COD Tax Consequences in a Loan Workout

Many borrowers are addressing debt workout issues in this current economic environment. Often clients are unaware of the tax consequences of these proposed transactions and are surprised to discover that there are potential adverse tax consequences that can result from ordinary workout situations. The tax rules in this area are complex and beyond the scope of a Client Alert; however, recent legislation has provided some significant relief in this area. Cancellation of indebtedness (“COD”) income can result from a number of situations, including an actual reduction in the face amount of debt (e.g., a “short sale” or other discounted loan payoff or a foreclosure sale for less than the outstanding loan amount), the exchange of property in relief of debt (e.g., the grant of a deed in lieu of foreclosure), or a “significant modification” of the terms of a debt instrument. For federal income tax purposes, a significant modification is treated as an exchange of the old debt for new debt. COD income can also arise when a related party of the debtor purchases the loan at a discount.

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