Dealing with the tax consequences of debt restructuring or cancellation

Introduction

Running a business these days is not for the faint of heart. High interest rates, mixed signals on inflation, global and domestic political tensions, extreme weather events, and ever-present worries about a recession all make for a challenging economic environment. On top of all that, hybrid and remote work, while a great benefit for employees, is contributing to empty offices, quiet downtowns and possible trouble on the horizon for the commercial real estate market. Up against these headwinds and crosscurrents, businesses may be struggling to service their debt and may be forced to reckon with the tax consequences of debt restructuring or cancellation.

Cancellation of debt (COD) income can arise in a wide range of situations – even if a debt is not reduced or cancelled outright. For example, foreclosures, significant modifications of the terms of the debt, shareholder contributions of debt to a corporation in exchange for capital, satisfaction of debt with stock or a partnership interest, and acquisition of debt by a related party may all result in taxable income to the borrower. And if that is not bad enough, COD income is “phantom” income – i.e., taxable income without the corresponding cash flow.

Fortunately, there are options available to defer the immediate pain of COD income. This usually takes the form of tax attribute reduction, such as reducing loss carryforwards or reducing the basis of other assets. Depending on how the business is structured, this may take place at the entity level or the individual owner level. While this does not eliminate the problem, deferring the COD income to later tax years buys taxpayers more time to plan for the impact on the business’s cash flow.

COD income – When do you have it?

Foreclosures

When a lender forecloses on a property, if the debt is recourse, the tax impact may be bifurcated into COD income and/or gain or loss. Depending on the balance of outstanding debt, and the fair market value (FMV) and adjusted tax basis of the property, taxpayers could end up with both COD income (which they might be able to defer under the provisions discussed below) and gain or loss (which must be recognized in the year of the transaction).

If the debt is nonrecourse, a foreclosure is treated as sale of the property for federal tax purposes. While there is no COD income in this scenario, the borrower will recognize gain or loss on the transaction in the year of the foreclosure.

Significant modifications of debt instruments