The Impact of Phantom Income on Debt Modifications

As the coronavirus pandemic continues, real estate investors who are having difficulty in servicing their debt will look to modify debt terms. While it might seem to be in the best interest of both the borrower and lender to modify the debt terms, there could be unexpected tax consequences for both.

A debt modification happens when parties to the debt, by an oral or written express agreement or conduct, alter a legal right or obligation of the issuer or holder of a debt instrument^[1]. Debt modification can happen when debt terms are amended including, but not limited to, changing the rate of interest, extending the life of the note, or reducing the principal so as to make the debt sustainable. An alteration of a legal right that occurs by operation of the terms of a debt instrument is generally not a modification, such as the annual resetting of the interest rate based on the changing value of an index. However, even if the alteration occurs by operation of the terms of a debt instrument, it may still be treated as a modification for tax purposes. An example of this is a change in obligor or a whole or partial change in the recourse nature of the debt instrument (e.g., from recourse to nonrecourse or from nonrecourse to recourse).

The second step in the process is to analyze whether the debt modification is "significant" under one of the six tests provided in the regulations^[2]. Tests two through six below provide specific bright-line rules for each specific situation. A modification falling within one of the specific situations is tested exclusively under those rules. The first test is the general catch-all rule applicable if the modification is not subject to one of the specific bright-line tests. The six tests provided are:

1. Facts and circumstances
2. Change in yield
3. Change in timing of payments
4. Change in obligor or security
5. Change in nature of debt
6. Change in accounting or financial covenants

If the parties to the debt modify the terms of a debt instrument and if those modifications are significant, the tax law treats the modification as if the old debt instrument is exchanged for a new one. The creditor is considered to have exchanged the old debt for new debt, and the borrower is considered as having paid off the old debt and issued a new debt. This deemed exchange can trigger adverse tax consequences. Why? Because the rules governing the recognition of gain or loss on the disposition of property require that the gain or loss realized from the exchange of property for other property differing materially either in kind or in extent is treated as income or as loss sustained. ^[3]

Tax consequences for both the creditor and debtor vary significantly based on whether or not the debt is publicly traded. There are special rules for determining such. For non-publicly traded debt, the debtor is presumed to have paid off the face value (or outstanding principal) of the old debt and taken on new debt equal to the new issue price. The debtor recognizes cancellation of debt income (“COD”) on the difference. The COD ramifications in such cases are anticipated and not surprising. However, if the debt is publicly traded, the debtor is considered as having issued new debt at fair market value (“FMV”), which is presumably less because its newly issued debt may be considered distressed. This causes unexpected COD income to the debtor, which is equal to the difference between the outstanding balance of the old debt and the FMV of the new debt.

With respect to non-publicly traded debt, the creditor will realize gain or loss on the difference between the issue price of the new debt and the tax basis in the old debt. This can cause material phantom gain for a creditor who has a low tax basis in the old debt, which can happen when the debt is purchased at a significant discount. The gain in such cases is sometimes purely phantom and devoid of any real change in the economics of the debt, because presumably the modification does not materially change the economics of the debtor’s business or property. This is not an issue in the case of publicly traded debt, because the FMV of the newly issued debt is not likely to be very different from the creditor’s basis in the discounted debt.

Before making any decisions about debt modifications, consider potential tax issues and address them at the outset. The adverse tax consequences arise when the debt modifications are considered significant. Fortunately, the bright-line tests provide clarity in determining, planning and structuring the modifications in order to avoid them being considered significant. Give attention to issues such as stated interest rules, determining issue price, and considering the rules of whether or not a debt is publicly traded. Planning opportunities, such as requiring the seller to execute the modifications prior to the sale and the use of the installment method of reporting tax gains, are available to the creditor. The debtor can exclude the COD income if an insolvency exception applies or there are avenues whereby in lieu of taking into account COD income, the attributes in either the property or net operating losses can be reduced depending on the type of debtor.

[1] Reg. §1.1001-3(c)

[2] Reg. §1.1001-3(e)

[3] Reg. §1.1001-1(a)