The IRS has provided a safe harbor that applies to the treatment of indebtedness secured by 100 percent of the ownership interest in a disregarded entity that holds real property.
The safe harbor will treat such indebtedness as indebtedness secured by real property for purposes of the income exclusion available under the cancellation of indebtedness rules.
Generally, a solvent taxpayer – other than a C corporation – whose qualified real property business indebtedness is discharged outside of a bankruptcy proceeding can elect to exclude some or all of the discharged amount from income. The excluded amount must be applied to reduce the basis of the taxpayer’s depreciable real property.
Qualified real property business indebtedness (QRPBI) is indebtedness that:
- Is incurred or assumed in connection with real property used in a trade or business and secured by such real property;
- Is considered “qualified acquisition indebtedness” if incurred or assumed by the taxpayer after 1992; and
- The taxpayer elects to treat as QRPBI.
QRPBI also includes indebtedness incurred to refinance qualified real property business indebtedness – but only to the extent it does not exceed the amount of the indebtedness being refinanced.
Revenue Procedure 2014-20 provides a safe harbor under which the IRS will treat indebtedness secured by 100 percent of the ownership interest in a disregarded entity holding real property as indebtedness secured by real property. If the indebtedness meets the other requirements, it will be QRPBI. Accordingly, any income from the discharge of indebtedness is eligible for the exclusion and basis reduction rules.
To qualify for the safe harbor, all of the following must be met:
- The taxpayer or a wholly owned disregarded entity of the taxpayer incurs indebtedness.
- The borrower directly or indirectly owns 100 percent of a separate disregarded entity owning real property; i.e., the borrower is not the same entity as the property owner.
- The borrower pledges to the lender a first-priority security interest in the borrower’s ownership interest in the property owner. Any further encumbrance on the pledged ownership interest must be subordinate to the lender’s security interest in the property owner.
- At least 90 percent of the fair market value of the total assets directly owned by the property owner must be real property used in a trade or business, and any other assets must be incidental to the acquisition, ownership and operation of the real property.
- Upon default and foreclosure on the indebtedness, the lender will replace the borrower as the sole owner of the property owner.
Failure to meet the requirements of this safe harbor does not preclude the taxpayer from arguing, based on facts and circumstances, that its debt nonetheless qualifies for exclusion/basis reduction.
The safe harbor is effective for elections made on or after Feb. 5, 2014.