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novation (that is, is not released from liability). fn 6 In such instance, the debtor does not realize any
COD income.

When the debtor transfers collateral to a creditor in retirement of a nonrecourse liability, the debtor has
an amount realized on sale of the property equal to the amount of the debt, which may result in a taxable
gain. fn 7 In such instance, the debtor does not realize any COD income. However, if a nonrecourse debt
is satisfied with cash (and the debtor retains the secured property), the difference between the principal
outstanding and the cash repaid is COD income. fn 8

If the debt is exchanged for the debtor’s stock, the amount of the COD income is the excess of the
amount of the debt over the fair market value of the stock. fn 9

If the debt is exchanged for new debt (or deemed exchanged by reason of a significant modification of
the debt, as discussed next), the amount of COD income is the excess of the adjusted issue price of the
old debt over the issue price of the new debt. fn 10

Many of the commonly sought modifications to the terms of troubled debt cause a deemed exchange of
debt. As noted, a COD income event can occur as the result of a deemed exchange resulting from a sig-
nificant modification of the terms of debt (for example, changes in yield, changes in timing and amount
of payments, changes in obligor or security, and so on). A significant modification occurs when the legal
rights and obligations of a debt instrument are modified to an extent which is considered significant un-
der Treasury regulations.

For example, if the terms of a taxpayer’s debt instrument are modified significantly, the existing debt is
deemed retired in exchange for new debt containing the modified terms. If neither the old debt nor the
new debt is publicly traded, and the new debt bears adequate stated interest, the new debt issue price will
equal its stated principal amount (for debt instruments governed by Section 1274) or its stated redemp-
tion price (that is, the adjusted issue price of the old debt), and no COD income will be recognized. fn 11
If either the old debt or new debt is publicly traded, the issue price of the new debt will be the trading
price of the debt (that is, the fair market value of the property). fn 12 The debtor would recognize COD
income equal to the difference between the outstanding balance on the old debt and the value of the new
debt. For purposes of this analysis, to be considered publicly traded, a debt instrument does not have to

fn 6 Reg. Section 1.1001-2(a)(1), (4)(ii), (c) Ex. (1).

fn 7 Reg. Section 1.1001-2(a)(1), (4)(i), (c) Ex. (7) and see also Commissioner v. Tufts, 461 U.S. 300 (1983).

fn 8 Rev. Rul. 1991-31, 1991-1 C.B. 19, and see also Gershkowitz v. Commissioner, 88 T.C. 984 (1987).

fn 9 IRC Section 108(e)(8).

fn 10 IRC Section 108(e)(10); 1273; 1274. Reg. Section 1.61-12(c)(2)(ii). The "adjusted issue price" is the issue price of the debt in-
strument (i) Increased by the amount of original issue discount previously includible in the gross income of any holder (determined
without regard to Section 1272(a)(7) and Section 1272(c)(1)); and (ii) decreased by the amount of any payment previously made on
the debt instrument other than a payment of qualified stated interest. Reg. Section 1.1275-1(b).

fn 11 IRC Section 1274(a)(1); 1273(b)(4).

fn 12 IRC Section 1273(b)(3). If the new debt is publicly traded, it is the value of the new debt. If the old debt was publicly traded and
the new debt is not, it is the value of the old debt.

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