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The Tax Implications of Debt Restructuring Agreements

By Spodek Law Group | February 20, 2024

The Tax Implications of Debt Restructuring Agreements

Debt restructuring can seem like a complex financial move, but it is often a necessary step for individuals or companies struggling with debt. When done correctly, debt restructuring can provide relief and a path towards financial stability. However, there are important tax considerations to keep in mind with any kind of debt restructuring agreement.

Overview of Debt Restructuring

Debt restructuring involves changing the terms of existing debt agreements in order to make repayment more manageable. This usually means reducing interest rates, extending the loan term, or reducing the total amount owed. For example, a homeowner struggling with mortgage payments might negotiate with their lender to refinance their home loan at a lower interest rate or switch to a loan with lower monthly payments.There are a few common types of debt restructuring agreements:

  • Debt consolidation – Combining multiple debts into one new loan, usually with better terms
  • Debt rescheduling – Adjusting the repayment schedule for a loan by extending the loan term
  • Debt reduction – Lowering the total amount owed on a debt

Businesses might also restructure debts through Chapter 11 bankruptcy, which involves negotiating a court-approved repayment plan with creditors.

Taxability of Cancelled Debt

One key tax issue with debt restructuring is the concept of cancelled debt. If part of the principal owed on a debt is reduced or eliminated, that cancelled amount may count as taxable income.For example, if Jane originally owed $100,000 on a business loan and negotiated to have $20,000 of that debt cancelled, the IRS would treat that $20,000 as income earned by Jane’s business. So she would owe income tax on the $20,000, even though she never actually received any cash.There are some exceptions to the tax rules around cancelled debt:

  • Debt cancelled in a Chapter 7 or Chapter 13 bankruptcy is not taxed
  • Cancelled debt on a principal residence up to $2 million is tax exempt
  • If the borrower is insolvent (liabilities exceed assets), cancelled debt is generally not taxed

So in the case of consumer debt like credit cards or personal loans, debt reduction usually does not create a tax liability. But for things like business loans, mortgages on rental properties, or second homes, cancelled principal can definitely trigger extra taxes.

Restructuring Fees

Many debt restructuring agreements involve paying fees to creditors, lawyers, or settlement companies. These fees essentially pay for the creditor to accept a “haircut” – they agree to reduce the debt owed in exchange for an upfront fee payment.The tax treatment of restructuring fees can vary:

  • Fees paid directly to the lender are generally deductible for businesses. For consumers, there is no tax deduction.
  • Legal fees related to debt restructuring may be deductible or added to loan basis.
  • Fees paid to debt settlement companies are controversial and may not be fully deductible based on IRS guidance.

So businesses have more flexibility to deduct restructuring costs than individuals under current tax law. Talk to a tax professional to understand the precise tax status of any fees paid as part of a debt reduction program.

Modification vs. Extinguishment

Another key tax concept in debt restructuring is the issue of modification versus extinguishment. Basically, the IRS makes a distinction between:

  • Debt modification – Altering the terms of a debt while keeping the original loan intact
  • Debt extinguishment – Canceling a debt completely in exchange for a new replacement debt

With a debt modification, the original loan stays on the books, so there is no taxable event. But debt extinguishment essentially terminates the old loan and replaces it with a new one. This could trigger tax issues:

  • Canceled principal may be taxed as income
  • The new replacement debt receives a new tax basis

Again, this matters most for large debts like business loans or rental property mortgages. But it is an important technical distinction – debt modifications do not create tax issues in most cases, while debt extinguishment often does.

Getting Professional Tax Help

As the examples above illustrate, the tax implications of debt restructuring can be very situation-specific. The type of debt, the form of restructuring, and whether it is personal or business debt can all impact the tax treatment.Because of this complexity, it is highly advisable to talk to a tax professional or CPA when negotiating debt relief. They can help structure the agreements appropriately and make sure all tax forms are handled correctly afterwards.Here are some tips on finding affordable tax help with debt restructuring agreements:

  • Ask your existing CPA or accountant for advice
  • Search for local IRS Enrolled Agents who specialize in debt relief issues
  • Look for CPAs or EAs who offer fixed-fee consultations on debt and taxes
  • Hire an expert just to review paperwork and file the right tax forms afterwards

With the right tax planning, it is possible to reduce debt significantly without negative tax surprises down the road. Please let us know in the comments if you have any other questions on the tricky tax implications of debt restructuring!

Resources

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I hope this overview on the tax issues around debt restructuring was helpful! Let me know if you have any other questions.

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