In general, discharge of indebtedness income is excluded from the gross income of a taxpayer (other than a C corporation) if the indebtedness is qualified real property business indebtedness (QRPBI). To qualify as QRPBI, the indebtedness must (1) be incurred or assumed by the taxpayer in connection with real property used in a trade or business and secured by the real property (the Secured-By Requirement); (2) have been incurred or assumed before January 1, 1993, or, if incurred or assumed after that date, be indebtedness incurred or assumed to acquire, construct, reconstruct, or substantially improve real property used in a trade or business; and (3) be indebtedness the taxpayer elects to treat as QRPBI.
Revenue Procedure 2014-20 provides a safe harbor by which a taxpayer will have satisfied the Secured-By Requirement if:
- The taxpayer or a wholly owned entity that is disregarded for federal tax purposes (disregarded entity) of the taxpayer (Borrower) incurs indebtedness.
- Borrower directly or indirectly owns 100 percent of the ownership interest in a separate disregarded entity owning real property (Property Owner). Borrower is not the same entity as Property Owner.
- Borrower pledges to the lender a first priority security interest in Borrower's ownership interest in Property Owner. Any further encumbrance on the pledged ownership interest must be subordinate to the lender's security interest in Property Owner.
- At least 90 percent of the fair market value of the total assets (immediately before the discharge) directly owned by Property Owner must be real property used in a trade or business and any other assets held by Property Owner must be incidental to Property Owner's acquisition, ownership, and operation of the real property.
- Upon default and foreclosure on the indebtedness, the lender will replace Borrower as the sole member of Property Owner.
If a taxpayer does not satisfy the requirements of the safe harbor, it may still argue that, based on facts and circumstances, its debt satisfies the Secured-By Requirement.
The safe harbor is available for taxpayers who elect to treat indebtedness as QRPBI on or after February 5, 2014.