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Attorney Seeks Guidance on Tax Consequences of Purchasing Distressed Debt

MAY 31, 2009

Attorney Seeks Guidance on Tax Consequences of Purchasing Distressed Debt

DATED MAY 31, 2009
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From: Swenson, Eric D. [EDS@procopio.com]

 

Sent: Sunday, May 31, 2009 7:51 PM

 

To: Notice Comments

 

Subject: Notice 2009-43

 

 

Dear Sir/Madam:

I. Request: Pursuant to Notice 2009-43, we respectfully request that the IRS include in its 2009-2010 Guidance Priority List guidance regarding the various tax ramifications to distress investors who purchase large pools of underperforming or "troubled" home mortgage loans (hundreds or thousands at a time) from various financial institutions with the intention of modifying such loans with the particular homeowner.

II. Discussion:

A. Background: The Issue/Problem. Given the current state of the economy, including the significant number of "troubled" home mortgage loans (i.e., "distressed debt") in existence, and the apparent need for financial institutions to reduce the amount of their distressed debt, the number of "distress investors" (those who purchase such distressed debt in bulk (in pools) from financial institutions), is on the rise. Such distress investors generally purchase distressed debt for investment, but also understand that most of the debt instruments (e.g., home loans) must be modified in order for such loans to have any continued economic value. Although the same tax consequences have always existed for distress investors, the need for guidance regarding the tax ramifications to distress investors is needed more than ever based on the current economic climate and the expected increase in the number of distress investors.

B. The Current Tax Law. When a debt instrument is modified, a "deemed" taxable exchange results if the modification is "significant" within the meaning of Treasury Regulation Section 1001-3. For example, a reduction in the principal of the debt instrument, an extension of the maturity of the debt instrument, or a change in the yield of the debt instrument can result in "significant" modification resulting in a deemed taxable exchange of the debt instrument by the distress investor. For non-publicly traded notes (debt instruments), this "deemed" exchange will generally result in taxable gain to the note holder (distress investor) based on the difference between the face amount of the modified note and the note holder's tax basis in the original note (i.e. the amount paid for the original note by the distress investor from the financial institution).

C. Example. A distress investor purchases an underperforming non-publicly traded note (home mortgage) from a financial institution with a face amount of $1 million for $750,000. To improve its chances of repayment, the distress investor then works with the borrower (homeowner) to extend the maturity date of the note and/or reduce the interest rate of the note. Assuming either of such modifications is deemed "significant" within the meaning of Treasury Regulation 1.1001-3, the distress investor will be treated (deemed) as if it exchanged the original note for the new note with the modified terms. Accordingly, under the current tax law, the distress investor will realize a current year short term capital gain in the amount of $250,000, which is the difference between the face amount of the new note with the modified terms ($1 million) over the distress investor's tax basis in the "old" note ($750,000) (the "Phantom Gain").

D. Phantom Gain. The Phantom Gain, resulting in current tax, bears absolutely no relationship to any economic gain realized by the distress investor. Certainly, the potential of such currently taxable gain will: (i) have a chilling effect on the number of distress investors willing to invest in distressed debt; and (ii) reduce the number of distress investors willing to modify such loans with homeowners.

Although not entirely clear, the distress investor may be able to recognize the Phantom Gain as payments are received under the Section 453 installment method rules, thereby mitigating the unfavorable tax result of "significantly" modifying a debt instrument. Nevertheless, to date, it does not appear that the IRS has commented on whether the use of Section 453 to reduce the potential Phantom Gain is appropriate under any circumstances. Furthermore, if the installment method can generally be used to mitigate the impact of the Phantom Gain, what are the limitations on using such method? For example, for the distress investor who purchases loans in bulk (in pools) for investment, will the modification of such loans, which are "deemed exchanges" under Section 1001-3, cause the distress investor to be defined as a "dealer" under Section 453, thereby precluding the use of the installment method (under Section 453) to report the gain?

Guidance from the IRS is needed now more than ever for these type of issues facing the distress investor, and for which the tax law is not entirely clear.

Thank you for your time and consideration.

Regards,

 

 

Eric D. Swenson

 

Attorney at Law

 

Procopio, Cory, Hargreaves &

 

Savitch LLP

 

530 B Street, Suite 2100

 

San Diego, CA 92101

 

direct dial: 619.515.3235

 

direct fax: 619.744.5415

 

eds@procopio.com

 

www.procopio.com

 

mailgw01.procopio.com made the following annotations

Sun May 31 2009 16:50:52

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