SECTION 2. BACKGROUND

.01 Under § 1.1001–1(a), if gain or loss is realized from the exchange of property for other property differing materially either in kind or in extent, it is treated as income or as loss sustained.

.02 Section 1.1001–3 provides rules to determine whether a modification of the terms of a debt instrument results in an exchange of the original debt instrument for a modified instrument that differs materially either in kind or in extent. Under § 1.1001–3(b), a modification of a debt instrument results in an exchange for purposes of § 1.1001–1(a) if, and only if, the modification is significant.

.03 Section 1.1001–3 applies to any modification of a debt instrument, regardless of the form of the modification (including an exchange of a new instrument for an existing instrument). Under § 1.1001–3(c), a modification means any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt instrument, whether the alteration is evidenced by an express agreement (oral or written), conduct of the parties, or otherwise.

.04 In general, a modification of a debt instrument is a significant modification under § 1.1001–3 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. Section 1.1001–3(e) provides rules to determine whether certain modifications, such as a change in the yield or in the timing of payments, constitute significant modifications.

.05 If the terms of a debt instrument are modified to defer one or more payments and the modification does not result in an

exchange under § 1.1001–3, § 1.1275–2(j) provides rules to account for the modified debt instrument. Under § 1.1275–2(j), solely for purposes of §§ 1272 and 1273 of the Internal Revenue Code, the debt instrument is treated as retired and then reissued on the date of the modification for an amount equal to the instrument’s adjusted issue price on that date. As a result, the debt instrument is retested for original issue discount based on the instrument’s adjusted issue price and the remaining payments, as modified, to be made on the instrument. If the debt instrument has original issue discount as a result of the modification, both the issuer and the holder account for the original issue discount over the remaining term of the instrument. See §§ 163(e) and 1272. .06 An issuer may want to refinance and consolidate outstanding debt instruments in a way that increases the liquidity of the issuer’s debt by concentrating more of the issuer’s outstanding debt in a smaller number of issues. In general, if the terms of the newly issued debt are not materially different from the terms of the outstanding debt, substituting the newly issued debt for the outstanding debt does not result in a significant modification of the outstanding debt under § 1.1001–3. Therefore, the substitution of the newly issued debt for the outstanding debt in the refinancing and consolidation is not a realization event for federal income tax purposes. Under § 1.1275–2(j), however, some or all of the newly issued debt may have original issue discount in varying amounts, depending upon the terms of the outstanding debt for which the newly issued debt was substituted. As a result, the newly issued debt may not be fungible.