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COVID-19: Modifications to Loans May Have Unintended Tax Consequences



As we previously discussed, on March 22, 2020, federal banking regulators published the Interagency Guidance ("the Guidance") to encourage lenders to, among other things, enter into short-term loan modifications (if prudent and appropriate) with borrowers impacted by the COVID-19 outbreak. Short-term loan modifications only include those effective for six months or less. The Guidance only applies to those loans that are current (less than 30 days past due) when the modification is implemented. Such modifications can include payment deferrals, fee waivers, repayment term extensions, or other "insignificant" delays.

Those intending to modify existing loans in accordance with the Guidance should keep in mind that modifications may have unintended federal income tax consequences. For tax purposes, a "significant modification" of an existing loan is treated as a deemed sale of the loan in exchange for a new loan bearing the modified terms. The deemed sale treatment could generate income tax for the lender if the lender acquired the loan at a discount from a third party, or could generate cancellation of indebtedness income for the borrower if the modified loan (treated as a new loan for tax purposes) bears interest at a rate that is less than the applicable federal rate.

"Significant modifications" include suspending interest and principal payments for more than half of the original loan term. Because the Guidance requires that short-term loan modifications only include those effective for six months or less, this deemed sale treatment could arise for underlying loans with a term of one year or less.

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