8136 / What is the qualified real property business indebtedness exclusion?
Unlike the other discharge of debt exclusions, a taxpayer must affirmatively elect to exclude qualified real property indebtedness from gross income. "Qualified real property business indebtedness" is secured debt that meets the following requirements:
- It was incurred or assumed in connection with real property used in a trade or business; and
- It was incurred or assumed prior to January 1, 1993, or, if incurred or assumed after December 31, 1992, is "qualified acquisition indebtedness."
Qualified acquisition indebtedness is:
- Debt incurred or assumed to acquire, construct, reconstruct or substantially improve real property used in a trade or business (including debt incurred in connection with refinancing to the extent that the ensuing debt does not exceed the amount of debt being refinanced); or
- Refinanced debt incurred before 1993 (any secured debt) to the extent that the amount of the ensuing debt does not exceed the amount of debt being refinanced.
If elected by the taxpayer, subject to two limitations, all or part of the discharged qualified real property business indebtedness is excluded from gross income. By being elective, the taxpayer can weigh the relative tax consequences of making or not making the election.
The following example illustrates the tax consequences of a taxpayer who elects to exclude discharged qualified real property indebtedness in the aftermath of a short sale:
Example: In 2027, Asher is in default on an $800,000 loan secured by a warehouse used in his moving business. Assume that the warehouse is the only depreciable property Asher owns and the $800,000 loan is Asher's only qualified real property business indebtedness. At that time, the fair market value of the warehouse is $500,000 and Asher's overall basis in the property is $750,000 (depreciable basis in the warehouse was $550,000 and $200,000 in the underlying land (non-depreciable)). On September 17, 2027, the secured lender approves a short sale of the warehouse to Ashley for $500,000. On December 31, 2027, after receiving the proceeds from the short sale and applying it to the loan, the lender forgives the remaining $300,000 balance of the loan.
Per the first limitation, the amount of the forgiven qualified real property business indebtedness excluded from gross income cannot exceed the difference between the outstanding balance immediately before the discharge ($800,000) and the fair market value of the secured real property ($300,000). So, in this example, the first limitation would be $300,000, which is the full amount of the forgiven debt.
Per the second limitation, the amount of excludable discharged qualified real property business indebtedness is further limited by the aggregate bases of all the taxpayer's depreciable real property held by the taxpayer immediately before the discharge. In this example, Asher's basis in the warehouse (his only depreciable property) was $550,000 – greater than the amount of the $300,000 discharged debt.
So, after applying both limitations, the full amount of the discharge of debt income would be excluded from gross income. As a consequence of the exclusion, however, the basis of the warehouse would be reduced by the amount of the discharged debt. Prior to the discharge, Asher's basis in the property was $750,000 ($550,000 for the warehouse plus $200,000 for the underlying land). As a result of the basis reduction of $300,000, the overall basis of the qualified property would be adjusted down to $450,000.
Importantly, like any other sale or exchange, the gain or loss from a short sale must be computed. By reducing the basis to $450,000, Asher would realize a $50,000 capital gain ($500,000 minus $450,000).
Bottom line: Asher would exclude $300,000 of discharged debt (treated as ordinary income) and recognize a capital gain of $50,000.
On the other hand, if Asher had not elected to exclude the discharged debt, the $300,000 would be included in gross income. Consequently, the basis of the warehouse would not be reduced. Therefore, with respect to the short sale, Asher would have recognized a $250,000 loss ($750,000 basis minus $500,000 short sale proceeds).
Bottom line: The overall transaction would result in a $250,000 loss and $50,000 of discharge of debt income.
Whether Asher should make the election depends on an analysis of Asher's overall tax picture to determine which alternative is more beneficial. Such an analysis could be quite detailed and is beyond the scope of this discussion.
Finally, other than the basis reduction, there is no further reduction of a taxpayer's tax attributes.