IRS provides relief for mezzanine financing workouts

The IRS has issued new guidance that will, in certain circumstances, exclude from gross income any discharged debt that’s secured by the ownership interest in a disregarded entity. Revenue Procedure 2014-20 should help taxpayers with so-called “mezzanine” financing in workouts and similar arrangements.

How the issue arises

Gross income usually includes income from the discharge of debt. But such income is excluded if, for any taxpayer but a C corporation, the debt is qualified real property business indebtedness (QRPBI). A requirement to qualify as QRPBI is that the indebtedness must be incurred or assumed by the taxpayer in connection with real property used in a trade or business, and it must be secured by such real property.

The term “secured by such real property” isn’t defined by the relevant law. While lenders commonly use mortgages to secure an interest in real estate, mortgages aren’t the only form of security allowed.

For example, in some cases, real property is held by the borrower in an entity that it wholly owns and that’s disregarded as a separate entity from the borrower for federal tax purposes. The mezzanine financing in such cases may be secured by the borrower’s ownership interest in that disregarded entity. The guidance notes that the IRS has, when certain conditions are satisfied, treated debt as secured by real property when the debt is secured by the sole membership interest in a disregarded entity that holds the real property.

How to qualify for the exclusion

Under the new IRS guidance, a safe harbor exclusion is available if:

  • The taxpayer or a wholly owned disregarded entity incurs debt,
  • The borrower owns 100% of the ownership interest in a separate disregarded entity owning real property (the property owner), and isn’t 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/disregarded entity,
  • At least 90% of the fair market value of the total assets directly owned by the property owner/disregarded entity is real property used in a trade or business, and any other assets held by the property owner/disregarded entity are incidental to the property owner/disregarded entity’s acquisition, ownership and operation of the real property,and
  • Upon default and foreclosure on the debt, the lender will replace the borrower as the sole member of the property owner/disregarded entity.

Notably, if a taxpayer fails to meet these requirements, it’s not precluded from arguing, based on facts and circumstances, that its debt nonetheless satisfies the “secured by” requirement.

The amount that may be excluded from gross income is limited to the amount by which the outstanding principal amount of the QRPBI immediately before the discharge exceeds the fair market value of the real property. It’s reduced by the outstanding principal amount of any other QRPBI secured by the property at the time of discharge.

Applying the exclusion

The exclusion is effective for taxpayers that make the required election regarding discharged debt on or after Feb. 5, 2014. Your financial adviser can help if you have questions.