For a more detailed overview, please see our previous client alert, ” Cancellation of Debt Income for Commercial Real Estate Partnerships .”
Qualified Real Estate Business Debt Exception
Forgiven debt is not includible in gross income for taxpayers other than C corporations if the forgiven debt is qualified real estate business debt.[.]” IRC § 108(a)(1)(D) (emphasis added).
Qualified real estate business indebtedness (QRPBI) is defined in IRC § 108(c)(3) as indebtedness that:
Encumbrances or assumptions made before January 1, 1993, in connection with real property used by the taxpayer in a trade or business and secured by such real property; or [not]Qualifying acquisition liabilities [emphasis added]and to which the taxpayer has elected to apply this section.
A “C” corporation (referred to above in IRC § 108(a)(1)(D)) is a taxable corporation, other than an “S” corporation, under IRC § 1361.
Thematic Properties
As previously discussed, to qualify as QRPBI, indebtedness must have been incurred or assumed in connection with, and secured by, real property used by the taxpayer in a trade or business, IRC § 108(c)(3)(A). The “trade or business” requirement (discussed below) is complex and applies to many tax issues.
Eligible Acquisition Obligations
Also, as noted above, to qualify as QRPBI, indebtedness must be “qualified acquisition indebtedness” IRC § 108(c)(3)(B). However, the qualified acquisition indebtedness requirement does not apply to indebtedness 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 indebtedness, IRC § 108(c)(4).
In addition, indebtedness resulting from the refinancing of qualified acquisition debt meets the requirements for qualified acquisition debt, IRC § 108(c)(3), to the extent that the indebtedness does not exceed the amount of the debt being refinanced.
election
To apply the QRPBI exception, a taxpayer must make a formal election with the Internal Revenue Service (IRS), IRC § 108(c)(3)(C).
In addition, a partner may request that the partnership reduce the tax basis of the partnership's depreciable property, and the partnership may give or withhold such consent unless certain ownership requirements are met. Treasury Regulation §1.1017-1(g)(2)(ii)(B).
Dollar Limit
There are dollar limitations. First, the amount excluded from gross income as QRPBI cannot exceed the excess (if any) of:
The outstanding principal amount of the debt (immediately prior to forgiveness) exceeds the fair market value of the debt. [Subject Real Property] (as of that time), less the outstanding principal amount (as of that time) of other eligible real estate business indebtedness secured by the property.
IRC § 108(c)(2)(A). See also Treasury Regulations §1.108-6(a) (Limits on exclusion of income from QRPBI exemption: Debt in excess of value).
Another dollar limit is the amount excluded from gross income.
It must not exceed the total adjusted basis of the depreciable property (after any reductions listed below). [IRC § 108(b), reduction of tax attributes] and [IRC § 108(g), qualified farm indebtedness]) (excluding depreciable real estate acquired with the expectation of receiving the exemption.)
IRC § 108(c)(2)(B). See also Treas. Reg. §1.108-6(b) (Limits on exclusion of income from QRPBI exemption: general limitations). IRC § 108(b) (referenced in the quoted provision above) requires a reduction of basis and certain other favorable tax attributes for the amount of income excluded from CODI because of bankruptcy, insolvency, or qualified farm indebtedness.
Bankruptcy and insolvency take priority
There are CODI exceptions for bankruptcy and insolvency that take precedence over the QRPBI exception. The QRPBI exception does not apply to cancelled debts that are excluded from CODI when a debt is discharged in a bankruptcy proceeding or when the taxpayer is insolvent. IRC § 108(a)(2).
Basic deduction
Use of the QRPBI exception reduces favorable tax attributes. The tax benefit of excluding CODI is offset by a reduction in the taxpayer's basis in depreciable real property under IRC § 108(c)(1). The required reduction in basis may increase future gains or reduce future losses or reduce future depreciation deductions. This effectively defers the tax on CODI rather than eliminating the tax entirely.
The QRPBI basis reduction applies to “any” depreciable property held by the taxpayer at the beginning of the taxable year following the year of the debt forgiveness. IRC § 1017(a) and (b)(3)(A) (emphasis added). Of course, the basis reduction applies first to the property securing the forgiven debt. Treas. Reg. § 1.1017-1(c)(1).
Additionally, if the property is disposed of before the end of the year of the debt forgiveness, IRC §1017(b)(3)(F) provides that the reduction in basis occurs immediately prior to 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 share of the partnership's depreciable property, but only if the tax basis of the depreciable property held by the partnership is reduced accordingly. IRC §1017(b)(3)(C).
Mezzanine Debt
A natural question is whether mezzanine debt that is secured by an interest in an entity that owns real estate, but is not directly secured by the real estate, qualifies as QRPBI. The IRS stated in its 2009 Private Letter Ruling (PLR) that mezzanine debt of a disregarded entity that owns real estate is treated as debt secured by real estate for purposes of QRPBI, PLR 200953005 (2009).
As previously mentioned, one of the requirements for QRPBI treatment is that the debt must be “secured by real property.” IRC § 108(c)(3)(A). However, mezzanine debt is not typically secured directly by real property. In this case, the debt was secured by a security interest in the ownership interest of a disregarded entity that owned the real property. The IRS gave weight to the debtor entity's disregarded nature for income tax purposes. Id.
As an aside, although second (or subordinate) mortgages are sometimes called mezzanines, such subordinate mortgages are not subject to the PLR above because the mortgages are actually secured by real estate, so QRPBI issues do not arise. Also, the entity securing the mezzanine debt may own real estate directly or indirectly through one or more subsidiaries. The same result would probably be achieved if you ignored all entities from the mezzanine debtor to the real estate for income tax purposes.
The PLR is informative but generally does not provide precedent for other situations. IRC § 6110(k)(3).
Real estate used for commercial or business purposes
The term “real estate used in a business or commerce” is not defined in IRC § 108(c) or related Treasury regulations. However, the IRS has noted in a Revenue Ruling that real estate developed and held by a taxpayer for lease in a leasing operation is “real estate used in a business or commerce” for purposes of QRPBI, but real estate developed and held by a taxpayer primarily for sale to customers in the ordinary course of business is not. Rev. Rul. 2016-15, 2016-26, IRB 1060, 2016 WL 3211467 (June 10, 2016).
In this situation, the lender accepted $5.25 million in cash in repayment of a loan with a principal balance of $8 million and canceled $2.75 million of debt. The debt was secured by real estate with a fair market value of $5 million. The debt was used to build apartments on the secured property. The taxpayer can choose to defer CODI on the $2.75 million by excluding that amount from gross income and reducing the basis of the secured property by the same amount. In contrast, canceled debt on real estate held for sale cannot be excluded from gross income. Id.
Applying for a Partnership
The IRS clarified how to determine whether a liability is QRPBI in a partnership context in PLR, IRS Priv. Ltr. Rul. 94-26-006, 1994 WL 312382 (July 1, 1994).
As noted above, to qualify as QRPBI, the indebtedness (among other things) must have been incurred or assumed in connection with a trade or real property used in a business, IRC § 108(c)(3)(A). The question is, whose trade or business?
The problem is that while a partnership owns real property and conducts a trade or business, the IRC provides that the QRPBI exception applies at the partner level (as well as other exceptions), IRC §108(d)(6).
In its private letter rulings, the IRS has determined that the trade or business requirement is determined at the partnership level. However, pursuant to IRC §108(d)(6), the rules governing the election and use of the QRPBI exception must be applied to the partners individually, not at the partnership level. IRS Priv. Ltr. Rul. 94-26-006, supra.
Fair market value of multiple properties
An IRS Chief Counsel Advisory Letter addresses how the net fair market value of multiple properties is determined for purposes of the QRPBI exception. The Advisory Letter states that the correct approach is to start with the fair market value of the specific property secured by the forgiven QRPBI indebtedness. This value is then reduced by all other QRPBI indebtedness secured by this property. The IRS rejected alternative methods such as reducing this value by indebtedness secured by property that is QRPBI for taxpayer-owned real property, or adding up the value of all properties with QRPBI and then subtracting all related QRPBI indebtedness. IRS Chief Counsel Advisory Letter 201623009, 2016 WL 3098400 (June 3, 2016).
As with the PLR, the advice of the chief counsel is informative but generally does not set precedent for other situations. IRC § 6110(k)(3).
Conclusion
Cancelling qualified real estate business debt allows you to avoid taxable income and instead defer the payment of income tax.
(This is another in our Client Alert series at the intersection of bankruptcy and real estate.)