The IRS has issued new guidance that will, in certain circumstances, exclude from gross income any discharged debt that is secured by the ownership interest in a disregarded entity. Revenue Procedure 2014-20 should help taxpayers with mezzanine financing in workouts and similar arrangements.

How the Issue Arises
Gross income usually includes income from the discharge of debt. But such income is excluded if, for any taxpayer but a C corporation, the debt is qualified real property business indebtedness (QRPBI). A requirement to qualify as QRPBI is that the indebtedness must be incurred or assumed by the taxpayer in connection with real property used in a trade or business. The debt  must also be secured by such real property.

The term “secured by such real property” is not defined by the relevant law. While lenders commonly use mortgages to secure an interest in real estate, mortgages are not the only form of security allowed.

For example, in some instances, real property is owned by the borrower in an entity that is wholly owned and thereby disregarded for federal tax purposes but respected under state law as a separate and distinct entity. The mezzanine financing in such cases may be secured by the borrower’s ownership interest in the respective entity. The IRS has recently noted that mezzanine debt secured by an interest in a wholly owned entity is also considered QRPBI so long as certain conditions are met.

How to Qualify for the Exclusion
Under the new IRS guidance, a safe harbor exclusion is available if:

• The taxpayer or a wholly-owned, disregarded entity incurs debt;
• The borrower owns 100% of the ownership interest in a separate, disregarded entity owning real property (the property owner), and is not the same entity as the property owner;
• The borrower pledges to the lender a first priority security interest in the borrower’s ownership interest in the property owner (a disregarded entity);
• At least 90% of the fair market value of the total assets directly owned by the property owner is real property used in a trade or business, and any other assets held by the property owner are incidental to the property owner’s acquisition, ownership and operation of the real property; and
• On default and foreclosure of the debt, the lender will replace the borrower as the sole member of the property owner.

Also note that if a taxpayer fails to meet these requirements, an argument can still be made, based on facts and circumstances, that the debt nonetheless satisfies the “secured by” requirement.

The amount that may be excluded from gross income is limited to the amount by which the outstanding principal amount of the QRPBI immediately before the discharge exceeds the fair market value of the real property. The excluded amount is reduced by the outstanding principal amount of any other QRPBI secured by the property at the time of discharge.

Applying the Exclusion
The exclusion is effective for taxpayers that make the required election regarding discharged debt on or after Feb. 5, 2014. If you have questions, contact Anita Wescott at [email protected] or call her at 312.670.7444.