- Investors who purchase distressed debt may trigger phantom income and significant tax exposure.
- Buyers can minimize tax exposure if they intend to acquire debt to ultimately obtain real estate that is secured by that debt, and they plan on repositioning or significantly improving their investment.
- Investors looking to purchase assets in Canada should understand local tax laws, including the lack of like-kind exchanges and a hefty provincial land transfer tax.
Buyers looking to purchase distressed debt need to think about more than just what they should be willing to pay. They also need to consider the tax implications, because a misstep could result in serious exposure.
If a buyer doesn’t pursue a debt workout with the borrower but holds the note to maturity, the market discount rules come into play which require the buyer to recognize ordinary income (rather than capital gain) related to the discount to face. In addition, if a buyer purchases nonperforming debt with the intention of pursuing a debt workout with the borrower, it could create so-called phantom income as it could be considered a significant modification of the original debt instrument.