In today’s volatile borrowing climate—marked by interest rates higher than in prior years, tighter credit conditions, and increasing borrower distress—troubled debt restructurings (TDRs) are a critical area of focus for both borrowers and lenders, auditors, tax professionals, and financial statement users. As economic pressure mounts, more borrowers are seeking concessions, and understanding the accounting and tax implications is essential.
What Is a TDR?
Under Accounting Standards Codification (ASC) 470-60, a TDR occurs when a borrower, facing financial difficulty, receives a concession from a lender that wouldn’t otherwise be granted. These concessions might include:
- Extended payment terms
- Reduced interest rates or principal
- Debt forgiveness or restructuring of covenants
The accounting treatment can be complex—and has an impact on the financial statements as well as the disclosures.
Why It Matters
Taxpayers should consider the following factors with TDRs:
- Impact on Earnings: Gains or losses from restructuring may affect reported income.
- Signal to Investors & Creditors: A TDR can raise red flags about solvency and future cash flows.
- Disclosure Requirements: GAAP mandates detailed disclosures that can influence market perception.
- Strategic Consequences: Renegotiated terms may trigger other contractual obligations or limit future financing options.
- Significant tax considerations and consequences (see details below).
Tax Considerations
Cancellation of Indebtedness Income
A common element in a TDR is a reduction or forgiveness of a taxpayer’s debt. Under Internal Revenue Code (IRC) Section 61(a)(12), the borrower will generally recognize cancellation of indebtedness income (CODI) on the forgiveness or reduction of the taxpayer’s debt. This can be an unfavorable result for many taxpayers; however, exceptions may apply.
IRC §108 provides for several exclusions that allow taxpayers to avoid the recognition of CODI into their gross income. While there are five statutory exclusions in IRC §108, e.g., bankruptcy or insolvency, one common exclusion is the qualified real property business indebtedness (QRPBI) exclusion under IRC §108(a)(1)(D). This provision is particularly relevant for real estate businesses facing financial distress, as it allows for the deferral of CODI through basis reduction rather than outright taxation.
The QRPBI exclusion provides that a taxpayer’s CODI is not included in gross income if “in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property indebtedness,” or QRPI.
The exclusion turns on whether the debt qualifies as QRPI. IRC §108(c)(3) provides that QRPI is indebtedness that:
- Is incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by that property;
- Was incurred or assumed before January 1, 1993, or if later, qualifies as qualified acquisition indebtedness;
- Is subject to an election by the taxpayer to apply the exclusion.
With respect to qualified acquisition indebtedness in (2) above, the debt must be “incurred or assumed to acquire, construct, reconstruct, or substantially improve such property,” according to IRC §108(c)(4).
The exclusion from gross income is then limited to the principal amount of QRPI forgiven or discharged, over the fair market value (FMV) of the property at the time of modification reduced by the outstanding principal of any other QRPI secured by such property. Further, the exclusion is limited to the adjusted basis of the subject property after applying the above.
This exclusion comes at a cost. The taxpayer must reduce its adjusted tax basis in depreciable property, which includes a partner’s proportionate interest in a partnership’s depreciable property but only if there is a corresponding reduction in the tax basis of the depreciable property held by the partnership with respect to the electing partner. The QRPI exclusion generally results in a deferral of the CODI, rather than an elimination of the income. Deferred COD income is generally recaptured as ordinary income.
Asset Transfers & Debt-for-Equity Exchange
During a TDR, an asset may be transferred to a lender to settle a debt. This will generally trigger a sale or exchange and a gain or loss recognized based on the amount of the debt if the debt is nonrecourse debt or if recourse debt is over its tax basis.
A taxpayer may also wish to settle a debt with a lender by issuing equity in exchange for the settlement of the debt. This type of transaction has the potential to generate CODI if the borrower is a partnership or a corporation and the FMV of the equity being issued is less than the debt being discharged under the settlement.
These areas are complex and consultation with a tax professional should be sought.
Key Questions to Consider
- Have you properly assessed whether your debt modification qualifies as a TDR?
- Are you documenting financial difficulty and lender concessions with sufficient clarity?
- Do you understand how the restructuring affects your future obligations and financial ratios?
- Will the TDR generate CODI? If so, will it qualify for one of the exclusions under 108? Is the debt QRPI under the requirements? Was the trade or business requirement met?
- Does the QRPI exclusion coordinate with any of the other exclusions? (For example, bankruptcy and insolvency exclusions are applied first.)
It is also important to evaluate the impact of future depreciation and potential gain recognition when making the QRPBI exclusion, as well as its impact to partnership partners and S corporation shareholders.
How Forvis Mazars Can Help
Our team at Forvis Mazars can assist with these considerations. If you’re navigating a debt restructuring and are unsure how to account for it, please reach out to one of our professionals.