Proper Tax Treatment of Discounted or Distressed Debt Purchased in the Secondary Market– September 21, 2017 by Lisa Loychik

Over the years we have seen companies, many of whom operate in real estate, purchase debt in the secondary market often significantly below the principal amount owed.  The goal is to collect the price paid for the debt as well as a substantial portion of its original principal amount. However, those who are unfamiliar with these types of transactions may not realize that market discount rules can put a wrinkle in even the best-laid plans.
It often takes over a year to collect or settle purchased debt. It would be easy to assume that the difference between the amount paid for the debt (the basis) and the amount collected would be capital gain — more specifically long-term capital gain, which enjoys a reduced tax rate. However, market discount rules reclass principal payments on the debt to ordinary income to the extent of accrued but unrecognized market discount. 

What is Market Discount?

Enacted by Congress in 1984, market discount is defined in the Internal Revenue Code as the excess of: 

  1. The stated redemption price at maturity (usually the bond’s principal amount) over
  2. The holder’s cost basis in the bond. 

Gain realized on the disposition of a market discount bond is considered attributable to market discount and thus taxed as ordinary income to the extent that the market discount has accrued during the holder’s ownership.
If the debtor makes a partial payment of principal on debt bought in the secondary market, the taxpayer must treat the payment as accrued market discount, to the extent it was not previously recognized. Accrued market discount is generally determined on a straight-line (ratable) basis from the date of acquisition to the date of maturity. The calculation is based on the number of days and accrues daily. This results in the first dollars received by the taxpayer being taxable as ordinary income. To the extent partial payment on the bond exceeds the amount of accrued and previously unrecognized market discount, the excess is treated as a nontaxable recovery of principal (basis). 

When Does Market Discount NOT Apply?

The Internal Revenue Code excludes certain debt instruments from the definition of a “market discount bond,” including: 

  1. Short-term obligations (maturing not more than one year from the date of issue - not date acquired),
  2. U.S. savings bonds, and
  3. Installment obligations to which Sec. 453B applies. 

These are not market discount bonds even though the taxpayer may have acquired the debt instrument at a price that was less than the stated redemption price at maturity.
A holder of the debt instrument is required to accrue market discount from the acquisition date to its maturity date (the remaining term of the bond) or disposition date, if earlier. What if the debt instrument has no remaining term when the holder acquires it? If the bond is distressed debt, it may very well be that the acquisition of the debt occurred after its maturity date had passed. Can the holder make an argument that the market discount rules do not apply because no remaining term exists? Would this argument hold up if the debt was acquired before maturity but it was in substantial default, whereby, under the terms of the note, the default provision causes the full amount due under the note to be payable currently and that provision is enforceable under applicable state law? In these circumstances, the debt instrument would be a demand loan when acquired. Therefore, there is no remaining term to accrue the market discount. It appears the market discount rules cannot apply, by their own terms, since no accrual period exists with respect to the debt. 

Cost-Recovery Method

Some cases that predate the enactment of the market discount rules may provide relief to the taxpayer. These cases have allowed for the use of the cost-recovery method. Under this method, a taxpayer can apply all payments of principal to basis first before recognizing income attributable to the market discount. The cases dealt with the timing of the recognition of the market discount income and did not deal with the character of the market discount income. To the extent addressed, characterizing the market discount as ordinary income was not challenged.
The courts have agreed the cost-recovery can apply to speculative debt, taking into account several factors to determine if debt is speculative, including: 

  • Whether the debtor and/or guarantor had personal liability, their credit standing, and resources available to make payment
  • The marketability of the debt instrument
  • Consideration as to whether the obligor was in substantial default on payments due at the time of acquisition
  • Whether a first, second, or other priority lien existed at the time of the acquisition, and the condition and market value of the underlying property, and;
  • The size of the discount 

Where certain debt obligations were determined to be speculative, the Tax Court allowed the taxpayer to use the cost-recovery method. In cases where it found the debt instruments were not speculative, it required the taxpayer to report the payments for principal pro rata, based on the total discount. 

In Summary

If at the time of the acquisition there is no evidence to support a finding that the notes are short term, and there is no evidence to support a finding that the taxpayer would not recover its basis in the notes, then market discount rules certainly apply. If, however, factors exist that would lead an informed person to conclude the likelihood that the cost of the notes and a substantial portion of the discount would not be collected after pursuing all legal options and remedies as provided by the terms of the note (foreclosure, guarantees, etc.), then, based on case history, the notes would be considered speculative, and the cost-recovery method may be appropriate.
Considering the impact that market discount rules can have on a strategy involving the purchase of debt in the secondary market, collaborate with your advisors and understand the rules before forging ahead. 
This piece was originally published in the August 2017 issue of The Tax Adviser, an AICPA publication.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.