In This Issue:
Take Advantage of the Bad-debt Conformity Election Tax Implications of Debt Modifications Understanding Mark-to-market Accounting for Loans Tax Considerations When Transferring Underwater Assets to Subsidiaries
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Tax Implications of Debt Modifications
By Julie A. Durbin, CPA In the current banking environment, many banks are facing the challenge of dealing with issues related to modifying debt. Author Julie Durbin explains that banks must understand the tax implications of any modifications to debt instruments and plan accordingly. Today’s rough economy is pushing many borrowers into default. As a result, banks must determine how best to handle the increase in the number of past-due loans they hold. Many banks might be more likely to restructure their debt instruments than to simply write off defaulted loans. Banks need to be cautious, however, as certain modifications can cause taxable events that require the reporting of gains or losses. Modifications also could create the potential for a deduction. The term “debt instrument” means a bond, debenture, note, certificate, or other evidence of indebtedness. Debt instrument modifications include any change – including any deletion or addition, in whole or in part – to a legal right or obligation of the issuer or a holder of a debt instrument. Modifications include changing the terms of a loan, bond, or other debt instrument; substituting the obligor; changing the recourse nature; and a change in the interest rate that results in a reduction of scheduled payments. A change of a legal right or obligation that occurs by virtue of a debt instrument’s terms generally is not a modification. Significant Modifications to Debt Instruments Five specific rules are applied to determine whether certain modifications are indeed significant. The specific rules relate to the following modifications: change in yield; change in timing of payments; change in obligor or security; change in the nature of the debt instrument; and a change in accounting or financial covenants. For example, a change in yield is significant only if the annual yield of the modified debt instrument varies from the annual yield of the unmodified debt instrument by more than 25 basis points or 5 percent of the annual yield of the unmodified instrument. When the timing of payments due is changed, the modification is significant under the rules if it results in the material deferral of scheduled payments. The deferral of one or more scheduled payments within the safe-harbor period is not a material deferral if the deferred payments are unconditionally payable no later than at the end of the safe-harbor period. The safe-harbor period begins on the original due date of the first scheduled payment that is deferred and extends for a period equal to the lesser of five years or 50 percent of the original term of the instrument. Taxable Events From a Significant Modification A taxable gain to a bank can result when the original debt instrument has been issued at a discount or the debt has been charged off in part or in whole. Generally, a bank will recognize a gain if the issue price of the modified debt instrument exceeds the bank’s tax basis in the original debt instrument or a loss if the issue price of the modified debt instrument is less than its tax basis in the original debt instrument. When a bank is required to recognize a gain under Treasury Regulation Section 1.1001-1(a), the bank's tax basis in the debt is increased by the amount of the gain recognized. Conversely, U.S. generally accepted accounting principles do not require a corresponding increase in book basis, so there will not be a book write-off of the increased tax basis of the debt instrument. However, Treasury Regulation Section 1.166-3(a)(3), “Partial or Total Worthlessness,” provides a deduction for partially worthless debt when a gain is recognized under Treasury Regulation Section 1.1001-1(a) as a result of debt modification and a deduction for partial worthlessness was claimed in any prior taxable year. Reporting Requirements A discharge of indebtedness is deemed to have occurred if and only if an identifiable event has occurred, regardless of whether an actual discharge has occurred on or before the date on which the identifiable event occurred. Identifiable events include a discharge of debt via a Chapter 11 bankruptcy and the cancellation or extinguishment of debt related to an election of foreclosure remedies by a creditor that extinguishes or bars the creditor’s right to pursue collection of the debt under a statute. Modify With Care Julie Durbin is a manager with Crowe Horwath LLP in the Nashville, Tenn., office. She can be reached at 615.360.5560 or Download PDF Under U.S. Treasury rules issued in 2005, we must inform you that any advice in this communication to you was not intended or written to be used, and cannot be used, to avoid any government penalties that may be imposed on a taxpayer. 
Archives Crowe Tax Notes (September 2009) |
