The economy is slowly recovering from the recession, but there are still many people who are underwater on real estate and other loans. One solution that can be a good option for some people is to modify, or restructure, the debt. But there are tax consequences you need to be aware of if you’re considering this option.
Debt that’s been significantly modified may be considered by the IRS as a deemed exchange, so a key to knowing whether restructuring is a good option for your situation is to determine whether your modification is significant. The regulations outline five specific rules and one general rule to classify the modification. (If none of the specific rules apply to a particular situation, then the general rule is applied.)
If your debt modification is considered significant, restructuring still may be a good option if the tax consequences are more favorable. You should talk with a tax adviser who can analyze the specifics of your individual situation.
The AICPA recently featured an in-depth paper on the tax consequences of modifying debt. Here’s a summary and explanation of the article.
What is Modification?
First, let’s define modification and how debt is modified. A modification is any alteration of a legal right or obligation of the issuer or a holder of a debt instrument. A modification can occur from amending the terms of a debt instrument or through exchanging one debt instrument for another.
However, there are a few exceptions to this broad definition.
- An alteration that happens as a result of the operation of the terms of a debt instrument, such as the annual resetting of the interest rate based on the value of an index, is not considered a modification. To make things more complicated, there are a few exceptions to this exception. If there is a change in obligor or the addition or deletion of a co-obligor, it’s still considered a modification. If there’s a change in the nature of the debt instrument, such as a change from recourse to nonrecourse, it’s still considered a modification. Or if the alteration results from the exercise of an option provided to an issuer or a holder to change a term of a debt instrument, it’s still considered a modification, unless the option is unilateral and the exercise of the option doesn’t result in a deferral of or reduction in any scheduled payment of interest or principal.
- If an issuer fails to perform its obligations under the debt instrument, then it’s not considered a modification.
- If one of the parties to a debt instrument has the option to change a term of the instrument but doesn’t, it’s not considered a modification.
Is the Modification Significant?
There are five specific rules that are to be examined to see if they apply in determining if the modification is significant.
1) The Change in Yield Rule
This rule applies to four categories of debt instruments: those that provide only for fixed payments, those with alternative payment schedules subject to Regs. Sec. 1.1272-1(c) (instruments subject to contingencies), those that provide for a fixed yield subject to Regs. Sec. 1.1272-1(d) (such as certain demand loans), and variable-rate debt instruments.
The Change in Yield rule holds that a debt modification is significant if the yield varies from the annual yield on the unmodified instrument (determined as of the date of the modification) by more than the greater of: (1) one-quarter of 1% (25 basis points) or (2) 5% of the annual yield of the unmodified debt instrument (0.05 × annual yield). Because a reduction in principal reduces the total payments on the modified instrument and results in a reduced yield on the instrument, reducing the principal often results in a significant modification. For this reason, the regulations give the same effect to changes in principal amounts as to changes in interest rates.
2) The Change in Timing of Payments Rule
This rule states that a modification that changes the timing of payments due under a debt instrument is significant if it results in the material deferral of scheduled payments. For example, an extension of the final maturity date or a deferral of interest payments would be considered a significant modification.
However, there is a safe-harbor period which allows the modification to not be considered significant if the deferred payments are required to be paid within the lesser of five years or one-half the original term of the instrument. The safe-harbor period starts with the due date of the payment that is being deferred (the original maturity date) and ends five years from this date.
3) The Change in Obligor or Security Rule
This rule holds that the substitution of a new obligor on a nonrecourse debt instrument is not a significant modification. Recourse debt instruments that substitute a new obligor are almost always a significant modification, unless one of the following are met:
a. The new obligor is an acquiring corporation to which Sec. 381(a) applies;
b. The new obligor acquires substantially all of the assets of the obligor; and
c. The change in obligor is a result of either a Sec. 338 election or the filing of a
Also, for a modification to be considered not significant, the change in obligor must not result in a change in payment expectations or a significant alteration.
For nonrecourse debt instruments, a modification that releases, substitutes, adds, or otherwise alters a substantial amount of the collateral for, a guarantee on, or other form of credit enhancement for a nonrecourse debt instrument is a significant modification. An exception is a substitution of collateral on a nonrecourse debt instrument if the collateral is of a type where the particular units pledged are unimportant, such as government securities or financial instruments of a particular type and rating. Other exceptions are the substitution of a similar commercially available credit enhancement contract and and an improvement to the property securing a nonrecourse debt instrument. These exceptions are not considered significant modifications.
4) The Change in the Nature of a Debt Instrument Rule
This rule holds that a change in the nature of a debt instrument from recourse to nonrecourse, or vice versa, is a significant modification.
An exception to this rule is that a defeasance of tax-exempt bonds is not a significant modification if the defeasance occurs by operation of the terms of the original bond and the issuer places in trust government securities or tax-exempt government bonds that are reasonably expected to provide interest and principal payments sufficient to satisfy the payment obligations under the bond. Another exception is a modification that changes a recourse debt instrument to a nonrecourse debt instrument–it’s not considered significant if the instrument continues to be secured only by the original collateral and the modification does not result in a change in payment expectations.
The rule also holds that a modification of a debt instrument that results in an instrument that is not debt for federal income tax purposes is a significant modification.
5) The Changes in Financial and Accounting Covenants Rule
This rule states that a modification that adds, deletes, or alters customary accounting or financial covenants is not a significant modification. However, the issuer may make a payment to the lender in consideration for agreeing to the modification, and that payment would be taken into account in applying the change-in-yield test. Because of this, a modification to a debt instrument’s covenants can result in a significant modification if the lender receives a payment for agreeing to the modification.
If none of these specific rules apply to the modification, then the general rule is applied to it, which states that a modification is significant only if the legal rights or obligations are altered to a degree that is economically significant. To determine economic significance, all modifications to the debt instrument are considered collectively–so that a series of modifications may be significant when considered together, although each modification alone would not be significant.
As mentioned previously, modifying debt may still make sense in certain circumstances, if the tax consequences are more favorable. The consequences of deemed exchange in your particular situation would need to be evaluated.