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State income tax traps for owners of distressed debt
One prevalent activity among some investors in recent years has been acquiring, holding, managing, and selling ‘‘distressed debt.’’ In fact, in the past few years, real estate investment trusts (REITs), hedge funds, and other investors have created various funds to buy distressed debt as an investment opportunity, often realizing significant gains as a result.¹
Considering the acquisition of distressed debt
When considering the acquisition of distressed debt, investors should be cognizant of the related state income tax consequences. When distressed debt generates interest income for its owner, it is often difficult to determine how that income is sourced for state income tax purposes. Some states provide specific guidance for the sourcing of interest income for financial organization taxpayers, with rules depending on payer location or other factors. However, that guidance is not applicable to nonfinancial organization investors holding distressed debt. The absence of guidance for nonfinancial organizations can lead to confusion, inconsistency, and improper reporting of interest income to the states.
This article discusses some of the complexities surrounding the proper state income tax treatment of distressed debt. In it, Parrish Ivy of Deloitte Tax LLP addresses questions surrounding the sourcing of interest income, examining how the sourcing rules may be affected by whether the holder of the debt is considered a financial organization.2
Key topics include:
- Sourcing interest income for a financial organization
- Defining financial organizations and financial institutions
- Sourcing interest income for nonfinancial organizations within generally applicable sourcing rules, such as market sourcing and cost-of-performance sourcing
By Parrish Ivy of Deloitte Tax LLP, originally published in Tax Analysts in November 2013
1 "Should You Buy Into a Distressed Debt Fund?" Bloomberg Businessweek (Sept. 9, 2009), available at http://www.businessweek.com/the_thread/hotproperty/archives/2009/09/should_you_buy_1.html; ‘‘Is This a Sign? Hedgies Closing Distressed Debt Funds,’’ InvestmentNews (Feb. 16, 2010), available at http://www.investmentnews.com/article/20100216/FREE/100219923.
2 Note that the complexities in this area are not limited to revenue apportionment and may include, for example, how the various states apply their apportionment property factors. That and other related questions are beyond the scope of this article.