Qualified real property business debt exclusion

Taxpayers who are not C corporations and who are not insolvent or bankrupt can elect to exclude cancellation–of–debt (COD) income resulting from the discharge of qualified real property business debt (Sec. 108(a)(1)(D)). However, if this election is made, the taxpayer must reduce the basis of their depreciable real property. Although several tests limit the ability of taxpayers to take advantage of this exclusion, it can provide excellent tax planning opportunities.

Qualified real property business debt is debt incurred or assumed to acquire, construct, reconstruct, or substantially improve real property used in a trade or business (and secured by the real property) (Secs. 108(c)(3) and (4)).

Note: For debt incurred or assumed before 1993, the debt only had to be incurred or assumed in connection with real property used in a trade or business and secured by such real property to be qualified real property debt.

Rev. Rul. 2016–15 provides guidance on when real estate is used in a trade or business for purposes of the definition of qualified real property business debt. When a taxpayer obtained a loan and used the proceeds to construct an apartment building for use in the taxpayer’s leasing business, the debt securing the property was qualified real property business debt because the real property was used in a trade or business. However, if the property had been developed and held for sale in the ordinary course of business, the property would have been nondepreciable inventory in the taxpayer’s hands, which is not real property used in a trade or business under Sec. 108(c)(3).

Rev. Proc. 2014–20 provides a safe harbor under which debt secured by 100% ownership of a disregarded entity (such as a single–member LLC) holding real property will be treated as debt secured by real property. Among other things, at least 90% of the fair market value (FMV) of the disregarded entity’s assets must be real property used in a trade or business. Also, upon default and foreclosure of the debt, the lender will become the disregarded entity’s sole member.

In Letter Ruling 200953005, the IRS looked through several layers of disregarded single–member LLCs (SMLLCs) that were ultimately owned by one multimember LLC. The parent multimember LLC was allowed to treat debt incurred by one of the disregarded SMLLCs as qualified real property business debt, thanks to another SMLLC’s ownership of real estate that was financed by that debt. In other words, the parent LLC and its SMLLCs were all treated as one taxpayer for applying the qualified real property business debt provision.

The amount of COD income that can be excluded with respect to qualified real property business debt is limited to the lesser of (Sec. 108(c)(2)):

• The FMV limit: The excess of the debt’s outstanding principal amount immediately before the discharge over the net FMV of the real property securing the debt.
  
  Note: “Net FMV” is the property’s FMV reduced by the outstanding principal amount of any other qualified real property indebtedness secured by that property immediately before and after the discharge (Regs. Sec. 1.108–6(a)).
• The overall limit: The aggregate adjusted bases of all depreciable real property held by the taxpayer immediately before the discharge. In computing this limit, property acquired in anticipation of the debt discharge is disregarded.

The determination of whether debt is qualified real property business debt and the application of the FMV limit are made at the LLC level. The overall limit is applied at the member level.

Since each member can elect separately to exclude the COD income arising from qualified real property business debt, some members may elect to exclude such income and some members may not. This will result in members having different bases in the LLC and different tax bases in the LLC’s depreciable real property.

The election to exclude COD income arising from qualified real property business debt is made on the member’s income tax return for the year of the debt discharge by filing a completed Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment). Once made, the election can be revoked only with IRS consent.

In Letter Rulings 201316009 and 201316010, a taxpayer who was a 50% member in an LLC classified as a partnership was granted an extension for filing an election to exclude income resulting from the discharge of qualified real property business debt and to instead reduce the basis of depreciable real property. The LLC’s Form 1065, U.S. Return of Partnership Income, and the Schedule K-١, Partner’s Share of Income, Deductions, Credits, etc., did not indicate that the discharge related to qualified real property business indebtedness. A second firm prepared the LLC member’s Form 1040, U.S. Individual Income Tax Return, and was unaware of the nature of the discharge until preparing tax projections in a later tax year.

In Letter Ruling 200543038, the IRS refused to grant an extension of time to make the election to an individual who filed a Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR), contesting the passthrough of COD income. The IRS concluded that the Form 8082, while noting the inconsistent position, did not constitute an election because it did not notify the IRS that an election was being made. In fact, the Form 8082 stated that the debt discharged was not part of any qualified debt. The taxpayer not only failed to reduce the basis of any property but took depreciation deductions in the succeeding years on property that would have had a zero basis had the election been made. Furthermore, the government’s interests would be prejudiced by permitting the late election because several of the years were closed, thus denying the IRS the opportunity to remove the depreciation deductions claimed in those years.

Basis reduction

As mentioned above, taxpayers who exclude COD income with respect to the discharge of qualified real property business debt must reduce their basis in their depreciable real property. The basis reduction generally is deemed to occur at the beginning of the tax year following the tax year in which the discharge occurs. However, the basis reduction takes place immediately before the disposition of the property if the member disposes of the property before the beginning of the next tax year. A member’s LLC interest may be considered depreciable real property to the extent of the member’s proportionate interest in the LLC’s depreciable real property, but only if there is a corresponding reduction in the partnership’s basis in depreciable property with respect to such partner. The reduction in basis is treated as depreciation, which increases the ordinary–income recapture if the property is sold after the reduction. A sale immediately after the reduction can trigger a large and unexpected amount of ordinary income.

When the election to exclude COD income resulting from the discharge of qualified real property business debt is made, the order of basis reduction is as follows (Regs. Sec. 1.1017–1(a)):

• Depreciable real property used in a trade or business or held for investment, other than real property treated as stock in trade or held for sale to customers in the ordinary course of business, that secured the indebtedness immediately before the discharge; and
• Remaining depreciable real property used in a trade or business or held for investment, other than inventory, accounts receivable, and notes receivable and real property treated as stock in trade or held for sale to customers in the ordinary course of business.

Members who exclude COD income resulting from the discharge of qualified real property business debt may treat their LLC interest as depreciable real property to the extent of their share of the LLC’s depreciable real property, provided the LLC consents to decrease the LLC’s basis in that property (inside basis) with respect to that member. Regs. Sec. 1.1017–1(g) provides guidance for treating a member’s interest in an LLC as a proportionate interest in the LLC’s depreciable property (if an election under Sec. 108(b)(5) is made) or its depreciable real property (if an election under Sec. 108(c) is made). The LLC member must request that the LLC adjust its basis with respect to the member’s share of depreciable property (or depreciable real property) by the due date of the tax return, including extensions, for the year in which the COD income arises.

Caution: A request to reduce the inside basis of LLC assets must be made if the member owns, directly or indirectly, more than 50% of the capital and profits interest in the LLC or if the reductions to the basis of the member’s depreciable property arise from an allocation of the LLC’s COD income. Likewise, an LLC must consent to the basis reduction if members owning (directly or indirectly) more than 80% of the capital and profits interest in the LLC request such a basis reduction. The LLC must also consent when five or fewer members owning (directly or indirectly) more than 50% of the capital and profits interest in the LLC request such a basis reduction. For example, if there is a cancellation of LLC indebtedness that is secured by real property used in an LLC’s trade or business, and if members owning (in the aggregate) 90% of the LLC’s capital and profits interests elect to exclude the COD income under Sec. 108(c), the LLC must make the appropriate reductions in those partners’ shares of inside basis.

Example 1. Basis reduction with respect to qualified real property business debt exclusion: J owns a 10% interest in F LLC, which is classified as a partnership. The LLC owns depreciable real property with a basis of $250,000 and other investments in stock with a basis of $100,000. J owns no other depreciable real property. The LLC has COD income of $150,000 that qualifies for the real property business debt exclusion. The LLC allocates $15,000 of COD income to J as a separately stated item. J elects to treat the COD income as from qualified real property debt. She must request that the LLC reduce her share of LLC depreciable real property. (She is treated as having depreciable real property of $25,000, her proportionate share of the LLC’s depreciable real property.) Assuming the LLC consents, it will reduce J’s basis in her share of the LLC depreciable real property by $15,000, and she will be able to exclude $15,000 of COD from income.

For the tax year following the year that ends with or within the tax year the member excludes COD income from gross income under Sec. 108(a), a consenting LLC must include with its Form 1065 a statement that states the amount of the reduction of the member’s proportionate interest in the adjusted bases of the LLC’s depreciable property or depreciable real property, whichever is applicable. The LLC must provide a similar statement to the member on or before the due date of the member’s return (including extensions) for the tax year in which the member excludes COD income from gross income. The reduction in the member’s proportionate interest in the LLC’s assets will be made in accordance with the normal order of basis reduction under Sec. 1017.

A member’s proportionate share of the LLC’s basis in depreciable property (or depreciable real property) equals the sum of (Regs. Sec. 1.1017–1(g)(2)(iv)(A)):

• Their Sec. 743(b) basis adjustments with respect to items of LLC depreciable property (or depreciable real property); and
• The common basis depreciation deductions (but not including remedial allocation of depreciation under Regs. Sec. 1.704-3(d)) that, under the terms of the articles of organization and operating agreement, are reasonably expected to be allocated to the member over the property’s remaining useful life. The assumptions made by a partnership in determining the reasonably expected allocation of depreciation deductions must be consistent for each partner. For example, a partnership may not treat the same depreciation deductions as being reasonably expected by more than one partner.

Contributor

Shaun M. Hunley, J.D., LL.M., is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org. This case study has been adapted from Checkpoint Tax Planning and Advisory Guide’s Limited Liability Companies topic. Published by Thomson Reuters, Frisco, Texas, 2026 (800-431-9025; tax.thomsonreuters.com).