Deemed Exchange: Significance Tests, Issue Price, and CODI Relief

Under Treasury Regulation Section 1.1001-3, a significant change to an existing loan is treated for federal tax purposes as if the old debt had been retired and a new one issued in its place. This is the deemed exchange, and the tax treatment of debt modifications that cross the significance threshold can hit both sides hard: the borrower may recognize cancellation-of-indebtedness income in the year of the modification, and the lender may realize gain or start accruing phantom interest, all without a dollar of new cash moving between them.

The practical danger is a tax bill without the cash to pay it. A borrower who renegotiates rate, principal, or timing to survive a downturn can find the concession itself taxed as income. A creditor who agreed to help can end up reporting interest it hasn’t received. Knowing which changes trip the wire, and which don’t, is the whole game.

What Triggers a Deemed Exchange

Two things have to line up. First, there has to be a modification. Second, it has to be significant.

A modification is any change to a legal right or obligation of the borrower or the lender under an existing debt instrument. Formal amendments count. So do oral agreements to change a payment schedule or interest rate, and even a lender’s decision to waive rights after a missed payment.¹ The definition catches informal deals that rewrite the economics, whether or not anyone signs a new document.

What isn’t a modification: a change that happens automatically under the original terms. A floating rate that resets against SOFR or Prime is a built-in feature, not a new event. A borrower exercising an option already written into the contract at closing is the same story.¹ The rule targets negotiated changes made after the fact, not adjustments both sides already agreed to.

Once a change qualifies as a modification, the question is whether it’s significant. The regulation applies a general facts-and-circumstances test — has the economic substance of the debt changed? — and layers on specific bright-line rules for common categories.¹ Meeting the general standard or crossing any bright line is enough.

One point catches parties off guard. Multiple modifications to the same instrument are tested together, not one by one. A series of small concessions gets aggregated, and the change that pushes the collective total across the line is treated as the significant modification. For yield-change testing, prior modifications older than five years drop out; for other categories, there’s no fixed look-back cutoff.¹ Incremental restructuring is not a way around the rule.

The Bright-Line Significance Tests

Yield Changes

A change in yield is significant if the new yield differs from the original by more than the greater of 25 basis points or 5 percent of the original annual yield.¹ On a 3% loan, the threshold is 25 basis points because 25 bp beats 5% of 3% (15 bp). On an 8% loan, the threshold rises to 40 basis points because 5% of 8% now exceeds the floor. Higher-rate loans get more room before a rate change becomes significant.

Payment Timing

Deferring payments doesn’t automatically trigger a deemed exchange. A safe harbor protects deferrals where the postponed payments remain unconditionally due within a period equal to the lesser of five years or 50 percent of the original loan term, measured from the original due date of the first deferred payment.¹ A ten-year loan gets a five-year safe harbor. A six-year loan gets three years. Unused safe-harbor time carries forward if payments get deferred again later.

Substitution of the Borrower

Replacing the obligor is generally a significant modification for recourse debt, unless the new borrower acquires substantially all the assets of the original one. That exception covers mergers and asset acquisitions where the economics haven’t really shifted. For nonrecourse debt, substituting the borrower is not a significant modification, because the lender’s real security is the collateral rather than personal creditworthiness.¹

Collateral and Recourse

Changes to collateral are significant when they alter the lender’s reasonable expectations of repayment, such as releasing a valuable asset from a lien package. Flipping the entire obligation from recourse to nonrecourse, or the reverse, is treated as significant in virtually all cases because it changes who or what actually stands behind the debt.¹

Nature of the Instrument

If a modification turns the debt into something that is no longer treated as debt for federal tax purposes, the change is automatically significant. Adding a conversion feature that lets the holder swap the note for equity in the borrower is the common example.¹

Changes That Don’t Trigger a Deemed Exchange

Two situations get explicit safe-harbor protection, and assuming tax consequences where none exist can derail an otherwise reasonable workout.

The first is temporary forbearance. When a lender pauses collection or temporarily waives an acceleration clause after a default, that forbearance is not a modification, as long as no other terms change at the same time. The protection lasts up to two years after the initial failure to perform, plus any additional time the parties spend in good-faith negotiations or the borrower spends in bankruptcy.¹

The second is financial covenant changes. Adding, deleting, or changing customary accounting or financial covenants — debt-to-equity ratios, minimum cash balances, and similar performance metrics — is not a significant modification.¹ These are protective terms for the lender, not economic terms of the debt itself.

How the Issue Price Is Set

Once a deemed exchange happens, the entire tax calculation hinges on one figure: the issue price of the fictional new instrument.

For debt traded on an established market, the issue price equals fair market value on the date of the modification.² If the market prices the debt at 85 cents on the dollar, the gap between that number and the old adjusted issue price drives the tax consequences on both sides.

For debt that isn’t publicly traded, Section 1274 controls. If the instrument carries adequate stated interest — meaning the stated rate meets or exceeds the applicable federal rate — the issue price equals the stated principal amount. If the stated rate is too low, the issue price drops to the imputed principal amount, which is the present value of future payments discounted at the Treasury’s test rate.³ A rate concession that pushes stated interest below the federal threshold widens the taxable spread.

What the Borrower Owes

When the issue price of the new debt is lower than the adjusted issue price of the old debt, the borrower has cancellation-of-indebtedness income (CODI) equal to the difference. That income is taxable in the year the significant modification occurs, not spread over the remaining term.⁴ The deemed exchange is a paper event with a real bill.

Corporate borrowers pay at the flat 21% federal rate. Individual borrowers pay at their marginal rate, which can reach 37% at the top. For a borrower already under financial pressure — often the reason for the modification in the first place — an unexpected six- or seven-figure income inclusion can create serious liquidity problems on its own.

What the Lender Reports

The creditor recognizes gain or loss equal to the difference between the issue price of the new instrument and its adjusted basis in the old one. An original lender whose basis equals outstanding principal typically shows a loss when the issue price comes in lower. An investor who bought the debt at a discount on the secondary market can end up with a gain it wasn’t planning to realize yet.

The deemed exchange can also generate original issue discount (OID) on the new instrument. OID arises whenever the issue price is below the stated redemption price at maturity, and the creditor must accrue that discount as interest income over the remaining term regardless of when cash actually arrives.² The phantom-income problem is worst for distressed-debt investors. Before the deemed exchange, discount from a secondary-market purchase would have been market discount, recognized only on sale or as principal came in. After the deemed exchange resets the clock, the same economic discount becomes OID, accrued into income year by year.

Excluding CODI Under Section 108

Not every borrower with CODI ends up paying tax on it. Section 108 provides several exclusions.

Bankruptcy

If the discharge occurs in a Title 11 case — the taxpayer is under the bankruptcy court’s jurisdiction and the discharge is granted or approved by the court — the full amount of CODI is excluded from gross income.⁴ This exclusion takes priority over the others. The excluded amount must then be applied to reduce the taxpayer’s tax attributes in a statutory order.⁵ The government defers the tax rather than forgiving it: smaller loss carryovers and lower basis mean higher tax in future years.

Insolvency

A taxpayer who is insolvent but not in bankruptcy can exclude CODI up to the amount of the insolvency. Insolvency means total liabilities exceed the fair market value of total assets, measured immediately before the discharge.⁴ A taxpayer insolvent by $200,000 who recognizes $300,000 of CODI excludes $200,000 and pays tax on the other $100,000. Attribute reduction follows the same statutory order.⁵

Qualified Real Property Business Indebtedness

Non-C-corporation taxpayers can elect to exclude CODI from the discharge of qualified real property business indebtedness — debt incurred to acquire, construct, or substantially improve real property used in a trade or business and secured by that property. The exclusion is capped at the lesser of the excess of outstanding principal over the property’s fair market value, or the aggregate adjusted basis of the taxpayer’s depreciable real property. The excluded amount reduces the basis of depreciable real property rather than following the general ordering rules.⁴ The election is common in commercial real estate workouts where the borrower is solvent but the property has lost value.

Filing Obligations on Both Sides

A deemed exchange creates paperwork with its own penalty risk.

Lenders file Form 1099-C (Cancellation of Debt) for any borrower whose discharged debt totals $600 or more in a calendar year. The form is due in the year following the identifiable event, with copies to the IRS and the borrower.⁶ Borrowers shouldn’t wait for the form to arrive before addressing the tax position. The obligation exists whether the lender files correctly, files late, or fails to file at all.

Borrowers who claim a Section 108 exclusion file Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness) with the return for the year of the excluded discharge. Certain elections on Form 982, including the election to reduce depreciable property basis first and the qualified real property business indebtedness election, must be made on a timely filed return, including extensions. A borrower who files on time without the election can still submit an amended return within six months of the original due date (excluding extensions); after that, the window closes.⁵

Attribute reduction follows a rigid sequence unless the taxpayer elects to reduce depreciable property basis first: net operating losses (dollar for dollar), general business credit carryovers (33⅓ cents per dollar), minimum tax credits (33⅓ cents per dollar), capital loss carryovers (dollar for dollar), property basis (dollar for dollar), passive activity loss and credit carryovers, and foreign tax credit carryovers last.⁵ Choosing the wrong reduction strategy, or missing the election window, can cost the taxpayer far more in future years than the CODI itself would have cost today.

1
eCFR. 26 CFR 1.1001-3 – Modifications of Debt Instruments
2
eCFR. 26 CFR 1.1273-2 – Determination of Issue Price and Issue Date
3
eCFR. 26 CFR 1.1274-2 – Issue Price of Debt Instruments to Which Section 1274 Applies
4
Office of the Law Revision Counsel. 26 USC 108 – Income From Discharge of Indebtedness
5
Internal Revenue Service. Instructions for Form 982
6
Internal Revenue Service. Instructions for Forms 1099-A and 1099-C