The Internal Revenue Service has issued a new revenue procedure (Revenue Procedure 2014-20) to help taxpayers in workouts when they have debts that have been discharged in connection with real property. Under the new guidelines, the IRS will treat indebtedness that is secured by 100 percent of the ownership interest in a disregarded entity holding real property as indebtedness that is secured by real property for purposes of § 108(c)(3)(A) of the Internal Revenue Code.
Often borrowers incur debt for real estate used in their business. If that debt is later discharged, the income from the discharge of indebtedness may be excluded from gross income if certain requirements are met. In some cases, the real property is held by the borrower in an entity that is wholly owned by the borrower, and is, for federal tax purposes, disregarded as an entity separate from its owner. In these cases, the debt may be secured by the borrower’s ownership interest in the disregarded entity holding the real property.
To qualify for the new safe harbor provisions, the following tests must be met:
(1) The taxpayer or a wholly owned disregarded entity of the taxpayer (“Borrower”) incurs indebtedness.
(2) Borrower directly or indirectly owns 100% of the ownership interest in a separate disregarded entity owning real property (“Property Owner”). Borrower is not the same entity as Property Owner.
(3) 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.
(4) 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 property.
(5) Upon default and foreclosure on the indebtedness, the lender will replace Borrower as the sole member of Property Owner.
Although very little additional guidance is provided in the Revenue Procedure, the IRS noted that not meeting each of the tests does not preclude a taxpayer for arguing for relief.
The new safe harbor is effective for taxpayers making an election under the Qualified Real Property Business Indebtedness (QRPBI) election under section 108(c )(3) on or after February 5th, 2014. The safe harbor is expected to be included in Internal Revenue Bulletin 2014-09 on Feb. 24, 2014.
About the author. Brian Mahany is a tax attorney and principal at Mahany & Ertl, a boutique tax and fraud law firm that concentrates in tax audit, tax planning and U.S. Tax Court litigation. They represent individuals, entrepreneurs and Fortune 500 companies. Brian can be reached at or by telephone at (414) 704-6731(direct). All inquiries protected by the attorney – client privilege.