Tax Pitfalls for Purchasers of Distressed Debt

February 2010Advisories

The current economic downturn has resulted in opportunities for investors to invest in distressed debt instruments, purchasing these assets at a deep discount to face value. Debt investors, however, need to be aware of potential tax pitfalls before acquiring these bargains. Two surprising pitfalls result from (1) “significant modifications” of debt acquired at a discount and (2) foreclosing on property after a discounted debt purchase.

Discounted debt investors may be surprised by the tax ramifications when they “significantly modify” a debt instrument acquired at a discount (e.g., by extending the maturity or changing the interest rates). Such a modification typically will cause the amount of the discount to become taxable gain. For example, assume an investor purchases mortgage debt with a “face” amount of $100 million for $60 million, and six months later, agrees to significantly extend the final maturity date without changing the face amount of the debt or reducing the interest rate below the IRS minimum rate (and assuming the debt is not publicly traded). The investor realizes $40 million of gain upon the modification without any cash to pay the taxes due. For U.S. investors, not only is the gain taxable, but it is taxed at high rates because a portion will be ordinary income under the market discount rules and the remainder is short-term capital gain.

An investor may be able to reduce its tax cost from a workout that creates taxable gain. For federal income tax purposes, an investor may be able to defer gain under the installment method. However, to the extent that the investor’s total amount deferred under the installment method exceeds $5 million, the IRS charges interest on the deferred tax. As an alternative, where possible, it is generally advantageous to the investor to request that the debt be modified by the selling debt instrument holder prior to the investor’s acquisition. The seller generally would not suffer adverse tax consequences from such a modification. Recognizing that (i) modifying a debt prior to the investor’s acquisition may not be practical or possible, and (ii) the interest cost on the installment gains over $5 million may neutralize the benefit of deferral on the installment, an investor needs to consider the potential income tax effects when determining its acquisition price.

The second pitfall occurs when an investor acquires distressed debt to facilitate acquiring the encumbered property in a “loan-to-own” strategy. Generally, at some time after the investor purchases the discounted mortgage, the investor will foreclose on the property or accept a deed-in-lieu of foreclosure. However, if the debt acquisition and foreclosure are separated in time by a significant period, the property value may have changed in the interim, causing surprising consequences upon foreclosure. For example, if the property is leased up or developed after the debt acquisition but before the foreclosure or deed-in-lieu, the property’s value may have increased. The investor may recognize taxable gain (without receiving any cash) for this appreciation upon foreclosure or deed-in-lieu of foreclosure.

Acquirers of distressed debt should consult their tax advisers when investing in or restructuring distressed debt.

For questions about the information contained in this advisory, please contact your usual Goulston & Storrs attorney or:

Steven R. Schneider
(202) 721-1145
[email protected]

Robert S. Towsner
(617) 574-6438
[email protected]

Pursuant to IRS Circular 230, please be advised that, to the extent this communication contains any federal tax advice, it is not intended to be, was not written to be and cannot be used by any taxpayer for the purpose of (i) avoiding penalties under U.S. federal tax law or (ii) promoting, marketing or recommending to another taxpayer any transaction or matter addressed herein.

This advisory should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own lawyer concerning your situation and any specific legal questions you may have.