The IRS Office of Chief Counsel released guidance on the exclusion limitation for discharge of qualified real property business indebtedness (QRPBI). The limitation is the excess of the debt’s outstanding principal over the net of the property’s fair market value (FMV) and other QRPBI secured by the property. The IRS determined the only property qualifying for the limitation is the single property that qualified the indebtedness as QRPBI, which affects the amount of income excluded and basis reduction in the property secured by the debt.
The debt must meet these requirements to be qualified as QRPBI:
- Incurred or assumed in connection with real property used in a trade or business and secured by the property
- Incurred or assumed before January 1, 1993, or, if incurred after, considered qualified acquisition indebtedness (indebtedness incurred or assumed, with respect to real property, to acquire, construct, reconstruct or substantially improve the property)
- An election is made to have indebtedness treated as QRPBI
The amount excluded may not exceed the excess of the outstanding principal amount over the FMV of the real property, reduced by the outstanding principal amount of any other QRPBI secured by the property. Consider the following example:
Sally purchased a retail store building for $220,000 and financed $200,000 with a bank loan. The loan was secured by the property and used in Sally’s business operations. Five years after the purchase, Sally entered into an agreement with the bank that canceled $20,000 of the debt. Immediately before cancellation, the loan’s outstanding principal balance was $185,000, the FMV was $165,000 and the adjusted basis of the building was $210,000.
Sally elects to exclude the canceled debt from income under the QRPBI exclusion. The limitation on the excluded amount is $20,000—the excess of the outstanding principal balance over the FMV of the business real property securing the debt ($185,000 minus $165,000).
The entire $20,000 cancellation of debt income is allowed to be excluded. Further, Sally reduces her depreciable property basis by the excluded amount.
Many taxpayers own more than one property and have incurred various debt instruments on those properties. Previously, it was unclear if it was appropriate to add the FMV of multiple properties together as well as what debt to consider in reducing the FMV when determining the limit of the exclusion from gross income.
To address the ambiguity, the IRS broke Section108(c)(2)(A) down into four components:
- The opening part of the code section describes the exclusion as it relates to any QRPBI. The IRS determined this is referring to the amount of debt forgiveness on a single item of real property.
- “Outstanding principal amount” refers to the debt only related to the single item of property mentioned in the first component.
- “FMV of the real property” also is only the single item of property. The IRS stated if Congress intended for it to be more than one property, it would have used language such as “any property” or “all properties.”
- “Reduced by the outstanding principal amount of any other QRPBI secured by such property” continues to refer to a single item of property based on the use of “such property.” In addition, this component uses the term “any” when discussing what indebtedness to include in the outstanding principal reduction. The IRS interprets this to include only debts that are QRPBI pertaining to the same single item of real property.
It’s also important to recognize the differences between taxpayers who develop and hold real property for lease in their leasing business and those who hold it primarily for sale to customers in the ordinary course of business. Real property held for lease is depreciable, while real property held for sale is considered inventory and not depreciable. An election exists whereby the real property held for sale is treated as depreciable; however, 26 U.S. Code § 108 and regulations preclude this from happening in the case of QRPBI.
Congress intends the deferral period to correspond to the period the taxpayer holds the property securing the canceled debt. The provisions surrounding the income exclusion on QRPBI require the basis of the depreciableproperty be reduced by the amount of income excluded. If debt on real property held for sale was recognized as QRPBI, the reduction of basis couldn’t be applied. This roadblock creates deferrals of cancellation of debt income that go beyond the holding period of the real property held for sale, which isn’t the intent of Congress.
For taxpayers experiencing debt forgiveness, the recent IRS clarification is helpful. Income from cancellation of debt can be excluded from gross income, but with certain limitations. Subsequently, the basis in the depreciable real property must be reduced by the income exclusion.
If you have questions about how the discharge of QRPBI can affect your business, contact your BKD advisor.