In a debt-for-equity swap, the tax and accounting treatment turns on one comparison: the carrying value of the debt being canceled against the fair value of the stock issued to replace it. Under U.S. GAAP, the debtor books the difference as a gain or loss on extinguishment in the current period. For federal tax purposes, that same spread generally produces cancellation-of-debt income to the debtor and a corresponding gain or loss to the creditor, subject to statutory exclusions and, for the debtor’s carryforwards, a potentially punishing limitation on future net operating loss use.
Debtor Accounting Under U.S. GAAP
A debt-for-equity swap is an extinguishment of debt. ASC 470-50 requires the debtor to recognize any difference between the debt’s net carrying amount and the reacquisition price as a gain or loss in current-period income.1Deloitte Accounting Research Tool. 9.3 Extinguishment Accounting The gain or loss cannot be deferred or amortized.
The reacquisition price is the fair value of the equity issued, unless the fair value of the debt itself is more clearly determinable. If the debt trades in a secondary market, its quoted price may be easier to pin down than shares in a distressed, possibly private company. The standard directs the debtor to use whichever measurement is more reliable.1Deloitte Accounting Research Tool. 9.3 Extinguishment Accounting
Say a company carries $100 million of debt, including accrued interest, and issues equity with a fair value of $40 million to extinguish it. Liabilities drop by $100 million. Common Stock and Additional Paid-in Capital together increase by $40 million. The $60 million difference is reported as a gain on debt extinguishment, a non-operating line that lifts net income for the period.
The gain is real for accounting purposes but not cash. The company received no money. It replaced a $100 million obligation with a smaller equity interest, and the gain simply captures that economic result. If the fair value of the equity issued exceeded the carrying value of the debt, the company would record a loss, though that outcome is uncommon in distressed restructurings.
Creditor Accounting
The creditor removes the receivable from its books and records the newly acquired equity at fair value. If the fair value of the equity is less than the carrying amount of the loan, which is almost always the case in a distressed swap, the creditor recognizes a loss.
Until recently, these transactions fell under the troubled debt restructuring framework in ASC 310-40, which imposed special measurement rules. FASB eliminated that framework through ASU 2022-02, effective for most public companies beginning in 2023.2Financial Accounting Standards Board. Accounting Standards Update 2022-02 Creditors now apply the general loan modification guidance in ASC 310-20 to determine whether a restructured arrangement is a new loan or a continuation of the old one. When the creditor takes equity in place of a modified loan, the debt receivable is derecognized entirely and the equity is recorded at its closing-date fair value. Enhanced disclosure requirements still apply when the borrower was experiencing financial difficulty.
IFRS Treatment
Companies reporting under IFRS follow IFRIC 19, which directly addresses extinguishment of financial liabilities with equity instruments. The interpretation requires the debtor to measure the equity issued at fair value and recognize any difference between that fair value and the carrying amount of the liability in profit or loss.3IFRS Foundation. IFRIC 19 Extinguishing Financial Liabilities with Equity Instruments If the fair value of the equity cannot be reliably measured, the instruments are measured at the fair value of the liability extinguished instead.
The end result is broadly consistent with U.S. GAAP: the debtor typically records a gain because the debt’s carrying amount exceeds the fair value of equity issued, and that gain runs through profit or loss. The mechanical difference is that IFRIC 19 defaults to measuring the equity instruments, while ASC 470-50 tells the debtor to pick whichever value between the equity and the debt is more clearly evident. In most distressed swaps the outcome converges, because the two fair values tend to line up at the negotiated conversion price.
Debtor Tax Treatment and Cancellation-of-Debt Income
The IRS treats forgiven debt as income. Under Section 61 of the Internal Revenue Code, gross income includes income from the discharge of indebtedness.4Office of the Law Revision Counsel. 26 USC 61 – Gross Income Defined When a corporation issues stock to cancel a debt, IRC Section 108(e)(8) provides the measuring rule: the corporation is treated as having satisfied the indebtedness with cash equal to the fair market value of the stock issued.5Office of the Law Revision Counsel. 26 USC 108 – Income from Discharge of Indebtedness The cancellation-of-debt (COD) income is the gap between the debt’s adjusted issue price and the stock’s fair market value.
This tax figure does not necessarily match the accounting gain. The accounting gain compares the debt’s carrying value to the reacquisition price under GAAP. The tax calculation compares the adjusted issue price to the stock’s fair market value under the Code. Different starting points can produce different numbers, and both need to be tracked.
Exclusions Under Section 108(a)
Section 108(a) provides several exclusions that keep COD income out of the debtor’s taxable gross income:5Office of the Law Revision Counsel. 26 USC 108 – Income from Discharge of Indebtedness
- Bankruptcy. If the discharge occurs in a Title 11 case, all COD income is excluded.
- Insolvency. If the debtor is insolvent immediately before the swap, meaning liabilities exceed the fair market value of assets, COD income is excluded up to the amount of the insolvency.
- Qualified farm indebtedness. Available to farming operations meeting specific criteria.
- Qualified real property business indebtedness. Available to taxpayers other than C corporations for certain real estate debt.
The bankruptcy exclusion is the broadest, with no dollar cap. The insolvency exclusion is partial. If a company is insolvent by $30 million but has $50 million in COD income, only $30 million is excluded and the remaining $20 million is taxable.
Attribute Reduction Is the Price of Exclusion
Excluded COD income is not a free pass. Section 108(b) requires the debtor to reduce its tax attributes, dollar-for-dollar or at a reduced rate for certain credits, in a prescribed order:5Office of the Law Revision Counsel. 26 USC 108 – Income from Discharge of Indebtedness
- Net operating losses, current-year and carryovers, reduced first.
- General business credit carryovers under Section 38.
- Minimum tax credits under Section 53(b).
- Capital loss carryovers, current-year and prior.
- Tax basis of the company’s property.
- Passive activity loss and credit carryovers under Section 469.
- Foreign tax credit carryovers under Section 27.
The reduction converts today’s exclusion into a future cost. Reducing NOLs means fewer losses to offset future profits. Reducing asset basis means larger taxable gains when those assets are eventually sold. The debtor reports the exclusion and the attribute reductions on IRS Form 982, attached to the federal income tax return for the year of the discharge.6Internal Revenue Service. Instructions for Form 982
Creditor Tax Treatment
The creditor recognizes a gain or loss equal to the difference between the fair market value of the equity received and the creditor’s tax basis in the debt. If the creditor bought the debt at par and never wrote it down, the basis is the face amount, producing a large loss. If the creditor previously claimed a partial bad debt deduction, the adjusted basis is lower, which shrinks the loss or could even produce a gain.
Character depends on whether the debt was a capital asset in the creditor’s hands. For banks and dealers holding debt as inventory, the loss is typically ordinary. For investors holding the debt as a capital asset, the loss is capital.
The creditor’s tax basis in the newly acquired stock equals the stock’s fair market value on the date of the exchange, and that basis sets the starting point for any future gain or loss on sale. If the creditor is an applicable financial entity such as a bank and the canceled portion of the debt exceeds $600, the creditor must file IRS Form 1099-C to report the cancellation to both the debtor and the IRS.7Internal Revenue Service. About Form 1099-C, Cancellation of Debt Valuation of the stock is the single most important documentation task for both parties, because the same fair market value figure drives both the debtor’s COD income and the creditor’s recognized gain or loss.
The Section 382 Ownership Change Trap
Even where COD income is excluded, a swap can hollow out the debtor’s remaining tax assets through a different provision. When creditors receive enough stock to become major shareholders, the transaction can trigger an ownership change under IRC Section 382, which severely limits the company’s ability to use its accumulated net operating losses going forward.8Office of the Law Revision Counsel. 26 USC 382 – Limitation on Net Operating Loss Carryforwards and Certain Built-In Losses Following Ownership Change
An ownership change occurs when one or more 5-percent shareholders collectively increase their ownership by more than 50 percentage points compared to their lowest ownership level during a rolling three-year testing period. A debt-for-equity swap can blow through that threshold easily, because creditors start at zero and jump to a substantial stake overnight. Shareholders owning less than 5 percent are grouped together and treated as a single 5-percent shareholder for testing purposes.
Once an ownership change is triggered, the company’s use of pre-change NOLs in any post-change year is capped at an annual limitation. That cap equals the fair market value of the company’s stock immediately before the ownership change, multiplied by the IRS-published long-term tax-exempt rate.8Office of the Law Revision Counsel. 26 USC 382 – Limitation on Net Operating Loss Carryforwards and Certain Built-In Losses Following Ownership Change As of early 2026, that rate is 3.58%.9Internal Revenue Service. Rev. Rul. 2026-6 For a distressed company with a low stock value, the annual cap can be small enough to render hundreds of millions in NOLs practically worthless.
Take a concrete case. If the company’s equity is worth $50 million immediately before the ownership change, the Section 382 annual limit is roughly $1.79 million ($50 million times 3.58%). A company sitting on $200 million in pre-change NOLs would need over a century to use them at that rate, assuming unused limitation carries forward. Anything that expires before it can be used is gone permanently. The collision between Section 108, which reduces NOLs for excluded COD income, and Section 382, which caps the annual use of what survives, can wipe out most of the tax benefit a distressed company hoped to preserve.
Where the Two Sets of Numbers Diverge
The accounting gain and the COD income figure both come from the same swap, but they answer different questions and use different inputs. The GAAP gain is measured against the debt’s carrying amount, which reflects accrued interest, unamortized premiums or discounts, and any prior modifications recognized in the books. The tax figure is measured against the debt’s adjusted issue price, a Code concept that follows its own amortization and original issue discount rules. A large book gain can sit alongside a much smaller COD income figure, or vice versa, and the exclusions in Section 108 only affect the tax side. Companies working through a swap should model both calculations before signing, because the number on the income statement rarely tells you what the tax return will look like.