Take-Away: With the historically low interest rates, there may be a desire to rewrite the terms of outstanding loans to reflect the lower prevailing interest rates. Before an existing loan is rewritten with a lower interest rate, caution needs to be exercised to avoid the tax ramifications of replacing a higher rate debt instrument with a lower interest rate debt instrument.

Background: Current applicable federal rates (AFRs) of interest are extremely low. There may be existing estate planning strategies in place that used higher interest rates, e.g. intra-family loan promissory notes; sales to intentionally defective grantor trusts (IDGTs) in exchange for an installment note. The planning goal would be to substitute a lower interest rate than the rate that was used in the existing promissory note. While the use of a lower interest rate will shift further wealth away from the promissory note holder’s taxable estate, one cannot simply ‘swap’ interest rates without incurring tax consequences.

Example: Molly made a $2.0 million loan to her daughter Diane in April 2020. The loan’s duration is just short of 9 years. The loan, documented by a promissory note, will balloon just short of 9 years. At the time of this ‘mid-term’ loan, the AFR rate was 0.99%. The goal was that Diane would invest the $2.0 million for the 9 years and earn 8% on the money that she borrowed. If all those assumptions prove to be accurate, at the end of the 9 years Diane will have about $3,998,009 in investments. Diane will have to repay Molly when the note balloons and its principal and interest $2,185,422 throughout the course of the loan. The difference is $1,812,587 that Molly will own without any gift tax consequences. Now, in July, 2020, the mid-term AFR rate has dropped even lower to 0.45%. If the promissory note is rewritten to reflect the lower AFR rate, arguably even more wealth can be transferred gift tax-free from Molly to Diane. Thus, if done properly, the renegotiated intra-family loan can result in significant transfer tax savings in excess of the savings contemplated back in April when the initial loan transaction took place.

Imputed Gift?: As a generalization, if an intra-family loan uses the AFR rate for the month of the loan, then the IRS will not impute a gift to the borrower, regardless of the creditworthiness of the borrower. An interest rate that is below the AFR will result in an imputed gift of the below-market interest rate that is used. In addition, the substituted promissory note given in exchange for the original promissory note may be less valuable due to the lower interest rate charged.

  • To avoid gift tax implications, an intra-family promissory note should contain unrelated party terms, i.e. arms’ length loan terms. This includes not only the interest rate and principal payment terms but also the loan’s duration, security requirements, prepayment penalties, default penalties, etc. The lender should also actually take steps to secure any collateral pledged as security for the loan’s repayment, e.g. file UCC-1 financing statement. Any interest received by the lender on the loan must be reported on Form 1099-INT. If the loan qualifies as a mortgage, then the lender’s interest should be reported on IRS Form 1098.
  • The substitution of one promissory note for another promissory note with more favorable terms to the borrower, like a lower interest rate, may result in a taxable gift by the note holder. [IRC 2512(b).] The key is if the fair market values of the two promissory notes are different.
  • If the original note carried the applicable AFR rate, and because the AFR rate drops, the new AFR is used in the replacement note, then there may not be an implied gift if the note expressly ‘applies the AFR.’ Thus, the IRS will not assess a gift tax if a promissory note is replaced with a new promissory note once the AFR rates drop. The IRS will consider the new promissory note to have the same value as the original promissory note, as they have the same face value. The only thing that changed is the AFR interest rate, not the value of the loan balance.
  • If the note terms change but the fair market value of the exchanged promissory notes remain the same, then there should be no gift.
  • Less clear is if the original promissory note used the then applicable AFR, which rate was ‘locked-in’ for the duration of the note, and the borrower then approaches the holder of the promissory note with a request to rewrite the promissory note to reflect the lower prevailing AFR. Presumably, with a lower interest rate, the fair market value of the replacement promissory note will be less than the fair market value of the original promissory note. Thus, if the note holder accommodates the borrower’s request to rewrite the original note, the note holder is giving up something of value, and a taxable gift potentially arises.
  • If the goal is to use a lower AFR rate for the intra-family loan and avoid the implication of a gift, then other terms of the promissory note may need to be changed to reflect additional value associated with the replacement promissory note, e.g. a shorter loan duration; more expensive default interest rates; dropping a prepayment provision or adding a prepayment penalty; additional collateral security, etc.
  • In a perfect world, the replacement promissory note would then be appraised to determine its fair market value to compare to the fair market value of the original promissory note, to confirm their values are comparable, i.e. no gift resulted from the rewriting of the note’s terms with the lower AFR for the replacement note. It is highly unlikely though, as a practical matter, that if a note is rewritten simply to reflect a lower prevailing AFR that the parties will have both the original and the replacement promissory notes appraised to document their fair market values.

Taxable Exchange? It is also possible that if an existing note is substituted with a new promissory note that the ‘exchange’ will be treated as a taxable exchange of a ‘capital’ asset that results in gain recognition. The IRS has published a multi-page, mind-numbing Regulation on the implications of modifying the terms of an existing debt instrument. [Treasury Regulation 1.1001-3.] The scope of this Regulation is quite broad. It applies to any significant modification of a debt instrument, regardless of the form of the modification, e.g. the exchange of a new debt instrument for an existing debt instrument, or the amendment of an existing promissory note. According to the Regulations-

  • Significant Modification: A significant modification of a debt instrument results in an exchange [IRC 1001(a)] of the original debt instrument for a modified instrument that differs materially either in kind or extent. Consequently, an exchange of one debt instrument for another debt instrument could result in the recognition of taxable gain on the exchange. [Treasury Regulation 1.1001-3(b).] If the modification of the debt instrument, or promissory note, is not significant then the modification is not an exchange under the Tax Code.
  • Forbearance: If the note holder agrees to stay collection or temporarily waives an acceleration of debt clause in the debt instrument, or waives a similar default right to demand payment, that forbearance will not be treated as significant modification unless and until the forbearance remains in effect for a period of two years following the note issuer’s failure to perform. After the two years the debt instrument will be treated as being significantly modified.
  • Agreement to Change Terms: An agreement to change the terms of a debt instrument, like its interest rate, is a modification at the time the note issuer and note holder enter into their agreement, even if the changed term is not immediately effective.
  • Economically Significant: A significant modification is described in the Regulations as follows: A modification is a significant modification only if based on all the facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant….In making a determination under [this section] all modifications to the debt instrument are considered collectively, so that a series of such modifications may be significant when considered together although each modification, if considered alone, would not be significant. [Did I mention ‘mind-numbing?’]

Changes in Yield: The Regulations make it clear that  a change in the yield of a debt instrument may be a significant modification. Specifically, if a change in yield varies from the annual yield on the unmodified debt instrument (determined as of the date of the modification) by more than the greater of ¼ of one percent (i.e. 25 basis points) or 5% of the annual yield of the unmodified interest (.05 x annual yield) it will be treated as a significant modification. Prepayment penalties are not, however, considered for a modification of a debt instrument, and they are not taken into account in determining the yield of the modified debt instrument.

  • Example: A debt instrument issued has an original maturity of ten years and provides for the payment of $100,000 at maturity, with interest payments at the rate of 10% payable at the end of each year. At the end of the 5th year, and after the payment of the annual interest installment, the note issuer and note holder agree to reduce the amount payable at maturity to $80,000. The annual interest rate remains at 10%, but it is payable on the reduced note principal. The yield of the instrument after the modification (measured from the date the parties agreed to the modification to the note’s final maturity date) is computed using the adjusted issue price of $100,000. With four annual interest accruals of $8,000 and a final payment of $88,000 at maturity, the yield on the note instrument after the modification for purposes of determining if there has been a significant modification is 4.332 percent. Thus, the reduction in principal resulted in a significant modification.

Change in Payment Expectations: A change in the priority of a debt instrument relative to other debts of the issuer is also a significant modification if it results in a change in payment expectations.

Nonrecourse Debt: A modification that changes a recourse debt instrument to a nonrecourse debt instrument is not a significant modification if the instrument continues to be secured only by the original collateral and the modification does not result in a change in the note holder’s payment expectations.

Conclusion: With very low interest rates and economic devastation caused by the pandemic, it is to be expected that the terms of many promissory notes will be revisited and possibly rewritten with new terms. Thought will need to be given to changing more than just the interest rate charged on the principal balance, if the goal is to avoid the change being treated as an imputed gift. In addition, any modification of the terms of an existing promissory note must take into consideration the Regulation’s inclination to treat a significant modification as a taxable capital asset exchange.