Converting debt into equity, or swapping one debt instrument for another, carries tax and legal implications on both sides of the table: the debtor can be hit with cancellation-of-debt income and lose net operating losses, the creditor recognizes gain or loss on the exchange, and the deal itself has to clear board approvals, charter capacity, stock-exchange rules, and SEC disclosure before any of the tax accounting matters. The rules for the two parties run on separate tracks, and a conversion that looks clean on the term sheet can produce a tax bill with no cash to pay it.
What Counts as a Debt Conversion
Three transactions get called “debt conversion,” and the tax and legal treatment turns on which one you have.
A debt-to-equity conversion replaces outstanding debt with shares in the debtor company. Creditors give up their right to repayment in exchange for a stake in the company. These show up most often in corporate restructurings and bankruptcy, where the company cannot pay and equity is the next-best outcome.
A debt-to-debt conversion swaps one debt instrument for another with different terms: a different rate, a different maturity, a different collateral package. It looks like ordinary refinancing, but the tax code can treat it as a taxable exchange when the terms change enough to be “significant.”
Convertible securities — convertible bonds and convertible preferred — are issued with a built-in option for the holder to convert into common stock on pre-set terms. The holder controls the timing, which distinguishes them from a negotiated swap.
The Debtor’s Tax Bill: Cancellation-of-Debt Income
The tax code treats a debt-to-equity conversion as if the debtor paid cash equal to the fair market value of the stock it issued. That rule sits in IRC Section 108(e)(8): when a corporation transfers stock to satisfy debt, the debt is treated as satisfied with money equal to the stock’s fair market value.1Office of the Law Revision Counsel. 26 USC 108 – Income from Discharge of Indebtedness If the stock’s FMV is less than the outstanding debt, the shortfall is cancellation-of-debt income, taxable as ordinary income under Section 61.2eCFR. 26 CFR 1.61-12 – Income from Discharge of Indebtedness
This is a paper gain with a real tax bill. The company received no cash, but it owes tax on the difference. A corporation reports the income on Form 1120 as other income. At the current 21% corporate rate, a $10 million gap between stock FMV and debt face amount produces a $2.1 million liability with nothing new in the bank to cover it.
When the Debtor Can Exclude COD Income
IRC Section 108(a) provides two exclusions that come up in most restructurings.
The bankruptcy exclusion applies when the conversion occurs while the company is under the jurisdiction of a court in a Title 11 case. All COD income is excluded from gross income.1Office of the Law Revision Counsel. 26 USC 108 – Income from Discharge of Indebtedness
The insolvency exclusion applies outside bankruptcy, but only up to the amount by which liabilities exceed the fair market value of assets immediately before the conversion. A company insolvent by $5 million that realizes $8 million of COD income excludes $5 million; the remaining $3 million is taxable.1Office of the Law Revision Counsel. 26 USC 108 – Income from Discharge of Indebtedness
The Attribute Reduction Price
Neither exclusion is free. In exchange for excluding the income, the debtor reduces its tax attributes dollar-for-dollar (with credits reduced at 33⅓ cents per dollar). IRC Section 108(b) sets the order:1Office of the Law Revision Counsel. 26 USC 108 – Income from Discharge of Indebtedness
- Net operating losses — current-year NOLs and carryovers first, dollar for dollar.
- General business credits — 33⅓ cents per dollar of excluded income.
- Minimum tax credits — 33⅓ cents per dollar.
- Capital loss carryovers — dollar for dollar.
- Property basis — the tax basis of assets is reduced, producing larger taxable gains when those assets are sold.
- Passive activity loss and credit carryovers — losses dollar for dollar; credits at 33⅓ cents per dollar.
- Foreign tax credit carryovers — 33⅓ cents per dollar.
Reductions happen after the current year’s tax is calculated, so the excluded income does not affect the discharge-year return directly. What it affects is the future: lost NOLs mean less shelter for future income, and reduced asset basis means bigger gains later. Companies weighing a conversion need to model those downstream effects before treating the exclusion as a win.
Section 382 and the NOL Cap After an Ownership Change
Even the NOLs that survive attribute reduction can be throttled by a separate rule. Under IRC Section 382, an “ownership change” occurs when one or more 5-percent shareholders increase their collective ownership by more than 50 percentage points over a three-year testing period.3Office of the Law Revision Counsel. 26 USC 382 – Limitation on Net Operating Loss Carryforwards and Certain Built-in Losses Following Ownership Change A large debt-to-equity swap that hands creditors a majority of the stock almost always trips this threshold.
After the change, the company’s annual use of pre-change NOLs is capped at the value of the company immediately before the change, multiplied by the IRS long-term tax-exempt rate. For ownership changes occurring in early 2026, that rate is 3.58%.4Internal Revenue Service. Rev. Rul. 2026-6 A company worth $50 million immediately before the conversion could use roughly $1.79 million of pre-change NOLs per year, no matter how much income it earns. For a company sitting on hundreds of millions of NOLs, the cap can render most of them practically worthless.
Section 382(l)(5) carves out an exception for conversions inside a Title 11 case. If pre-change shareholders and creditors end up owning at least 50% of the reorganized company’s stock, the annual limitation does not apply.3Office of the Law Revision Counsel. 26 USC 382 – Limitation on Net Operating Loss Carryforwards and Certain Built-in Losses Following Ownership Change The trade-off: the company must reduce pre-change losses by the interest deducted on the converted debt during the three years before the change, and if a second ownership change happens within two years, the Section 382 limitation drops to zero.
The Creditor’s Side of the Trade
For the creditor, exchanging debt for stock is a taxable event. The creditor is treated as having sold the debt for an amount equal to the fair market value of the stock received. Gain or loss equals the difference between that FMV and the creditor’s adjusted tax basis in the debt. A creditor holding a $1 million bond at face who receives stock worth $600,000 recognizes a $400,000 loss.
The character depends on whether the debt was a capital asset in the creditor’s hands. For most investors and funds, it is a capital loss. The basis in the new stock equals its fair market value on the conversion date, which becomes the starting point for any later sale. Creditors report the exchange on Form 8949 and Schedule D.5Internal Revenue Service. Instructions for Form 8949
The creditor’s treatment is independent of the debtor’s. Whether the debtor recognizes COD income, claims an exclusion, or reduces tax attributes has no effect on how the creditor calculates its own gain or loss. Each side is analyzed separately.
Related-Party Debt Buybacks
Having a related entity purchase the debt at a discount and retire or convert it does not sidestep COD income. IRC Section 108(e)(4) treats acquisition of the debt by a person related to the debtor as if the debtor itself satisfied the debt for the acquisition price. The difference between face amount and price paid is COD income for the debtor.
The definition of “related party” under IRC Section 267(b) is broad. It captures an individual and a corporation where the individual owns more than 50% of the stock, two corporations in the same controlled group, partnerships and corporations with more than 50% common ownership, and trust relationships that create overlapping interests.6Office of the Law Revision Counsel. 26 USC 267 – Losses, Expenses, and Interest with Respect to Transactions Between Related Taxpayers Constructive ownership rules widen the net further: stock held by a corporation or partnership is attributed to its owners proportionally, and family attribution treats an individual as owning stock held by a spouse, siblings, ancestors, and lineal descendants.
When “Just Refinancing” Becomes a Taxable Exchange
Not every debt modification is a tax event. But when the terms of an instrument change enough to be a “significant modification” under Treasury Regulation 1.1001-3, the old debt is treated as exchanged for a new one, and both parties recognize gain or loss as if a sale occurred.7eCFR. 26 CFR 1.1001-3 – Modifications of Debt Instruments
The regulation applies regardless of form. Issuing a new instrument in exchange for an old one, amending the existing agreement, or accomplishing the change indirectly through third parties all count. A modification is significant when the resulting terms differ materially in kind or extent from the original. Common triggers include changes to the interest rate, the maturity date, the principal amount, or the addition of a conversion feature.
The stakes are highest in debt-to-debt restructurings that look like ordinary refinancings. Extending maturity and cutting the rate on a loan can trip a deemed exchange, and if the issue price of the “new” instrument is less than the adjusted issue price of the old, COD income follows. A modification that stays below the significance threshold is simply a continuation of the existing debt with no immediate tax consequences.
Legal and Regulatory Steps to Close the Conversion
A conversion needs corporate authority before it can produce any tax result. The board of directors formally authorizes the share issuance, usually through a board resolution in the corporate minutes. If the conversion would create more shares than the company’s charter allows, the charter has to be amended first, which generally requires a shareholder vote.
Public companies on the NYSE or Nasdaq have an extra layer. Exchange rules generally require shareholder approval before issuing shares equal to 20% or more of the company’s outstanding common stock, and a large debt conversion crosses that line easily.
The SEC requires public companies to file a Form 8-K within four business days of triggering events, including unregistered sales of equity securities under Item 3.02.8U.S. Securities and Exchange Commission. Form 8-K Securities Act registration or an available exemption also has to be addressed for the shares themselves.
Valuation matters at every step. Public-company FMV is typically the market price on the conversion date. Private companies usually need an independent appraisal. Without a defensible valuation, the transaction is exposed to challenge from existing shareholders, the IRS, and regulators.
GAAP Reporting in Brief
The accounting under Generally Accepted Accounting Principles has three tasks: remove the old liability, record the new equity, and recognize any gain or loss. The general framework for when a liability qualifies as extinguished lives in ASC 405-20; the measurement and reporting rules for the extinguishment sit in ASC 470-50.
A liability is extinguished when the debtor is relieved of the obligation, whether by paying cash, delivering other assets, or, in a conversion, issuing equity. The entire carrying amount comes off the balance sheet, including principal, any unamortized premium or discount, and accrued but unpaid interest.
The new shares are recorded at fair value on the conversion date, split between par value and additional paid-in capital. When the equity’s fair value is not readily determinable, as often happens with private companies or illiquid distressed issuers, the fair value of the extinguished debt is used instead.
Any difference between the fair value of the equity issued and the carrying amount of the debt removed produces a gain or loss. Equity worth less than the debt’s carrying amount produces a gain; equity worth more produces a loss. ASC 470-50-40-2 requires the gain or loss to appear as a separate item on the income statement, though companies can present it as a distinct line or fold it into interest expense with footnote disclosure.
Transaction costs follow the parties. Fees exchanged between debtor and creditor adjust the debt’s carrying amount. Third-party costs — legal, advisory, appraisal — in a transaction that qualifies as an extinguishment (which debt-to-equity swaps almost always do) reduce the net carrying amount of the debt and effectively raise future interest expense rather than hitting the income statement immediately.