A taxpayer is generally required to recognize income (which is ordinary income) upon the forgiveness or cancellation of its debt. For this purpose, the purchase of the taxpayer’s debt at a discount by a person “related” to the taxpayer or a “significant modification” of the taxpayer’s debt (e.g., deferral of one or more payments; reduction in stated interest rate) could also give rise to COD income for the taxpayer.
Under the Act, a taxpayer who realizes COD income in 2009 or 2010 through the “reacquisition” of an “applicable debt instrument” (generally, evidencing debt incurred in connection with a trade or business) may elect to defer the recognition of such income until 2014 and then recognize such income ratably over the succeeding five taxable years (the “COD Deferral Election”). For purposes of the new provision, a “reacquisition” means, with respect to any applicable debt instrument, any “acquisition” of the debt instrument by: (i) the debtor which issued (or is otherwise the obligor under) the debt instrument; or (ii) a related person to such debtor. The term “acquisition,” with respect to any applicable debt instrument, includes: (a) an acquisition of the debt instrument for cash; (b) the exchange of the debt instrument for another debt instrument (including an exchange resulting from a modification of the debt instrument); (c) the exchange of the debt instrument for corporate stock or a partnership interest; (d) the contribution of the debt instrument to capital; and (e) the complete forgiveness of the debt instrument by the holder thereof. The Act’s Conference Committee Report defines an “acquisition” to include, “without limitation,” the types of transactions enumerated in (a)-(e) above.
Prior to the Act, a non-C corporation taxpayer that realized COD income in connection with debt secured by real property, could avoid the recognition of such income for certain “qualified real property business indebtedness.” Under this exclusion, such taxpayer could exclude all, or a portion, of the COD income by electing to reduce the basis of the taxpayer’s depreciable real property. Now, for COD income that arises in 2009 and 2010, the Act provides such taxpayer with the alternative of being able to defer the recognition of such COD income without having to reduce depreciable real property basis.
COD income also arises in either a foreclosure by the lender or the transfer of the property in lieu of foreclosure. Where the debt that secures the mortgaged/pledged property is recourse debt1 and the lender waives/foregoes any claim that it may have against the debtor to collect on the remaining portion of the debt, the amount of the COD income that would result would generally equal the excess of the amount of the debt over the fair market value of the foreclosed upon/transferred property. While the Act does not expressly address foreclosure/deed-in-lieu transfers, for the reasons discussed below, we believe that there is language in both the Act and its Conference Committee Report to support the view that the COD Deferral Election should apply to such transfers.
As noted above, the Conference Committee Report defines “acquisition” to include, among other things, certain enumerated transactions, thus evidencing a Congressional intent to provide a non-exclusive list of transactions that constitute an “acquisition.” Further support for this proposition is the fact that the statutory language itself defines the term “acquisition” as including the above-mentioned transactions (thereby, strongly suggesting that there may be other transactions that would so qualify). Moreover, if the lender of recourse debt does take back property (in either a foreclosure or by deed-inlieu of foreclosure) in a transfer that results in COD income and cancels the remaining debt, then it would seem that such cancellation would, at that point, constitute a “complete forgiveness of the debt by the holder” (and, thus, an “acquisition”).