A purchaser of a distressed loan should be aware that the federal income tax implications of holding and receiving payments on the loan after purchase are frequently more complex than simply recognizing the stated interest as income. Though the purchase of a distressed loan is generally not a taxable event to the purchaser for federal income tax purposes, issues that could cause complications include: (i) the extent to which interest is expected to be paid, (ii) whether the purchased loan has original issue discount (OID), and (iii) whether the loan is being purchased at a discount from its remaining principal amount.
Oftentimes, when a distressed loan is purchased, interest on the loan is not being paid on a current basis. If the purchaser is an accrual basis taxpayer, it will be required to include accrued interest in income even when the interest is not paid currently, so long as it has a reasonable expectation that the interest will be collected. If the purchaser does not have a reasonable expectation that the interest will be collected, it is not necessary to continue the accrual of interest. Further, if the purchaser has accrued interest that it has determined is uncollectible, such interest may be deducted. However, if the purchaser simply expects the interest payments to be delayed, the accrual may not be suspended. If the purchaser has accrued interest that remains unpaid, amounts it subsequently receives with respect to the loan are treated as payments of accrued interest to the extent of the interest accrued to date. This concept applies even if a payment is earmarked as a principal payment or if the purchaser has already taken a deduction with respect to the accrued interest.
Original Issue Discount
OID is included in the annual income of the holder in instances when a debt instrument’s redemption price is greater than its issue price. Assuming that a distressed loan is not modified upon purchase, it is important to consider the extent to which the loan has any OID. If it does, the purchaser is required to include OID in income on the same basis as included by the prior holder of the loan. Although OID is conceptually similar to interest, there is guidance from the IRS that the “reasonable expectancy” exception described in the paragraph above does not apply to OID. Based on the IRS guidance, the purchaser of a distressed loan with OID may not suspend inclusion of the OID as income irrespective of the issuer’s financial condition.
When a loan is purchased at a discount from its outstanding principal balance, the purchaser is subject to rules addressing the spread between the remaining principal amount and the purchaser’s tax basis, termed the “Market Discount.” Although a lender’s tax basis is ordinarily the principal amount of the loan, in the case of a purchased loan, the purchaser’s tax basis is the amount paid for the loan. If the aggregate principal payments received by the purchaser, including amounts received upon disposition, exceed the purchaser’s tax basis, the excess is treated as ordinary income gain rather than capital gain up to the amount of the Market Discount. In lieu of the foregoing tax treatment, the purchaser may elect to take the Market Discount into account ratably over the remaining term of the loan, as ordinary income on an annual basis. Thus, if a purchaser ultimately receives principal amounts in excess of the amount it paid for the distressed loan, the excess is likely to be characterized as ordinary income gain.
In order to determine the federal income tax implications of the purchase of any particular distressed loan, it is necessary to consult with experienced tax counsel to evaluate the considerations described above.