Cancellation of Debt Income: The Qualified Real Property Business Indebtedness Exception

For a more detailed overview, please see our previous client alert, Commercial Real Estate Partnership Cancellation of Debt Income.

The Qualified Real Property Business Indebtedness Exception
Cancelled debt is not included in gross income if, “in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness[.]” IRC § 108(a)(1)(D)(emphasis added).

Qualified real property business indebtedness (QRPBI) is defined in the IRC § 108(c)(3) as indebtedness which (among other things):

• Was incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by such real property,
• Was incurred or assumed before January 1, 1993, or if [not], is qualified acquisition indebtedness [emphasis added], and
• With respect to which such taxpayer makes an election to have this paragraph apply.

A “C” corporation (referred to in above-quoted IRC § 108(a)(1)(D)) is a taxable corporation; that is, any corporation that is not an “S” corporation. IRC § 1361.

Subject Property
As noted above, 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 must be secured by such real property. IRC § 108(c)(3)(A). The “trade or business” requirement (discussed below) is complex and applies to many tax issues.

Qualified Acquisition Indebtedness
Also as noted, to qualify as QRPBI, the debt must be “qualified acquisition indebtedness.” IRC § 108(c)(3)(B). However, the qualified acquisition indebtedness requirement does not apply to debt incurred or assumed before January 1, 1993. IRC Id.

The term “qualified acquisition indebtedness” means “indebtedness incurred or assumed to acquire, construct, reconstruct, or substantially improve” the real property that is the subject of and secures the debt. IRC § 108(c)(4).

Additionally, debt resulting from refinancing qualified acquisition indebtedness satisfies the qualified acquisition indebtedness requirement to the extent it does not exceed the amount of the debt being refinanced. IRC § 108(c)(3).

Election
To invoke the QRPBI exception, the taxpayer must make a formal election with the Internal Revenue Service (IRS). IRC § 108(c)(3)(C).

In addition, a partner must also request that the partnership reduce the partnership’s tax basis in depreciable property of the partnership, and, unless certain ownership requirements are satisfied, the partnership may grant or withhold such consent. Treas. Reg. §1.1017-1(g)(2)(ii)(B).

Dollar Limits
There are dollar limits. For one, the amount excluded from gross income as QRPBI cannot exceed the excess (if any) of:

• The outstanding principal amount of such indebtedness (immediately before the discharge), over
• The fair market value of the [Subject Real Property] (as of such time), reduced by the outstanding principal amount of any other qualified real property business indebtedness secured by such property (as of such time).

IRC § 108(c)(2)(A); see also Treas. Reg. §1.108-6(a)(limitations on the exclusion of income from the discharge of QRPBI: indebtedness in excess of value).

Another dollar limit is that the amount excluded from gross income:

Shall not exceed the aggregate adjusted bases of depreciable real property (determined after any reductions under [IRC § 108(b), reduction of tax attributes] and [IRC § 108(g), qualified farm indebtedness]) held by the taxpayer immediately before the discharge (other than depreciable real property acquired in contemplation of such discharge).

IRC § 108(c)(2)(B); see also Treas. Reg. §1.108-6(b)(limitations on the exclusion of income from the discharge of QRPBI: overall limitation). IRC § 108(b) (referred to in the above quoted provision) requires the reduction of basis and certain other beneficial tax attributes in the amount of income excluded from CODI due to bankruptcy, insolvency or qualified farm indebtedness.

Bankruptcy and Insolvency Take Precedence
There are CODI exceptions for bankruptcy and insolvency that take precedence over the QRPBI exception. The exception for QRPBI does not apply to cancelled debt that is excluded from CODI when the debt relief occurs in a bankruptcy proceeding or when the taxpayer is insolvent. IRC § 108(a)(2).

Basis Reduction
Using the QRPBI exception results in a reduction in a beneficial tax attribute. The tax benefit of excluding the CODI is offset by a reduction in the basis of the taxpayer’s depreciable real property. IRC § 108(c)(1). The required reduction in basis could increase future gains or decrease future losses, and decrease future depreciation deductions. This in effect defers the taxation of the CODI, rather than eliminating the tax entirely.

The basis reduction for QRPBI is applied to “any” depreciable property held by the taxpayer at the beginning of the taxable year after the year of the discharge of debt. IRC § 1017(a) and (b)(3)(A)(emphasis added).  The basis reduction is, of course, applied first to the property securing the cancelled debt. Treas. Reg. § 1.1017-1(c)(1).

Also, if the property is disposed of by the end of the year of the debt cancellation, IRC §1017(b)(3)(F) provides for the basis reduction to be made immediately before the disposition.

For this purpose, a partner’s interest in a partnership is treated as depreciable property to the extent of the partner’s proportionate interest in the partnership’s depreciable property, but only if there is a corresponding reduction in the tax basis of the depreciable property held by the partnership. IRC §1017(b)(3)(C).

Mezzanine Debt
An obvious question is whether mezzanine debt, secured by interests in an entity that owns real property, but not secured directly by real property, can qualify as QRPBI. The IRS, in a 2009 Private Letter Ruling (PLR), said that mezzanine debt of a disregarded entity that owns real property is treated as debt secured by real property for QRPBI purposes. PLR 200953005 (2009).

As noted above, one of the requirements for QRPBI treatment is that the debt must be “secured by the real property.” IRC § 108(c)(3)(A). But mezzanine debt generally is not directly secured by real property. In this case, the debt was secured by a lien on the ownership interests in a disregarded entity that owned real property. The IRS viewed as significant the nature of the debtor entity as one disregarded for income tax purposes. Id.

As an aside, sometimes a second (or subordinate) mortgage loan is referred to as mezzanine, but such a subordinate mortgage loan is not the subject of the above PLR. That is because a mortgage loan would not raise the QRPBI issue since the mortgage loan would actually be secured by real property. Also, the entity securing the mezzanine debt may own real property directly or indirectly, through one or more subsidiary entities. Presumably the same result would be obtained if all entities were disregarded for income tax purposes, from the mezzanine debtor down to the real property.

PLRs are instructive but generally not precedent for other situations. IRC § 6110(k)(3).

Real Property Used in Trade or Business
The term “real property used in a trade or business” is not defined in IRC § 108(c) or the related Treasury Regulations. However, the IRS, in a Revenue Ruling, noted that real property developed and held by a taxpayer for lease in its leasing business qualifies as “real property used in a trade or business” for QRPBI purposes, whereas property developed and held by a taxpayer primarily for sale to customers in the ordinary course of business does not. Rev. Rul. 2016-15, 2016-26, IRB 1060, 2016 WL 3211467 (June 10, 2016).

In that situation, the lender accepted $5.25 million in cash in satisfaction of a loan with a remaining principal balance of $8 million, thus canceling $2.75 million in debt. The debt was secured by real property with a fair market value of $5 million. The debt was used to build an apartment building on the security property. The taxpayer may elect to defer the $2.75 million of CODI by excluding that amount from its gross income and reducing its basis in the security property by the same amount. In contrast, canceled debt on real property held for sale cannot be excluded from gross income. Id.

Application to Partnerships
The IRS, in a PLR, clarified how to determine whether debt is QRPBI within the context of a partnership. IRS Priv. Ltr. Rul. 94-26-006, 1994 WL 312382 (July 1, 1994).

As noted above, to qualify as QRPBI, the debt (among other things) must have been incurred or assumed in connection with real property used in a trade or business. IRC § 108(c)(3)(A). The question is whose trade or business?

The issue is that, while the partnership owned the real property and conducted the trade or business, the IRC provides that the QRPBI exception is applied at the partner level (as are other exceptions). IRC §108(d)(6).

In the Private Letter Ruling, the IRS determined that the trade or business requirement was determined at the level of the partnership. However, consistent with IRC §108(d)(6), the provisions governing election and use of the exception for QRPBI must be applied individually to the partners, not at the partnership level. IRS Priv. Ltr. Rul. 94-26-006, supra.

Net Fair Market Value of Multiple Properties
An IRS Chief Counsel Advisory addressed how the net fair market values of multiple real properties are determined for purposes of the QRPBI exception. The Advisory said that the correct approach starts with the fair market value of the specific real property secured by the discharged QRPBI debt. This value is then reduced by all other QRPBI debt secured by this property. The IRS rejected alternative methods, such as reducing this value by debts secured by the property that are QRPBI for any property owned by the taxpayer or aggregating the value of all properties with QRPBI and then subtracting all associated QRPBI debts. IRS Chief Counsel Advisory 201623009, 2016 WL 3098400 (June 3, 2016).

Like PLRs, Chief Counsel Advisories are instructive but generally not precedent for other situations. IRC § 6110(k)(3).

Conclusion
Canceled qualified real property business indebtedness can avoid being taxable income and instead result in deferral of income tax consequences.

(This is another in our series of client alerts at the intersection of bankruptcy and real estate.)