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In today’s climate of low interest rates, many people are thinking about modifying existing promissory notes to take advantage of lower rates for a longer period of time. The willingness of financial institutions to cooperate with the desire to take advantage of lower rates varies. In the context of a sale between related parties, however, installment notes are often structured with an interest rate just high enough to avoid imputed interest, and the parties would be happy to modify the notes to provide for less interest or even make other changes.
It almost seems like a deal too good to be true. Many people thinking about modifying a promissory note may wonder exactly what tax consequences would result from such an action.
In general, when the terms of a debt instrument are significantly modified, the result is a deemed disposition of the old debt instrument for the new, modified debt instrument (the “Modified Note”). See Code § 1001 and the accompanying Treasury Regulations. As a result of the deemed disposition, the Noteholder may realize gain or loss. In the context of family note modifications, where the lender will have a basis in the note equal to its face value, the deemed exchange of notes likely results in a loss. However, such losses between related parties cannot be recognized. Code § 267. From the debtor’s perspective, the debtor may realize income due to cancellation of indebtedness, depending upon the nature of the modification, although in practice this is not an issue when the Modified Note provides for adequate stated interest and certain other conditions are met.
Under Code Section 1001 and the accompanying Treasury Regulations, there are many changes which result in a “significant modification” of a note and therefore a deemed disposition of an old note for a new note. A modification generally occurs if there is an alteration of a legal right or obligation of the issuer or holder of a debt instrument, which is a very low threshold. The determination of whether such a modification is significant is made under Treasury Regulation Section 1.1001-3(e) which lists certain changes in yield, certain changes in timing of payments, changes in the identity of the obligor, the addition or deletion of a co-obligor, change in security or credit enhancement, change in priority of debt, change from debt to equity, change in recourse nature of debt, and changes in covenants as significant modifications for purposes of triggering a disposition under Section 1001.
In contrast to the relatively low threshold for a disposition under Section 1001, the Code and Treasury Regulations provide different treatment for installment obligations issued in connection with the sale of property. Whether there has been a deemed disposition of an installment obligation is governed by the law under Code Section 453B and not Code Section 1001. Preamble to T.D. 8675, 61 Fed. Reg. 32926 (June 26, 1996) (the preamble to the final debt modification Regulations issued in 1996 provide that the cases and rulings applicable to Section 453B, and not the Section 1001 significant modification rules, will govern whether there has a deemed taxable disposition of an installment obligation). A deemed disposition of an installment obligation would result in the acceleration of gain deferred under the installment reporting rules. Fortunately, the rules governing modifications that constitute a disposition of the note under Code Section 453B are significantly more lenient than under Code Section 1001.
In order for a deemed disposition to result from the modification of an installment obligation, the modification must be substantial and result in a material change in, or elimination of, the rights of the seller so that the need to postpone recognition ceases. The Internal Revenue Service has found that the following modifications to an installment obligation did not result in a deemed disposition:
- Extension of maturity date;
- Suspension of principal payments;
- Change in interest rate;
- Substitution of one obligor for another;
- Change in nature of interest (i.e. variable versus flat rate);
- Modification of original purchase price; and
- Substitution of multiple installment notes for the original installment note.
In addition, a combination of those modifications may not result in a deemed disposition. In Revenue Ruling 68-419, 1968-2 C.B. 196, the parties modified an installment obligation to defer the dates of payment by 5 years and raise the interest rate from 6% to 7%.
On the other hand, Revenue Ruling 82-188, 1982-2 C.B. 90, is cited consistently as the example of when modification of an installment obligation goes too far and results in a deemed disposition. The corporate obligor in this ruling substantially increased the amount of its outstanding installment obligation in return for the Noteholder’s waiver of certain rights to convert the obligation into shares of the obligor corporation’s common stock. This amounted to a material change in the Noteholder’s rights and, therefore, a deemed disposition which accelerated the deferred gain.
Due to the more lenient treatment of installment obligations under Code Section 453B, they are excellent candidates for modification. In stark contrast to the rules relating to the modification of other debt instruments, it is easier to avoid a deemed disposition of an installment obligation when modifying terms such as payment term, interest rate, and even purchase price.