By William B. Acker
Businesses and individual debtors seeking to restructure or escape from debt obligations should carefully consider their income tax consequences. Debtors may be surprised to learn that when debt is reduced, the amount of the reduction is considered “ordinary income” for federal income tax purposes. Fortunately, that debt forgiveness income can be excluded from a debtor taxpayer’s income for federal and state tax purposes in certain situations.
Debt restructuring that modifies the debtor’s obligations, alters the rights of the creditor, or exchanges debt for new debt with different terms, may result in income taxable to the creditor at capital gains rates (even if the amount of the debt is not reduced). If the outstanding balance of debt is also reduced by the restructuring, by foreclosure or from voluntary exchange of property, the amount of the reduction also may result in ordinary income to the debtor.
Debtors can plan to qualify for exclusion of debt forgiveness income in certain situations:
- Insolvent or certain bankrupt debtors can exclude or defer debt forgiveness income, provided that they make various income tax adjustments.
- Solvent debtors can exclude debt forgiveness income from reduction of “qualified real property business” debt, or from “qualified principal residence debt” under provisions of the Mortgage Forgiveness Debt Relief Act of 2007. Exclusion is also available for income from reduction of certain qualified agricultural debt.
- Debt forgiveness income from the reduction of debt incurred to purchase property can generally also be excluded from current income and deferred.
The American Recovery and Reinvestment Act of 2009 allows a debtor to defer debt reduction income until 2014, and then spread the tax over five years. Careful planning will aid in choosing whether to elect this deferral.
Debt exchanges or contributions of debt to corporations, partnerships and limited liability companies require careful planning and are generally taxable, but can result in tax advantage in some cases. Transactions with related parties require careful scrutiny.
Traps in negotiating debt restructuring may produce surprising tax results:
- If a lender and borrower do not act consistently within their rights and obligations under the terms of the debt instrument, they may be treated as if they agreed to a debt modification that is taxable. If a lender does not exercise remedies when a borrower defaults for too long a period of time, that may also be taxable.
- Some debt modifications will qualify for protection under “safe harbor” rules, such as limited changes in the timing of payments and small interest rate changes. Planning for tax qualified entity reorganizations can also protect certain debt modifications from taxation. However, many meaningful debt restructurings will not fit these protections, and careful planning is important to gain tax advantages and to avoid pitfalls.
Analysis of the amount and character of income tax from alternatives available will guide debt restructuring negotiations and choices for lenders and debtors.
Foreclosures and voluntary transfers (deeds in lieu) of property subject to defaulted debt may be taxable, depending on whether a debtor is personally liable for the debt and other factors. These transactions may produce both debt forgiveness income taxed at ordinary rates and capital gains rates. Careful planning can yield favorable choices depending on the tax circumstances of the debtor.
For further information regarding these matters, please contact Mr. Acker at 248.740.5665 or
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