Cancellation of debt income

BY CHRISTOPHER SIVAK

The recent recession has created many challenges for business owners. In some cases, reduced cash flow has prohibited borrowers from meeting the company’s debt obligations. If a lender restructures all or a portion of the company’s debt, the company may have unintended tax consequences. Gross income generally includes income realized by a debtor from the cancellation of debt (COD) subject to certain exceptions. Where COD income is excluded from gross income under the exceptions to the general rule, taxpayers generally must reduce certain tax attributes (such as net operating loss and tax credit carryovers or depreciable tax basis), by the amount of the debt canceled.
Companies may now be able to avoid this reduction in tax attributes due to a recent law change. If your business has COD income, the information contained in this column may have significant benefits for your business.
The most recent provision that addresses how COD income is recognized was signed into law as a part of the American Recovery and Reinvestment Act (ARRA) of 2009. This provision is discussed below along with other provisions that existed prior to 2009 that may be just as helpful or even more helpful.
Deferral of debt forgiveness income on repurchase of debt. The rules we will be discussing generally apply to the exchange of an old obligation for a new obligation, such as a debt-for-debt exchange. A debtor that repurchases its debt instrument (such as a note, mortgage or lease) for an amount that is less than the “adjusted issue price” of such debt instrument realizes income equal to the excess of the adjusted issue price over the repurchase price. This income is often referred to as COD income.
According to ARRA, in tax years ending after Dec. 31, 2008, a taxpayer can elect to have this COD income from the reacquisition of an applicable debt instrument after Dec. 31, 2008, and before Jan. 1, 2011, included in gross income ratably over five tax years beginning in 2014.
While all of the deferred COD income will eventually be recognized, the taxpayer benefits from the deferral of tax to later years. For example: In 2009, a contractor repurchases for $6 million notes that it issued with an adjusted issue price of $10 million. The contractor realizes $4 million of COD income, but does not need to recognize that income in 2009. Instead, it can recognize $800,000 of the COD income ($4 million divided by five years) in each of the five years from 2014 to 2018.
Other exceptions to recognition of income on COD. Debtors who are: 1) insolvent, 2) in bankruptcy, 3) debtors of qualified farm indebtedness or 4) noncorporate debtors whose debt is qualified real property business indebtedness (this generally includes debtors other than C-corporations whose debt was incurred in connection with business real property and that is secured by the real property) do not recognize income on a cancellation of a debt. Instead, they must reduce their loss or tax credit carryovers or, if they choose not to adjust their tax attributes, they may elect to first reduce the basis in their assets. These debt cancellation rules are applied at the partner level for partnerships, and at the corporate level for S-corporations.
Although the income deferral provided by ARRA is favorable, other existing provisions may be even more favorable. For example, if COD income is realized on real property indebtedness, the reduced depreciation deductions resulting from a decrease in the taxpayer’s basis may provide an effectively longer deferral period than the ARRA.
In addition, cancellations of up to $2 million of mortgage debt on an individual taxpayer’s main home in 2007 through 2012 are excluded from income, but the taxpayer’s basis in the home must be reduced.

Wrapping up
Please keep in mind, only COD income can be excluded in the exceptions listed above. For example, where the foreclosure of property was treated as resulting in gain from the sale of an asset and not as income from the cancellation of debt, that gain was included in income and the above exclusions were inapplicable.
The most prudent course of action if you have experienced income from COD is to consult your tax advisor to determine which method of handling the income will be most beneficial for your business. BXM.
Christopher G. Sivak, CPA, is with Skoda Minotti. For more information
on this topic, call him at Skcda Minotti, 440-449-6800.