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The article in brief:

• Debt forgiveness may trigger CODI, generating significant tax liabilities.
• Valuation is central to a CODI analysis, as fair market value determinations of debt, equity, and assets may impact the amount of the tax liability.
• Internal Revenue Code (IRC) Section 108 exclusions, especially insolvency, can mitigate CODI, but require rigorous, well‑documented valuation analyses to withstand IRS scrutiny.

Economic Pressures Driving Debt Restructurings and CODI Exposure

Borrowers contemplating the cancellation, exchange, restructure, or modification of debt should be aware that such actions may trigger a taxable event requiring complex tax analyses and robust valuation documentation prior to transaction closing. Proactive planning and well-supported valuation documentation may help inform tax planning considerations and reduce uncertainty around potential tax consequences or transaction timing.

Economic conditions, including elevated interest rates, tighter credit availability, tariffs, and inflation, have increased financial pressure on many businesses. Higher borrowing costs, refinancing risk, and constrained liquidity have strained leveraged balance sheets, increasing the likelihood of insolvencies and defaults, capital structure restructurings, or formal bankruptcy proceedings. Many of these situations may result in the original debt instrument being canceled or exchanged, both of which may trigger a CODI tax reporting requirement.

When Debt Forgiveness Triggers CODI

When a taxpayer is relieved of all or part of a debt obligation, CODI for the value relieved must be recognized and may be taxable under IRC Section 61. CODI may arise in a variety of restructuring scenarios, including debt settlements for less than face value, loan modifications resulting in a principal reduction, foreclosure or repossession, or the expiration or abandonment of a creditor’s collection rights.

CODI can also arise through constructive debt cancellation, where a debt instrument is treated as satisfied or discharged for tax purposes even in the absence of explicit forgiveness or a formal cancellation agreement.

Debt Restructuring Transactions That Can Create CODI

Debt-for-Equity Exchanges. When a debtor transfers equity to a creditor in satisfaction of debt, the debt is treated as exchanged for the fair market value (FMV) of the equity. CODI equals the excess of the debt’s adjusted issue price (within the meaning of IRC Section 108) over the equity FMV, often necessitating an independent equity valuation at the discharge date.

Debt-for-Debt Exchange. If a debtor issues new debt to satisfy existing debt, the exchange may be treated as a taxable event. In such cases, CODI equals the adjusted issue price of the old debt minus the issue price of the new debt, which may require an independent debt valuation of the newly issued debt.

Significant Debt Modifications. A significant modification to an existing debt instrument may be treated for tax purposes as an exchange of the old debt for a new instrument issued at its FMV. CODI may be triggered if the modified debt’s issue price is less than the original debt’s adjusted issue price.

The Role of Valuation in Determining CODI

Although publicly traded debt is generally valued using quoted prices under the IRS’s property framework, taxpayers may be able to rebut this presumption when market quotes are stale, indicative, or based on thin trading and materially misrepresent FMV. In distressed contexts, a well‑supported valuation can materially affect the CODI calculation by establishing an issue price that more accurately reflects economic reality.

Valuation becomes a critical component of any discharge‑of‑debt analysis whenever the tax outcomes depend on FMV rather than stated debt amounts. In practice, valuations often inform whether, how much, and what character of income may be recognized or excluded.

Exceptions to CODI Recognition Under IRC Section 108

IRC Section 108 provides several exceptions from the general rule requiring CODI recognition, such as:

• Title 11 bankruptcy
• Insolvency
• Qualified farm indebtedness
• Qualified real property business indebtedness
• Qualified principal residence indebtedness

When CODI is excluded under one of these provisions, taxpayers must reduce specified tax attributes, such as net operating losses, capital loss carryovers, tax credit carryovers, and asset basis, in a prescribed order. The reduction mechanism ensures that the tax benefit of the debt discharge is eventually recognized through reduced future deductions or increased future income. The process is intricate, time-intensive, and may require sophisticated tax modeling.

Claiming the Insolvency Exclusion for Debt Forgiveness

For purposes of IRC Section 108, insolvency is measured immediately before a debt discharge and exists when a taxpayer’s liabilities exceed the FMV of its assets.

The insolvency exclusion may extinguish or significantly reduce the CODI tax liability to the extent of the taxpayer’s insolvency. To qualify, a taxpayer must quantify the extent of its insolvency effective immediately before the debt is discharged,  and the amount of CODI that may be excluded is limited to that excess of liabilities over asset value.

“Assets” and “liabilities” are not statutorily defined under the tax code for the insolvency calculation. Tax court precedent suggests that a liability should be included if it is more probable than not that a taxpayer will be required to satisfy the obligation. Asset values are determined using FMV immediately before the discharge. As a result, taxpayers often engage tax advisors to establish the value of liabilities and an independent valuation specialist to determine and support the FMV of its assets for insolvency purposes.

Taxpayers claiming the insolvency exclusion must be prepared to substantiate both the quantitative insolvency calculation and the valuation methodologies underlying it. Given the heightened scrutiny applied to CODI exclusions, experienced tax and valuation advisors can help support the development and documentation of an insolvency position.

Key Takeaways for Taxpayers and Advisors

As economic pressures increase, companies should thoughtfully evaluate tax and valuation implications in advance of a debt restructuring transaction. Whether arising from an outright discharge, a debt‑for‑equity exchange, a debt‑for‑debt restructuring, or a significant debt modification, valuation may impact CODI outcomes.

Valuation is an important component of substantiating insolvency exclusions, which require a contemporaneous balance‑sheet analysis and appropriate FMV conclusions immediately prior to discharge. Especially in stressed and distressed situations, robust and well-supported valuation may impact how much CODI is recognized, and whether applicable exclusions are available. Engaging experienced tax and valuation professionals early in the process can help improve the quality of documentation around CODI positions and insolvency claims.

How VRC Can Support CODI and Insolvency Analyses

VRC’s tax valuation practice provides independent, well-documented valuation analyses designed to support CODI-related tax reporting, insolvency analyses, and audit or examination scrutiny.  For a more in-depth conversation, we invite you to contact the article’s authors or a VRC team member.

Note: This article is for informational purposes only and does not constitute legal or tax advice. Readers should consult their own advisors regarding their specific circumstances.