In light of the coronavirus pandemic and significant economic downturn, this blog post briefly discusses questions that are commonly being asked right now regarding the income tax treatment of cancellation of indebtedness income (“COD”).
The tax code provides that income from the cancellation of indebtedness is taxable, subject to a number of exceptions. As an example, if a taxpayer has a loan of $100, and the lender forgives $20 of the debt so that the remaining loan balance is $80, then the taxpayer has $20 of taxable COD income. This is often an adverse result for the borrower as it results in phantom income, that is, taxable income without corresponding cash to pay the tax. In addition, COD income is taxed at ordinary income rates.
On the other hand, if the lender merely modifies the debt, for example by extending the maturity period, reducing the interest rate or agreeing to other forbearance, there generally is not COD income, and instead, from a tax perspective, the parties have to determine whether a “significant modification of a debt instrument” has occurred and whether it is taxable.
If a borrower has COD income, the borrower then must consider the various exceptions to immediate taxation. There are several ways to eliminate recognition of COD income, but all require careful review to ensure relief will be granted.
Bankruptcy offers relief from COD income, but that is often a path of last resort.
In addition, COD income is not recognized if and to the extent that a taxpayer is insolvent. In other words, a taxpayer is insolvent if the taxpayer’s liabilities are greater than fair market value of his or her assets. Reliance on this exemption generally requires getting an appraisal or other third-party support for fair market value.
Cancellation of accrued but unpaid business interest may also escape taxation provided a tax deduction was not taken for this amount. There is an exception to COD income for income that would otherwise give rise to a deduction, such as interest which generally is income to the lender and deductible by the borrower.
The owner of business real estate may take advantage of an exception to COD income rules for “qualified real property business indebtedness.” This allows the real estate owner to reduce the basis of other depreciable real property rather than recognizing the COD income and serves as a deferral technique. The fair market value of the mortgaged real estate and the tax basis of their depreciable real estate are key factors in determining the value of this approach.
A partnership can admit its lender as a new partner in consideration for cancelling debt and not recognize COD income. Thus, a “debt for equity” swap is often a way to avoid COD income. The fair market value of the newly issued partnership interest must match the amount of cancelled debt, and a review of other partnership tax rules affecting the impact of liabilities on a partner is needed to ensure full benefit can be achieved.
If a taxpayer has nonrecourse debt on a property secured by a mortgage, and transfers property to a lender in satisfaction of the debt (usually a “deed in lieu of foreclosure”), different tax treatment applies. This is treated as a deemed taxable sale of the property for an amount equal to the mortgage debt even if the fair market value of the property is less than the amount of the debt. Capital gain, and not COD income, results. For example, if a $10M mortgage is secured by real estate with a tax basis of $2M and a value of $7M, then $8M of taxable gain results ($10M mortgage minus $2M basis). This is often an adverse result.
If a taxpayer has recourse debt secured by a mortgage, and transfers the property to a lender in satisfaction of the debt, the transaction is bifurcated into two taxable events. First, there is a deemed taxable sale of the property, with capital gain equal to the excess of the value of the property minus its tax basis. Second, there is cancellation of the recourse debt in excess of the value of the property, with COD income equal to the amount of the debt minus the value of the property. In the example from the previous paragraph, there would be $5M of capital gain ($7M minus $2M) and $3M of COD income ($10M minus $7M).
This is a highly technical area of US tax law. Each borrower’s facts must be carefully considered. State income tax treatment of COD income may be different than the federal tax treatment. In sum, a tax analysis relating to COD income issues is usually critically important to avoid adverse tax results when debt is being modified or forgiven.
As the law continues to evolve on these matters, please note that this article is current as of date and time of publication and may not reflect subsequent developments. The content and interpretation of the issues addressed herein is subject to change. Cole Schotz P.C. disclaims any and all liability with respect to actions taken or not taken based on any or all of the contents of this publication to the fullest extent permitted by law. This is for general informational purposes and does not constitute legal advice or create an attorney-client relationship. Do not act or refrain from acting upon the information contained in this publication without obtaining legal, financial and tax advice. For further information, please do not hesitate to reach out to your firm contact or to any of the attorneys listed in this publication.