By Jones Osborn II

The depression in Arizona real estate has caused many debtors to seek a renegotiation of their debts, particularly debts secured by real property. Often debtors seek a modification that will (a) accrue but defer the payment of all or a portion of the interest, (b) reduce the rate of interest, or (c) reduce the principal balance of the note. Each of these modifications can have unexpected tax consequences for one or both parties to the transaction.

Deferral of Interest. The deferral of the payment of interest generally is not a problem for the debtor. The creditor or note holder, however, will probably have to recognize the accruing interest as income, at least if the creditor is an accrual basis taxpayer. This can come as an unpleasant surprise because no one likes to pay income taxes on income he has not yet received. An exception is available, however, if the creditor can show that the future payment of the interest is reasonably uncertain.

Reduction of Interest Rate. If the interest rate is reduced below the applicable federal rate, the modification can create cancellation of indebtedness income for the debtor and a loss (usually a capital loss) for the creditor. The applicable federal rate is a floating rate tied to U.S. Treasury securities of varying maturities which is used as a standard for judging whether the parties to a transaction have provided for a reasonable rate of interest. The applicable federal rate changes from month to month to reflect changes in market rates of interest.

Cancellation of indebtedness income results from a reduction in the interest rate below the then applicable federal rate because the Internal Revenue Service recharacterizes some of the principal payments as interest payments in order to bring the stated rate up to the required rate. As a result, the principal balance of the note is treated as having been reduced, since principal payments which are to be treated as interest cannot also be treated as principal. This can create cancellation of indebtedness income for the debtor and capital loss for the creditor. Again, this can be an unpleasant surprise for the debtor who is treated as having income for tax purposes when he has received no money.

Reduction of Principal. An agreement to reduce the principal amount of a debt will generally result in debt cancellation income to the debtor and capital loss to the creditor. An exception is available, however, for purchase money indebtedness if (a) the reduction is the result of an agreement between the seller and buyer of the property, (b) the parties to the agreement are the original seller and original buyer of the property, and (c) the reduction does not occur in a bankruptcy or when the debtor is insolvent.

Conclusion. The tax rules governing the modification of debt instruments are extremely complex and are well understood only by experts in the field. Those involved in debt renegotiations should be aware of the general types of modifications that can create tax consequences, and before finalizing any modification agreement, should consult with a competent tax advisor to be sure they understand all the costs and benefits of the transaction.