REAL ESTATE WORKOUTS—ORIGINAL ISSUE DISCOUNT IMPLICATIONS OF TROUBLED DEBT RESTRUCTURINGS

Historically, debtors have considered a troubled loan workout to be a viable alternative to a foreclosure or deed in lieu of foreclosure, at least in part because of the potential to avoid incurring a tax liability. However, the application of the original issue discount principles to debt instruments issued for nontraded property as part of the Deficit Reduction Act of 1984 will change the focus in real estate workouts if the proposed regulations issued pursuant to Internal Revenue Code Section 1274 are finalized in their current form. To the surprise of tax practitioners who considered a loan modification to be a nontaxable event to the debtor, the proposed regulations could force the debtor to recognize income from discharge of indebtedness even if the stated principal amount of the loan is not modified. Some important factors include the status of the lender as either a financial institution or the seller of the property securing the loan and the terms of the proposed restructuring.