IRS Provides Safe Harbor for Exclusion from Cancellation of Indebtedness Income

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Rev. Proc. 2014-20, released on February 5, provides guidance regarding whether debt secured by an interest in a disregarded entity that holds real estate — rather than by the real estate itself — qualifies for the exclusion from cancellation of indebtedness income provided by section 108(c)(3).

Background

When a lender forgives all or a portion of a debt, the borrower generally recognizes cancellation of indebtedness income — frequently referred to as “phantom income.” Taxpayers (other than C corporations) generally are permitted to exclude such cancellation of indebtedness income if the debt is “qualified real property business indebtedness” (QRPBI). Debt is QRPBI only if it was incurred or assumed by the taxpayer in connection with real property used in the taxpayer’s trade or business and is secured by such real property.

Prior to Rev. Proc. 2014-20, it was unclear whether debt secured by the interests in a disregarded entity that holds real estate qualified as debt “secured by” the real estate for this purpose.

The Rev. Proc. 2014-20 Safe Harbor

Rev. Proc. 2014-20 provides that, if certain requirements are met, debt secured by the interests in a disregarded entity will be treated as secured by the real property itself for purposes of determining whether the debt is QRPBI. In general, a taxpayer qualifies for the safe harbor if each of the following requirements is met:

  1. The taxpayer (or a wholly owned disregarded entity of the taxpayer) incurs the indebtedness.
  2. The taxpayer directly or indirectly wholly owns a disregarded entity that owns real estate.
  3. The taxpayer pledges its interest in the disregarded entity as a priority security interest. Any further encumbrance on the pledged ownership interest must be subordinate the lender’s security interest in the disregarded entity.
  4. At least 90 percent of the fair market value of the disregarded entity’s assets (immediately prior to the discharge) must be real property used in a trade or business. Any other assets owned by the disregarded entity must be incidental to the acquisition, ownership, and operation of the real property.
  5. Upon default and foreclosure on the indebtedness, the lender will replace the taxpayer as the sole member of the disregarded entity.

Rev. Proc. 2014-20 is consistent with private letter ruling 200953005, in which the IRS ruled that indebtedness was treated as “secured by” real property for purposes of determining whether the debt was QRPBI when the debt was secured by the interests in a disregarded entity that owned the real estate.

It is important to note that the safe harbor provided by Rev. Proc. 2014-20 is only that: a safe harbor. Taxpayers who do not meet the requirements of Rev. Proc. 2014-20 may nevertheless take the position that indebtedness should be treated as QRPBI if, based on the facts and circumstances, the debt otherwise satisfies the “secured by” requirement. Accordingly, debt in complex structures where several tiers of disregarded entities are utilized may qualify for the exclusion.

In order to exclude cancellation of indebtedness income from the discharge of QRPBI, a taxpayer generally must make an election on the taxpayer’s return for the taxable year in which the discharge occurs. Making the election is not free from adverse consequences. For example, a taxpayer who elects to use the exclusion generally must decrease the tax basis in other depreciable real property that the taxpayer owns.

- See more at: http://www.hklaw.com/TaxBlog/IRS-Provides-Safe-Harbor-for-Exclusion-from-Cancellation-of-Indebtedness-Income-02-14-2014/#sthash.fkin8xYT.dpuf

Rev. Proc. 2014-20, released on February 5, provides guidance regarding whether debt secured by an interest in a disregarded entity that holds real estate — rather than by the real estate itself — qualifies for the exclusion from cancellation of indebtedness income provided by section 108(c)(3).

Background

When a lender forgives all or a portion of a debt, the borrower generally recognizes cancellation of indebtedness income — frequently referred to as “phantom income.” Taxpayers (other than C corporations) generally are permitted to exclude such cancellation of indebtedness income if the debt is “qualified real property business indebtedness” (QRPBI). Debt is QRPBI only if it was incurred or assumed by the taxpayer in connection with real property used in the taxpayer’s trade or business and is secured by such real property.

Prior to Rev. Proc. 2014-20, it was unclear whether debt secured by the interests in a disregarded entity that holds real estate qualified as debt “secured by” the real estate for this purpose.

The Rev. Proc. 2014-20 Safe Harbor

Rev. Proc. 2014-20 provides that, if certain requirements are met, debt secured by the interests in a disregarded entity will be treated as secured by the real property itself for purposes of determining whether the debt is QRPBI. In general, a taxpayer qualifies for the safe harbor if each of the following requirements is met:

  1. The taxpayer (or a wholly owned disregarded entity of the taxpayer) incurs the indebtedness.
  2. The taxpayer directly or indirectly wholly owns a disregarded entity that owns real estate.
  3. The taxpayer pledges its interest in the disregarded entity as a priority security interest. Any further encumbrance on the pledged ownership interest must be subordinate the lender’s security interest in the disregarded entity.
  4. At least 90 percent of the fair market value of the disregarded entity’s assets (immediately prior to the discharge) must be real property used in a trade or business. Any other assets owned by the disregarded entity must be incidental to the acquisition, ownership, and operation of the real property.
  5. Upon default and foreclosure on the indebtedness, the lender will replace the taxpayer as the sole member of the disregarded entity.

Rev. Proc. 2014-20 is consistent with private letter ruling 200953005, in which the IRS ruled that indebtedness was treated as “secured by” real property for purposes of determining whether the debt was QRPBI when the debt was secured by the interests in a disregarded entity that owned the real estate.

It is important to note that the safe harbor provided by Rev. Proc. 2014-20 is only that: a safe harbor. Taxpayers who do not meet the requirements of Rev. Proc. 2014-20 may nevertheless take the position that indebtedness should be treated as QRPBI if, based on the facts and circumstances, the debt otherwise satisfies the “secured by” requirement. Accordingly, debt in complex structures where several tiers of disregarded entities are utilized may qualify for the exclusion.

In order to exclude cancellation of indebtedness income from the discharge of QRPBI, a taxpayer generally must make an election on the taxpayer’s return for the taxable year in which the discharge occurs. Making the election is not free from adverse consequences. For example, a taxpayer who elects to use the exclusion generally must decrease the tax basis in other depreciable real property that the taxpayer owns.