Code §108(a)(1)(D) avoids debt discharge income to taxpayers (other than C corporations) when indebtedness is forgiven if it is qualified real property business indebtedness. This is generally indebtedness incurred in connection with real property used in a trade or business if secured by such real property.
A question has existed whether a direct mortgage on the real property is required indebtedness to be considered secured by the real property. In a useful Revenue Procedure, the IRS is providing a safe harbor as to this question in certain circumstances – if the debt is secured by a pledge of the taxpayer’s ownership interest in a disregarded entity that holds the real property, that will be treated as meeting the security requirement.
There are some miscellaneous requirements to meet the safe harbor requirements. For example, the security interest must be a first priority security interest.Also, at least 90% of the fair market value of the total assets of the disregarded LLC must be real property used in a trade or business, with the other assets being incidental to the acquisition, ownership and operation of the real property. Thus, it would appear that the LLC must be a special purpose vehicle to own just the real property to qualify under this exception.
Even if the safe harbor is not met, taxpayers can still argue that they meet the requirements of the security requirements – according to the Revenue Procedure the safe harbor is not intended as the sole method of qualifying when security arrangements are not accomplished through a mortgage. The Revenue Procedure acknowledges, and further discusses, legislative support that a mortgage is not a requirement under Code §108(a)(1)(D).
Rev.Proc. 2014-20
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