TAX ASPECTS OF DEBT RESTRUCTURING, WORKOUTS & FORECLOSURE May 2004

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1 TAX ASPECTS OF DEBT RESTRUCTURING, WORKOUTS & FORECLOSURE May 2004 WENDI L. KOTZEN BALLARD SPAHR ANDREWS & INGERSOLL, LLP 1735 Market Street, 51 st Floor Philadelphia, PA Wendi L. Kotzen 2004

2 Table of Contents I. APPLICABLE GENERAL PRINCIPLES OF TAX LAW....1 A. GENERAL DEFINITIONS Discharge of Indebtedness or Cancellation of Indebtedness Income ( COD ) Nonrecourse Debt Purchase Money Debt Realization and Recognition Sale or Exchange IRC 1231 Property...1 B. CALCULATION OF TAX BASIS, AMOUNT REALIZED, AND GAIN OR LOSS Tax Basis for Purchased Property Amount Realized on Sale or Exchange of Property Calculation of Gain or Loss....2 C. CHARACTERIZATION OF GAIN OR LOSS Ordinary income...2 a. COD. IRC 61(a)(12)....3 b. Depreciation recapture Gain or Loss from Sales or Exchanges of Capital Assets Gain or Loss from Sales or Exchanges of IRC 1231 Property...3 D. TAX CONSEQUENCES OF BORROWING TO BORROWER/MORTGAGOR....3 E. TAX CONSEQUENCES OF LENDING TO LENDER/MORTGAGEE...3 II. TAX CONSEQUENCES TO BORROWER....4 A. DISCHARGE OF INDEBTEDNESS INCOME COD Debt...4 a. COD only arises if the taxpayer first incurred a debt...4 b. A contingent liability is not treated as a debt...4 (1) Guarantees Discharge....4 B. STATUTORY OVERLAY - IRC Bankruptcy and Insolvency - Nonrecognition Qualified Real Property Business Indebtedness ( QRPBI ) Basis Reduction Rules Other Rules....5 a. Purchase Money Debt...5 b. Acquisition of Debt by Parties Related to the Debtor...5 c. COD and Deduction...5 d. Stock for Debt...5 e. Indebtedness Satisfied by Issuance of Debt Instrument...5 Page i

3 5. Rules Applicable to Partnership Debt Rules applicable to S Corporation Debt...5 C. TAX CONSEQUENCES ON TRANSFER OF PROPERTY IN SATISFACTION OF DEBT General Rule Foreclosure and Deed in Lieu Recourse Debt Nonrecourse Debt Part Recourse and Part Nonrecourse Debt Purchase Money Debt Other Rules....5 III. TAX CONSEQUENCES TO LENDER...5 A. FIRST MORTGAGEE General Rules Accrual of Interest Foreclosure...5 a. General...5 b. Bad Debt....5 c. Gain or Loss on Acquisition of Property Securing Loan....5 d. Basis...5 e. Timing...5 f. Examples: Voluntary Transfer/Deed in Lieu of Foreclosure Purchase Money Debt - Repossession...5 a. IRC b. Gain Recognized...5 c. Basis for Repossessed Property....5 d. Holding Period...5 e. No Deduction...5 B. SECONDARY MORTGAGEE...5 C. INFORMATION, NOTICE, AND OTHER REPORTING REQUIREMENTS FORM 1099 REQUIREMENTS...5 a. Foreclosures and Abandonments Federal Notice Requirements for Discharge of Tax Liens....5 a. Judicial Proceedings...5 b. Other Sales...5 (1) U.S. Tax Lien...5 (2) Adequate Notice FIRPTA WITHHOLDING....5 a. Nonforeign Affidavit...5 b. Foreclosure...5 c. Deed in Lieu of Foreclosure....5 IV. MODIFICATION OF DEBT INSTRUMENTS...5 A. RENEGOTIATION...5 B. TAX ISSUES RAISED UPON RENEGOTIATION OF A DEBT INSTRUMENT....5 ii

4 C. MODIFICATIONS THAT ARE TREATED AS EXCHANGES In General Treas. Reg Modification Regulations...5 (1) Deemed Exchange...5 (2) Borrower s Results....5 (3) Holder s Tax Results....5 d. What is a modification?...5 e. When is a modification significant?...5 (a) General Rule...5 (b) Relevant Term...5 (c) Changes in Yield...22 (d) Changes in Timing and Amount of Payments...22 (e) Change in Obligor...22 (f) Change in Security or Credit Enhancement...23 (g) Change in Priority of Debt...23 (h) Changes in Nature of Debt Instrument...23 (i) Change in Covenants...23 (j) Multiple Modifications...23 D. INSTALLMENT OBLIGATIONS Generally Modifications that Amount to a Disposition or Satisfaction Modifications that are Not Dispositions or Satisfactions....5 iii

5 I. APPLICABLE GENERAL PRINCIPLES OF TAX LAW. * A. GENERAL DEFINITIONS. 1. Discharge of Indebtedness or Cancellation of Indebtedness Income ( COD ) is ordinary income that is realized when the liability to repay a debt ceases or the debt is satisfied at less than its face amount. 2. Nonrecourse Debt is an obligation pursuant to which the lender may look only to specified security for repayment; the lender bears the risk of depreciation in the value of the property. Neither the borrower nor any other person has any personal obligation to repay the debt. a. Special tax significance and use - A partner in a partnership may deduct losses up to his tax basis (and atrisk amount) for his partnership interest. A partner s tax basis is calculated by adding to the money and the tax basis for property he contributed to the partnership, his share of partnership debt. If the partner is a limited partner, his tax basis is increased only by his share of partnership nonrecourse debt. However, a partner is not at-risk for nonrecourse debt except for qualified nonrecourse financing. 3. Purchase Money Debt is debt taken by a seller from a buyer in connection with the sale of property. a. This is a narrower definition than the UCC definition. For example, if Buyer buys machinery from Seller by incurring a bank loan, the loan is not purchase money debt. However, if Buyer buys machinery from Seller by issuing to Seller his note, the note is purchase money debt. 4. Realization and Recognition. Gain or loss realized is the tax gain or loss inherent in the transaction. Gain or loss recognized is the tax gain or loss which must be reported on a tax return. 5. Sale or Exchange is a transfer in which gain or loss is realized of the Internal Revenue Code of 1986 (the IRC ). 6. IRC 1231 Property generally includes real property and depreciable property used in a trade or business, which has been held for more than one year that is not inventory, or held primarily for sale to customers in the ordinary course of the taxpayer s trade or business, and certain other exclusions not here relevant. IRC 1231(b). B. CALCULATION OF TAX BASIS, AMOUNT REALIZED, AND GAIN OR LOSS. 1. Tax Basis for Purchased Property. a. The tax basis for purchased property is its cost. IRC Cost is determined by the consideration paid. The consideration paid generally includes cash, the fair market value of property exchanged (ordinarily, the tax basis of property exchanged plus any gain or minus any loss recognized on the exchange), purchase money debt, debt assumed or taken subject to, and capitalized costs. b. Example: Buyer buys a parcel of real estate by delivering to Seller $10,000 in cash that Buyer borrowed and a $50,000 note with a market rate of interest. In connection with the acquisition, Buyer pays $5,000 of capitalizable costs to parties other than Seller. The property is subject to a $100,000 nonrecourse debt payable to a bank which Buyer does not assume and will not be paid off by Seller. Two years after Buyer acquired the property, Buyer refinances by borrowing $200,000. Buyer s tax basis is: Cash paid to Seller $10,000 * Special thanks to Harry T. Lamb, Blank Rome LLP, for assistance with various parts of this outline.

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