On February 17, 2009, President Obama signed into law the American Recovery and Reinvestment Act of 2009 (the “Act”). The Act contains a number of tax law changes, including new Internal Revenue Code Section 108(i) that provides taxpayers with an election to defer recognition of income from the cancellation of indebtedness (“COD Income”) in certain circumstances.
Lenders are currently under significant pressure to reduce their exposure to real estate. Moreover, lenders generally desire to avoid acquiring ownership of financed property. Accordingly, borrowers may have the opportunity to acquire or repay loans on a discounted basis, which may result in current tax liability due to the recognition of COD Income. In such cases, borrowers may be able to elect under new Section 108(i) to defer recognition of such COD Income. However, as described below, the election may preclude application of certain exceptions to the recognition of COD Income that would apply absent the election. Whether a borrower will benefit from the election is fact specific. Therefore, borrowers should consult with their tax advisors to determine whether the election fits their individual circumstances.
Cancellation of Indebtedness Income in General
Subject to certain exceptions, a debtor is required to recognize (and pay tax on) COD Income when debt is forgiven, reduced or acquired by certain related parties at a price lower than the outstanding balance owed. COD Income may also be recognized in an exchange of debt for stock, partnership interests or another debt instrument of the debtor. Even the modification of a promissory note or loan agreement may be considered an exchange of debt instruments for tax purposes.
Deferral of Cancellation of Indebtedness Income under New Section 108(i)
New Section 108(i) permits a taxpayer to elect to have COD Income from the “reacquisition” of an “applicable debt instrument” in 2009 or 2010 included in income ratably over a 5 year period beginning in 2014. Applicable debt instruments include any debt instrument issued by any person in connection with the conduct of such person’s trade or business. A reacquisition includes any “acquisition” of the debt instrument by the debtor or certain related persons. An acquisition includes (i) an acquisition of the debt for cash, (ii) an exchange of the debt instrument for another debt instrument (including an exchange resulting from the modification of the debt), (iii) the exchange of the debt for corporate stock or a partnership interest, (iv) the contribution of the debt to capital or (v) the complete forgiveness of the debt by the holder.
The Deferral Election
The election to defer COD Income must be made on the tax return of the debtor for the year in which the reacquisition occurs. The election is made on an instrument-by-instrument basis and is irrevocable once made. For pass through entities (i.e., partnerships, limited liability companies, S corporations and other pass through entities), the election is made at the entity level.
Effect of Election on Exceptions to Cancellation of Indebtedness Income Recognition
Under current tax law, certain exceptions to the recognition of COD Income apply, including exclusions for COD Income recognized by an insolvent debtor, a debtor in bankruptcy and the discharge of certain types of real property indebtedness and qualified farm indebtedness. The listed exceptions will not apply if the debtor elects to defer the COD Income under new Section 108(i). Accordingly, the specific facts surrounding a discharge of debt must be analyzed to determine whether the Section 108(i) election would be advantageous for a particular debtor.
Assume taxpayer borrowed $1 million in 2007. In 2009, taxpayer acquired the debt for $500,000 while the outstanding principal balance remained at $1 million. Thus, taxpayer realizes $500,000 of COD Income in 2009. If taxpayer makes the deferral election under Section 108(i), taxpayer will not recognize (and will not pay tax on) any COD Income in 2009. Rather, taxpayer will recognize $100,000 of COD Income in each of the five tax years from 2014 to 2018, inclusive.
Pass Through Entity Elections: Handle with Extreme Care
The Section 108(i) election to defer COD Income recognition is a welcome change for taxpayers unable to take advantage of the exceptions to the recognition of COD Income. For pass through entities, however, such exceptions apply at the owner level (e.g., partner, member, Subchapter S shareholder, etc.) rather than the entity level.
An election to defer recognition of COD Income effectively waives the application of certain COD Income recognition exceptions for owners of a pass through entity. Thus, the general partner, managing member or other governing authority, as the case may be (collectively, “manager”), must analyze whether the election will benefit the owners or harm them by preventing owners from taking advantage of otherwise available exceptions to COD Income recognition. In some cases, the manager may determine that the deferral election would benefit some owners while harming others. Thus, the manager should seek owner approval before making the deferral election on behalf of a pass through entity, since a failure to seek such approval may invite litigation from owners harmed by the election or failure to make the election.