What do you do when you find yourself “underwater” on your loans, meaning the property you own is worth less than the loan balance you owe?

Many borrowers rely on a debt restructuring transaction, in the form of debt modifications, to help them de-lever their property and work out existing debt. A modification of a debt instrument may result in a deemed taxable exchange of the old debt instrument for a new debt instrument. A two-step analysis determines whether a deemed exchange has occurred in this restructuring:

First, were the terms of the debt instrument modified?

In general, a modification means any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt instrument, whether the alteration is evidenced by an express agreement (oral of written), conduct of the parties, or otherwise. A modification can occur from amending the terms of a debt instrument or through exchanging one debt instrument for another. 

Second, was the modification significant?

The regulations provide six rules for addressing whether a modification is significant:

1. General test – Under the general test, a modification is significant only if, based on all facts and circumstances, the legal rights or obligations are altered to a degree that is economically significant.
2. Change in yield – In general, a change in the yield of a debt instrument is a significant modification if the yield varies from the annual yield on the unmodified instrument by more than the greater of (1) one-quarter of 1% or (2) 5% of the annual yield of the unmodified debt instrument.
3. Change in timing of payments – In general, a modification that changes the timing of payments (including any resulting change in the amount of payments) due under a debt instrument is a significant modification if it results in the material deferral of scheduled payments.
4. Change in obligor or security – The substitution of a new obligor on a nonrecourse debt instrument is not a significant modification. Conversely, a substitution of a new obligor on a recourse debt instrument is generally a significant modification.
5. Changes in the nature of a debt instrument – In general, a change in the nature of a debt instrument from recourse to nonrecourse, or vice versa, is a significant modification.
6. Changes to accounting or financial covenants – A modification to a debt instrument’s covenants can result in a significant modification if the lender receives a payment for agreeing to the modification.

If the modification was significant, what are the tax consequences to the borrower and lender?

If a significant modification of a debt has occurred, an adviser should analyze the various tax consequences to the borrower and the debt holder of the deemed exchange, in order to avoid any unpleasant surprises.