Can my real estate business avoid tax on cancelled debt using the qualified real property exception?

Canceling a business debt is a great way to keep yourself afloat when your business is in trouble, but it also counts as income. This cancellation of debt income, or CODI, is generally taxable under IRC § 61(a)(11) unless an exception applies.

One exception to the general rule is for real estate owners. If a creditor forgives qualified real property business indebtedness, it is excluded from income under IRC § 108(a)(1)(D). However, this exclusion is not available to C corporations.

Requirements for Qualified Real Property Business Indebtedness

IRC § 108(c)(3) lists a few requirements for qualified real property business indebtedness, or QRPBI:

• The debt must have been incurred or assumed in connection with real estate business property.
• The debt must be secured by that business real estate property.
• The debt has to date from before January 1, 1993, or it has to be qualified acquisition indebtedness.
• Also, the taxpayer has to elect the exclusion.

As for the C corporation limit mentioned above, section 1361 of the tax code defines the term “S corporation” and then refers to a non-S corporation as a C corporation.

Under IRC § 108(c)(3)(A), the loan must have been for real estate used in your trade or business and secured by it. The trade-or-business test is tricky, and it shows up in all kinds of places where the government has a special rule for business activities.

IRC § 108(c)(3)(B) mentions another condition, but you don’t have to worry about it if your debt predates January 1, 1993. Otherwise, your debt has to be “qualified acquisition indebtedness”.

Section 108(c)(4) defines “qualified acquisition indebtedness”. The rule is that the loan has to be used to acquire, construct, reconstruct or substantially improve the property that secures it.

IRC § 108(c)(3) mentions that a refinancing of acquisition debt still counts as qualified acquisition indebtedness, but only up to the amount of debt that was refinanced.

The last requirement is that you have to notify the IRS that you want to claim this exclusion. This notification is called an election, per IRC § 108(c)(3)(C).

Cap on Exclusion

Even if the debt qualifies for exclusion, you might be limited in the amount you can exclude. The cap on exclusion is a little complicated.

The first limit on exclusion is the amount of the debt’s outstanding principal right before it was discharged.

And you also subtract the net value of the property from the loan balance. The net value is the property’s fair market value, reduced by the balance of any other QRPBI the property secures.

This first limit comes from IRC § 108(c)(2)(A) and is explained in Treasury Regulation § 1.108-6(a).

There is also a second limit on how much you can exclude.

Next, you calculate the total adjusted bases of all your depreciable real property held just before the discharge. You use this adjusted basis figure after it has been reduced by any amounts taken into account under § 108(b) or § 108(g). Don’t count the adjusted bases for any properties acquired in anticipation of the discharge.

This overall limit comes from § 108(c)(2)(B) and Treasury Regulation § 1.108-6(b). Section 108(b) means that if you’ve excluded debt from your income under the bankruptcy, insolvency or farm-debt rules, you have to subtract the amount of debt excluded from certain tax attributes.

A big catch is that bankruptcy and insolvency take precedence over the real estate debt exclusion. Section 108(a)(2) says the QRPBI exclusion doesn’t apply to debt discharged in bankruptcy or while you’re insolvent. So, if you qualify for either of these two exclusions, you would use them instead of the QRPBI exclusion.

The real estate exclusion isn’t a total escape, either. Under § 108(c)(1), you have to lower basis in your depreciable real property by the amount of the excluded CODI. This catch isn’t as bad as an immediate tax, but it can mean bigger gains later, smaller losses and less depreciation. Basically, the tax isn’t eliminated, merely postponed.

The cut applies to any depreciable property you have when the year after the discharge begins, says § 1017(a) and (b)(3)(A). Treasury Regulation § 1.1017-1(c)(1) says the property securing the forgiven loan gets its basis reduced first.

The basis adjustment is delayed until the start of the year after the discharge, unless you sell or dispose of the property before the discharge year ends. In that case, § 1017(b)(3)(F) makes the basis cut right before the sale.

A partnership interest can also count, to a certain extent, as depreciable property for purposes of § 1017(b)(3)(C). This rule works only in proportion to your share of the partnership’s depreciable property, and only if the partnership also reduces its own basis.

Mezzanine Loans

A natural question would be what about mezzanine loans, secured by ownership interests in the entity that owns the building rather than the building. In PLR 200953005, issued in 2009, the IRS has said such debt of a disregarded entity qualifies as secured by real property.

For QRPBI, the debt must be secured by real property (§ 108(c)(3)(A)). Mezzanine debt often doesn’t meet that standard. Instead of being secured by the building, the loan was secured by equity in a disregarded entity that owned the building. But the IRS ruled that this loan would be covered, stressing the entity’s disregarded status.

Subordinate mortgages that people also call mezzanine are a different animal. They are secured directly by the real estate, not by the shares in the owning entity. For true mezzanine debt, the pledged entity may own the property directly or through subsidiaries, and presumably the result holds if every tier is disregarded.

One warning about relying on that ruling: under § 6110(k)(3), private letter rulings are generally not precedent.

The tax laws are full of ambiguities, and the trade-or-business test is one. Neither § 108(c) nor the Treasury regulations define “real property used in a trade or business”, or “real estate business property”. In Rev. Rul. 2016-15, issued on June 10, 2016, the IRS offered a guide. It ruled a building held as rental property counts, but a property held mainly as inventory for sale to customers does not.

In Rev. Rul. 2016-15, the IRS gave a ruling about $8 million that was left on a construction loan for an apartment building when the market value of the collateral was only $5 million. The lender took $5.25 million in cash and forgave the $2.75 million balance. The IRS said the taxpayer can elect to exclude that $2.75 million of income and cut the building’s basis by that much.

If the building is owned by a partnership, does that affect the analysis? In Priv. Ltr. Rul. 94-26-006 (July 1, 1994), the IRS looked at how to decide QRPBI status in a partnership.

Section 108(c)(3)(A) requires the property to be used in a trade or business, but whose trade or business? Is it the partnership’s, or each partner’s?

The partnership is a pass-through entity, so the building and the business activity belong to the partnership, not to the individual partners. The way § 108 works makes this even trickier. Section 108(d)(6) applies each of these exclusions to an individual partner, and not to a partnership.

In its ruling, the IRS applied the trade-or-business test at the partnership level. But, of course, the exclusion applies to partners only, so each one has to decide if they want to elect the exclusion. Some might choose the QRPBI exclusion, and others might not.

Another tricky area is how to calculate the limit when you have more than one property. In CCA 201623009 (June 3, 2016), the IRS dealt with this issue. Start with the value of the specific property that secures the forgiven loan. Reduce that by the balance of any other QRPBI that’s secured by that same property, and not by QRPBI on any other property you own. You can’t add up all your QRPBI and subtract it from all your property values.

The same caveat applies here: under § 6110(k)(3), a Chief Counsel Advisory, like a PLR, generally is not precedent.

So, QRPBI is a tool to keep income out of your taxes, with a twist. Instead of escaping taxation entirely, it gives you a tax postponement, letting you subtract the amount of your exclusion from your basis.