IRS Provides Safe Harbor for Debt Secured by an Interest in a Disregarded Entity.
(Parker Tax Publishing February 2014)

Cancellation of a debt generally results in taxable income. Often, debt is discharged because the taxpayer doesn't have the money to pay the debt. The additional income to the taxpayer is problematic because the taxpayer usually doesn't have the money to pay the taxes on the income either.

Special rules apply, however, to the discharge of qualified real property business indebtedness (QRPBI). The discharge of QRPBI can be excluded from income if the debt was incurred or assumed by the taxpayer in connection with real property used in a trade or business and the debt was secured by such real property. This exception is especially useful in times of declining property values, where a taxpayer may find himself underwater with respect to real property used in the taxpayer's business.

An issue practitioners have faced with respect to clients seeking to use this exception is the fact that neither the Code nor the legislative history define what is meant by "secured by such real property." Often, for liability reasons or at the request of lenders, a taxpayer will set up a single-member LLC (SMLLC) to hold real property used in a trade or business. The question practitioners were confronted with was whether debt obtained to purchase the property and secured by an interest in an SMLLC was "debt secured by such real property." In Rev. Proc. 2014-20, the IRS answered "yes," as long as certain conditions are met.

Rules for Excluding Discharge of QRPBI from Income

Under Code Sec. 108(a)(1)(D), income from the discharge of debt is excluded from gross income if, in the case of a taxpayer other than a C corporation, the debt discharged is QRPBI. Code Sec. 108(c)(3) provides that, to qualify as QRPBI, the debt must be incurred or assumed by the taxpayer in connection with real property used in a trade or business and be secured by such real property. In addition, the taxpayer must make an election to treat the debt as QRPBI. Qualified farm indebtedness does not qualify as QRPBI.

QRPBI must be debt that was incurred or assumed before January 1, 1993, or if the debt was incurred or assumed on or after January 1, 1993, it must be qualified acquisition indebtedness. Qualified acquisition indebtedness is debt incurred or assumed to acquire, construct, reconstruct, or substantially improve real property used in a trade or business. QRPBI also includes debt resulting from the refinancing of debt, but only to the extent it does not exceed the amount of debt being refinanced.

The amount of the exclusion is subject to two limitations:

(1) a limitation based on the fair market value of the real property securing the debt, and

(2) an overall limitation based on the adjusted bases of all depreciable real property held by the taxpayer.

Under the first limitation, the amount of the exclusion is limited to the excess of: (1) the outstanding principal amount of the debt, over (2) the net fair market value of the real property securing the debt.

Both amounts are measured immediately before the discharge. The net fair market value of the real property securing the debt is its fair market value, reduced by the outstanding principal amount of any other qualified real property business debt that is secured by it immediately before and after the discharge.

Under the second limitation, the amount of the exclusion is limited to the aggregate adjusted bases of depreciable real property held by the taxpayer immediately before the discharge (other than depreciable real property acquired in contemplation of the discharge), reduced by the sum of: (1) any depreciation claimed for the year of the discharge; and (2) any reductions to the adjusted bases of depreciable real property for the year of the discharge.

This exclusion does not apply to a cancellation of debt in a title 11 bankruptcy case or to the extent the taxpayer was insolvent immediately before the cancellation. If qualified real property business debt is canceled in a title 11 bankruptcy case, the taxpayer must apply the bankruptcy exclusion rather than the exclusion for canceled qualified real property business debt. If the taxpayer was insolvent immediately before the cancellation of QRPBI, the taxpayer must apply the insolvency exclusion before applying the exclusion for canceled qualified real property business debt.

As noted above, to qualify for this exclusion, the debt must be secured by the real property upon which the debt is incurred. Neither the Code nor the legislative history contains any explanation of, or definition for, the term "secured by such real property."

Rev. Proc. 2014-20

According to the IRS, while mortgages are commonly used by lenders to secure an interest in real estate, there is no suggestion in the legislative history that mortgages are the exclusive form of security for purposes of the exclusion from income of the discharge of QRPBI. The fact that the Code does not limit the security interest to a mortgage, the IRS said, indicates an intent to include a broader range of security interests. As a result, the IRS issued Rev. Proc. 2014-20 to provide taxpayers with a safe harbor under which debt that is secured by a 100 percent ownership interest in a disregarded entity holding real property will be treated as debt that is secured by real property for purposes of cancellation-of-debt rules for QRPBI.

OBSERVATION: A taxpayer that does not meet the requirements of this safe harbor is not precluded from arguing, based on facts and circumstances, that its debt satisfies the "secured by" requirement.

Taxpayers, other than C corporations, may avail themselves of the safe harbor in Rev. Proc. 2014-20 if they meets all of the following requirements:

(1) The taxpayer or a wholly owned disregarded entity of the taxpayer (i.e., the borrower) incurs indebtedness.

(2) The borrower directly or indirectly owns 100 percent of the ownership interest in a separate disregarded entity owning real property (i.e., the property owner). The borrower cannot be the same entity as the disregarded entity.

(3) The borrower pledges to the lender a first priority security interest in the borrower's ownership interest in the disregarded entity. Any further encumbrance on the pledged ownership interest must be subordinate to the lender's security interest in the disregarded entity.

(4) At least 90 percent of the fair market value of the total assets (immediately before the discharge) directly owned by the disregarded entity must be real property used in a trade or business, and any other assets held by the disregarded entity must be incidental to the acquisition, ownership, and operation of the real property by the disregarded entity.

(5) Upon the default and foreclosure on the debt, the lender will replace the borrower as the sole member of disregarded entity.

Debt that satisfies these requirements will be treated as debt secured by real property for purposes of the exclusion from income of discharged QRPBI.

Effective Date

Rev. Proc. 2014-20 is effective for taxpayers who make an election to exclude the discharge of QRPBI from income on or after February 5, 2014. (Staff Contributor Parker Tax Publishing)

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Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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