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Will 'toxic asset' plan address tax trap for distressed bond buyers?

March 23, 2009

The Treasury is set to issue its plan for dealing with the bad loans held by banks and other institutions today. Such a plan should address a tax trap that the Treasury established a few years ago.

Under current rules, if somebody buys a dodgy $100,000 loan from a bank for $50,000, and they then work out a deal where the borrower will pay $70,000 in principal to get the debt settled, the buyer normally has a $20,000 taxable gain that day, before a dime gets paid on the loan. This is true even if the terms of the loan, other than principal, don't change. See Regs. 1.1001-3. The theory is that the buyer has exchanged the old loan he bought for $50,000 for a new $70,000 loan, triggering a $20,000 gain. Needless to say, this trap affects the marketability of bad loans.

If the new rules to be issued today fail to address this, it's a sign that they really haven't thought things through.

Tags: bailout.bank tax.tax policy.

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