Loan Workouts

Justin Horst – CFO, Pinnacle Bancorp, Inc.Jason Anderson – Partner, Deloitte Tax LLPCraig Gibian – Principal, Deloitte Tax LLPGregory Marques – Senior Manager, Deloitte Tax LLP

Agenda

• Loan Modifications• Bad Debt Deductions• Foreclosure Property Expenses

Loan Modifications

Loan Modifications Overview

• It is often advantageous for both the borrower and the lender to modify the terms of a loan prior to default.

• These modifications, often referred to as “amend and extend,” can have important tax consequences for both the borrower and the lender.

• The threshold question is whether the modification is treated as a “significant modification” under the relevant rules, thereby causing a deemed exchange of the original loan for a loan with the modified terms.

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Loan ModificationsOverview (cont.)

• From the lender’s perspective, a deemed exchange may cause the current recognition of gain or loss. While the result is generally a timing difference, certain entities must also consider character issues, including the possibility of recognizing a capital loss and the future inclusion of ordinary income.

• From the borrower’s perspective, a deemed exchange may cause the recognition of cancellation of debt income (“CODI”). Similar to the result for lenders, this generally results in a timing difference for tax purposes by accelerating income, but can lead to a permanent difference for borrowers in certain circumstances.

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Loan Modifications Overview (cont.)

• The calculation of gain or loss for lenders and the determination of CODI for borrowers is based upon the “issue price” of the loan issued in the deemed exchange; this in turn depends upon whether the loan is considered to be “publicly traded” for tax purposes.

• Recently revised treasury regulations expanded the definition of publicly traded property, but with one important exception that narrows the definition in limited circumstances.

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Loan Modifications Overview (cont.)

This discussion covers three key concepts:• When does a modification of the terms of a loan trigger a deemed

exchange for tax purposes?• What are the tax consequences to lenders and borrowers upon a

deemed exchange?• How does the expanded definition of publicly traded property

impact lenders and borrowers?

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Loan Modifications “Significant Modifications”

• The rules for determining whether a modification of a loan is a “significant modification” that causes a deemed exchange are found in Treas. Reg. § 1.1001-3.

• With limited exceptions, modifications that occur by operation of the terms of a loan, including modifications that occur pursuant to a unilateral option, are not tested.

• Generally, other than the five categories of modifications discussed below, the question is whether the modification is “economically significant.” For purposes of this test, the cumulative effect of modifications are considered.

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Loan Modifications “Significant Modifications” (cont.)

• Yield change. A change in the annual yield by more than the greater of (a) 25 basis points or (b) 5% of the yield of the unmodified loan is a significant modification. This test is based on cumulative changes over the prior 5 years.

• Change in timing of payments. A deferral of payments within the safe harbor of the lesser of 5 years and 50% of the loan’s originalterm is not a significant modification.

• Change in obligor or security. With limited exceptions, a change in obligor on a recourse loan is a significant modification. The treatment of a change in security depends upon a number of factors.

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Loan Modifications“Significant Modifications” (cont.)

• Change in nature of the loan. A modification that results in the loan not being treated as debt for tax purposes or changes the recourse nature of the loan is a significant modification.

• Change in accounting or financial covenants. A modification that alters customary accounting or financial covenants is not a significant modification; however, if a payment is made by the borrower to change a covenant, the change in yield test must also be considered.

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Loan Modifications Determination of Issue Price

The determination of the issue price of a loan issued for property (including the new modified loan in a deemed debt-for-debt exchange) generally depends on whether either the new modified loan or the old unmodified loan is “publicly traded.”

• If the new loan is publicly traded, then the issue price is the fair market value of the new loan.

• If the new loan is not publicly traded, but the old loan is publicly traded, then the issue price of the new loan is the fair market value of the old loan.

• If neither the new loan nor the old loan is publicly traded, then the issue price of the new loan is determined under IRC § 1274 (generally the face amount if the loan has adequate stated interest).

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Loan Modifications Lender Consequences

• The amount realized by lenders (including secondary purchasers) upon a deemed exchange will equal the issue price of the new modified loan (plus any cash consideration received).

• If such amount is greater than the lender’s tax basis, the lender will realize gain, and, conversely, if the amount realized is less than the lender’s tax basis, the lender will realize loss. Gain or loss may not be recognized if the “recapitalization” rules apply in the case of corporate borrowers where the loan is a “security” for these purposes.

• Even where gain or loss is currently recognized, the result is generally a timing difference that will accelerate current gain or loss, with offsetting income or deduction realized over the remaining life of the loan through the inclusion of original issue discount (OID) or the deduction of premium. 13

Loan ModificationsLender Consequences (cont.)

• For certain lenders or purchasers of loans, these rules do have the potential to cause character whipsaws where taxpayers may recognize a current capital loss, and then take into account OID as ordinary income over time.

• For purchasers of loans, the rules can also turn “market discount” into OID, which generally is an unfavorable result because it will generally accelerate income.

• We also note that in certain circumstances involving distressed loans, taxpayers may not be required to accrue interest or follow the market discount rules.

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Loan ModificationsBorrower Consequences

• Borrowers will have CODI to the extent that the issue price of the new modified loan is less than the “adjusted issue price” of the original unmodified loan (generally the stated principal amount of the loan if it was originally issued for par and pays cash interest currently).

• Distressed borrowers may recognize a large amount of CODI if fair market value is used to determine issue price (i.e., in situations where the new loan or the old loan is treated as publicly traded). Consider the application of any exceptions for bankruptcy and insolvency.

• Because the new loan deemed to be issued would generally have OID equal to the amount of the CODI, the result is often a timing difference for borrowers as opposed to a permanent difference. However, the application of the applicable high yield discount obligation (AHYDO) rules can cause a permanent difference if the borrower is not entitled to deduct all of the OID as it accrues or is paid.

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Loan ModificationsPublicly Traded Property

• A debt instrument is considered to be publicly traded if it is “traded on an established securities market.”

• Recent Treasury regulations replace the four categories of publicly traded property under the prior regulations with three categories of property, each determined by looking to the 31-day period ending 15 days after the issue date of the new instrument.

• These rules make it likely that a large, syndicated loan will be treated as publicly traded for this purpose.

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Loan ModificationsPublicly Traded Property (cont.)

Category 1: Sales Price• The price for an executed purchase or sale of the property is

reasonably available within a reasonable period of time after the sale.

Category 2: Firm Quotes• A price quote is available from at least one identified broker,

dealer or pricing service, and the price is substantially the same as the price for which the person could purchase or sell the property.

Category 3: Indicative Quotes• A price quote is available from at least one broker, dealer or

pricing service, and the price quote is not a firm quote. If the quote is from a pricing service, the broker/dealer providing the quote need not be identified.

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Loan ModificationsPublicly Traded Property (cont.)

• Small Debt Exception. A loan will not be treated as publicly traded if the stated principal amount of the loan does not exceed $100 million. In this case, if the loan is restructured or modified, the debt will be deemed to be issued at its face amount (assuming it has adequate stated interest), regardless of its actual fair market value. This rule generally alleviates the CODI concern for borrowers.

• Section 1274. As part of the new regulations package, the regulations under IRC §1274 were revised to provide that taxpayers may not use the “recent sales transaction” exception to IRC §1274 to use fair market value for issue price in the case of a debt-for-debt exchange.

• Anti-abuse Rule. If the purpose of any temporary restriction on trading of property is to avoid causing such property to be publicly traded, then the property will be treated as publicly traded. If a principal purpose of any sale or price quotation is to cause the property to be publicly traded or to materially misrepresent the value of the property, such sale or price quotation will be disregarded.

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Loan ModificationsPublicly Traded Property (cont.)

• Determination of Fair Market Value. The fair market value of publicly traded property will be presumed to be equal to its sales price or quoted price. If there are multiple prices, a taxpayer may use any reasonable method to determine fair market value. For indicative quotes, if the taxpayer determines that the indicative quote materially misrepresents the fair market value of the property, the taxpayer may use any method that provides a reasonable basis to determine the fair market value of the property.

• Issuer/Holder Reporting Consistency. Issuers are required to exercise reasonable diligence to determine if property is publicly traded and, in such case, its fair market value and to disclose that information to holders. The determination made by the issuer is binding on the holder, unless the holder explicitly discloses a different determination on its tax return.

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Loan ModificationsTax Reporting Considerations

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• If debtor is personally liable for debt (i.e. “recourse debt”), the amount of a canceled debt should usually be included as income to the debtor for tax purposes. (i.e. COD)

• Non-recourse debt cancelation usually does not result in income unless‒ The lender offers a discount for early payment or‒ The lender agrees to a loan modification that results in a reduction of the principal debt

amount.

• A taxable cancelation of debt must be reported on the income tax return‒ IRS Form 1099-C is meant to ensure cancelations of debt are reported as income on

tax returns where appropriate

• Loan modifications or discounts can also generate COD income, depending on the type of debt.

• Sales or dispositions (e.g. foreclosure or repossession) of property subject to recourse debt that exceeds the fair market value (“FMV”) of the property can also lead to COD income.

Loan ModificationsTax Reporting Considerations

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In 2004, Nancy Oak bought a main home for $435,000 subject to a $420,000 mortgage with a down payment of $15,000, secured by the home. In 2005, Nancy took out a second mortgage loan in the amount of $30,000 that was used to substantially improve her kitchen.

In 2008, when the outstanding principal on the loans was $440,000, Nancy refinanced the loans into one loan for $475,000. The FMV of Nancy's home at the time of the refinancing was $500,000.

In 2010, Nancy was unable to make her mortgage loan payments. On August 31, 2010, when the outstanding balance of her refinanced mortgage loan was still $475,000 and the FMV of the property was $425,000, Nancy's bank agreed to a loan modification (a “workout”) that resulted in a $40,000 reduction in the principal balance of her loan. Nancy was neither insolvent nor in bankruptcy at the time of the loan modification.

* Examples based on IRS Publication 4681

Loan Modifications Form 1099-C

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Note that because Nancy used $35,000 of her loan to pay off personal credit cards and college tuition for her son; only $5,000 of the COD was qualified principal residence indebtedness.

Bad Debt Deduction

Bad Debt Deduction Requirements

• Generally, a bank is entitled to an ordinary deduction under IRC §166(a) if it owns a debt instrument that becomes either wholly worthless, or partially worthless and is charged off.

• For non-banks, there are other requirements to obtain ordinary treatment, including a requirement that the debt not be a security under IRC § 165(g)(2)(C).

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Bad Debt Deduction Worthlessness

A wholly worthless bad debt deduction must be taken in the year the debt becomes worthless.

• Taxpayer has the burden of proof;• Taxpayer must show that the debt had some value at the

beginning of the tax year and no value at the end; and• Taxpayer must show an identifying event during the year

indicating worthlessness or otherwise satisfy the burden of proof based on the taxpayer’s documentation.

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Bad Debt Deduction Partial Worthlessness

• Under the general rule, the taxpayer must prove partial worthlessness independently of the amount of the charge-off. The same general standards apply in determining partial worthlessness as total worthlessness.

• There are special rules to establish partial worthlessness (discussed later).• Specific orders by regulators under Treas. Reg. § 1.166-2(d)(1)

(conclusive presumption).• Conformity election available to banks under Treas. Reg. §

1.166-2(d)(3).• Industry Director Directive for insurance companies.

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Bad Debt Deduction Partial Worthlessness (cont.)

• Establishing partial worthlessness under the general rule does not mean a mere difference between a debt’s face amount and its fair market value.

• As a practical matter, the taxpayer may be able to follow book where the security is charged off based on “credit losses.”• A “credit loss” is measured based on expected flows discounted

at the original yield of the security.• The determination of “credit loss” under general accounting rules

might suffice to establish worthlessness under IRC § 166.

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Bad Debt Deduction Charge-off requirement

• The purpose of the book charge-off requirement is to prevent taxpayers from carrying assets on their books at a higher value than such assets are carried for tax.

• Neither the Internal Revenue Code nor the regulations prescribe a particular method for making a charge-off of a bad debt.

• Generally speaking, an effective charge-off has been made if the book entries relied upon have effectively eliminated the amount of the debt (or the part which is worthless) from the book assets of the taxpayer.

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Bad Debt Deduction Charge-off requirement (cont.)

• Must a charge-off occur for the year of the deduction?• Can a taxpayer claim a partial bad debt deduction by amending a

prior return?• Can a taxpayer claim a partial bad debt deduction in a year

subsequent to the book charge-off?• Consider deemed charge-offs under Treas. Reg. § 1.166-3(a)(3),

relating to significantly modified debt.

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Bad Debt Deduction Conclusive Presumption

Banks or other corporations subject to supervision by Federal or State authorities may take a bad debt deduction in whole or in part if it occurs:

• In obedience to the specific order of such authorities, or• In accordance with established policies of such authorities,

and, upon their first audit of the bank or other corporation subsequent to the charge-off, such authorities confirm in writing that the charge-off would have been subject to such specific orders if the audit had been made on the date of the charge-off.

Applies to banks and other corporations subject to supervision by Federal authorities, or by State authorities maintaining substantially equivalent standards.

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Bad Debt Deduction Book conformity method

• This is a method of accounting under which a bank claims a bad debt deduction in the year in which the debt is charged-off for regulatory purposes. Treas. Reg. § 1.166-2(d)(3).

• If a bank regulator issues an express determination letter stating that a bank electing this method applies loan loss classification standards consistent with regulatory loan loss classification standards, loan losses are conclusively presumed to be worthless in whole or in part.

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Bad Debt DeductionNotice 2013-35

• In Notice 2013-35, the IRS requested comments on whether recent changes to the bank regulatory standards for loan charge-offs require changes to the conclusive presumption and the book conformity method.

• The IRS is concerned that changes to bank regulatory standards have created standards that are no longer consistent with the principles of IRC § 166.

• Treasury has indicated that administrative convenience alone is not a sufficient reason for the conclusive presumption and the book conformity method.

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Bad Debt Deduction Notice 2013-35 (cont.)

Notice 2013-35 raises a number of specific questions, including:• In addition to banks, which other corporations should be covered

by revised rules?• What process should be required to verify losses?• Should there be just a single rule providing for conclusive

presumptions?

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Bad Debt Deduction Industry Director Directive

Industry Director Directive (LB&I-4-0712-009) allows insurance companies to claim a partial bad debt deduction for the amount of SSAP 43R credit-related impairment charges as reported on the company’s annual statement.

• Must be elected no earlier than the taxpayer’s 2009 return and no later than its 2012 return.

• Allows taxpayers to claim a partial bad debt deduction without demonstrating that the debt is partially worthless for tax purposes.

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Foreclosure Property Expenses

Foreclosure Property Treatment of Expenses

• Costs associated with certain real or personal property acquired by a taxpayer for resale are required to be capitalized. IRC §263A(b)(2)(A).

• There has been an ongoing controversy regarding whether expenses incurred by banks with respect to “other real estate owned” (OREO) acquired in foreclosures must be capitalized.

• The IRS took the position that banks were required to capitalize expenses that are attributable to OREO.

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Foreclosure PropertyTreatment of Expenses (cont.)

• In GLAM 2013-001, the IRS changed its position in a situation involving OREO acquired through foreclosure proceedings by the bank that originated the underlying loan.

• The IRS focused on whether the bank had acquired the OREO for resale, consistent with the wording of IRC § 263A(b)(2)(A).

• The IRS then looked to regulations providing that a bank’s expenses relating to loan origination activities are not required to be capitalized.

• Based on this analysis, the IRS concluded that the bank was not required to capitalize its expenses because the OREO was not “property acquired for resale” within the meaning of IRC §263A(b)(2)(A).

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Foreclosure Property Treatment of Expenses (cont.)

Rev. Proc. 2014-16 issued on January 24, 2014• Automatic Consent to discontinue capitalizing costs under

Section 263A to real property acquired through foreclosure• Applies to taxpayers that originate, or acquire and hold for

investment, loans that are secured by real property and acquire the real property that secures the loans at a foreclosure sale, by deed in lieu of foreclosure, or in another similar transaction

• Expands taxpayer friendly guidance in GLAM 2013-001• Scope limitations waived for first or second taxable year

ending after December 31, 2012

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About this presentation• This presentation contains general information only and the

respective speakers and their firms are not, by means of this presentation, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This presentation is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. The respective speakers and their firms shall not be responsible for any loss sustained by any person who relies on this presentation.

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Contact InformationJustin HorstCFO, Pinnacle Bancorp, Inc.(402) 697-5951justin.horst@pinnbank.com

Jason AndersonPartner, Deloitte Tax(206) 716-7573jasoanderson@deloitte.com

Craig GibianPrincipal, Deloitte Tax(202) 220-2637cgibian@deloitte.com

Gregory MarquesSenior Manager, Deloitte Tax(415) 783-6478grmarques@deloitte.com