a borrower may exclude DOI and reduce the tax basis of the borrower’s depreciable real property by the amount of the DOI related to the qualified real property business indebtedness. While these rules for the exclusion of DOI from qualified real property business indebtedness assist some borrowers, the rules are subject to significant limitations, including limitations on the debt considered “qualified real property business indebtedness” and the amount of DOI eligible for exclusion.
Further, if a borrower is a partnership (which also includes a limited liability company), although DOI is determined at the partnership level, the foregoing exclusions of DOI from income for bankruptcy, insolvency and/or qualified real property business indebtedness are applied at the partner level instead. This means that a solvent partner could have to include significant DOI on the partner’s tax return as the result of an insolvent partnership restructuring a loan made to the partnership.
Provisions of the Stimulus Act
The Stimulus Act has modified the existing tax law to provide borrowers with DOI in 2009 and 2010, an alternative with the potential for significant tax relief:
Deferral of DOI.
A borrower that recognizes certain DOI in 2009 or 2010 may elect to defer including the DOI in its income until 2014, and then take the DOI into income ratably over a five-year period, subject to possible acceleration, as discussed below. The DOI eligible for the deferral is limited to DOI that (i) relates to loans to C corporations or loans to any other person in connection with the conduct of a trade or business, and (ii) results from the complete forgiveness of the loan or the acquisition of an existing loan for cash, a new debt instrument, corporate stock, a partnership interest or the contribution of debt to capital. Therefore, the new deferral rules do not apply to DOI resulting from the restructuring of a home loan or consumer debt or DOI resulting from the exchange of debt for other property. (However, individual taxpayers may qualify to exclude up to $2 million of DOI under the Mortgage Forgiveness Debt Relief Act of 2007 for DOI on a principal residence.) Further, the new deferral rules do not apply to DOI resulting from the satisfaction of a recourse real estate loan through foreclosure or a deed-in-lieu of foreclosure.
Rules on Elections.
A borrower that has DOI with respect to more than one loan is allowed to make the deferral election separately for each loan. Once made, an election to defer DOI under the new rules is irrevocable. In the case of a partnership, limited liability company, S corporation or other pass-through entity, the election to defer DOI is made at the entity level. Therefore, a partnership’s election to use the deferral rules under the Stimulus Act may be of benefit to the partners of the partnership who are not eligible for any of the existing exceptions to recognizing DOI. The Stimulus Act also contains special provisions for other potential tax consequences to partners resulting from the decrease of their share of partnership liabilities as the result of a debt restructuring resulting in deferred DOI. Also, if a borrower elects to defer DOI for an existing loan under the new rules, the borrower may not subsequently elect to use any of the existing exclusions for DOI (e.g., the bankruptcy, insolvency or qualified real property business indebtedness exclusions).
Acceleration of DOI.
Recognition of the deferred DOI by a borrower will be accelerated under certain circumstances, including the death or liquidation of the borrower, the sale of all or substantially all of its assets (including a subsequent bankruptcy filing), or the cessation of its business or any similar event. If the borrower is a partnership or other pass-through entity, the acceleration rules will apply to a partner or other owner of an interest in the pass-through entity upon a sale, exchange or redemption of such ownership interest.
OID Deductions Deferred.
A restructuring that involves a debt-for-debt exchange, including a “deemed exchange” because the restructuring includes a material modification of the terms of an existing loan, may result in the creation of original issue discount (OID) if the “new loan” has a face amount in excess of the adjusted issue price of the existing loan. If the borrower has elected to defer any DOI resulting from the debt-for-debt exchange, then, instead of deducting the OID over the life of the new loan, the borrower must defer the deduction of the OID and take it over the same five-year period as the inclusion of the DOI. In addition, there are limitations on the deduction of OID in excess of the deferred DOI, and there are new provisions with respect to the suspension of the applicable high yield discount obligation rules in certain situations.
A borrower evaluating a potential loan restructuring should make sure to fully understand the potential for discharge of indebtedness income that may result from the restructuring and the options available for minimizing the adverse tax consequences of the discharge of indebtedness, including the new deferral rules included in the Stimulus Act. Special considerations will apply to evaluating the available options if a borrower is a partnership or other pass-through entity and/or the loan to be restructured is a real estate loan.