CHIEF COUNSEL'S OFFICE CLARIFIES FORMULA FOR QUALIFIED REAL PROPERTY BUSINESS INDEBTEDNESS EXCLUSION LIMITATION

In CCA 201623009, Taxpayer (T) owned two items of real property used in a trade or business, Property X and Property B. At the time of the debt forgiveness at issue, Property X was security on Debt C, and Property B was security on Debt D. Neither Debt C nor Debt D were incurred or assumed before January 1, 1993. Debt D was also secured by Property X, and Debt C was secured by Property B. Debt C proceeds were used to improve Property X and not Property B. Debt D proceeds were used to construct or improve Property B and not Property X. To reflect a discharge amount, Debt C was reduced.  

Gross income does not include discharged amounts that are “qualified real property business indebtedness” or QRPBI under §108(a)(1)(D).  QRPBI, as defined in §108(c)(3), is indebtedness that (1) was incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by such real property; (2) was incurred or assumed before January 1, 1993, or, if incurred or assumed on or after January 1, 1993, is qualified acquisition indebtedness; and (3) indebtedness that the taxpayer has made an election to exclude. Under §108(c)(4), “qualified acquisition indebtedness” is indebtedness incurred or assumed to acquire, construct, reconstruct, or substantially improve real property, described above.  

Under §108(c)(2)(A), the amount excluded under §108(a)(1)(D) cannot exceed the excess (if any) of (1) the outstanding principal amount of such indebtedness (immediately before the discharge), over (2) the (net) fair market value (FMV) of the real property (described in §108(c)(3)(A) (as of such time), reduced by the outstanding principal amount of any other QRPBI secured by such property (as of such time).  

At issue in CCA 201623009, is what is the correct interpretation of “net fair market value” formula in the §108(c)(2)(A) QRPBI exclusion limitation. According to the Taxpayer, the starting point for the calculation, i.e., the interpretation of “the fair market value of the real property (described in §108(c)(3)(A) (as of such time),” is the FMV of the single item of real property for which the discharged debt is QRPBI. The IRS interpreted this clause as referring to the FMV of all items of real property held by the Taxpayer with respect to which any debt is QRPBI and not just the single item of property for which the discharged debt is QRPBI.

The Taxpayer and the field agreed that the net FMV formula in the QRPBI exclusion limitation requires the FMV to be reduced by the total of all other debts that are QRPBI with respect to any item of real property held by the Taxpayer.

After analyzing each element of the QRPBI exclusion and interpreting Reg. §1.108-6(a) and Reg. §1.1017-1(c)(1), the Chief Counsel’s Office advised that (1) both the IRS and the taxpayer had incorrectly interpreted the formula; and (2) the formula for the QRPBI exclusion limitation in §108(c)(2) and Reg. § 1.108-6(a) begins with the total FMV of the single item of real property to which the discharged debt is QRPBI reduced by the sum of all other debts that are secured by, and QRPBI with respect to, that item of real property.

  The Chief Counsel’s Office concluded that because the proceeds of Debt C were only used to improve Property X, Debt C is qualified acquisition indebtedness and considered QRPBI only with respect to Property X. Likewise, because the proceeds of Debt D were only used to construct or improve Property B, Debt D is qualified acquisition indebtedness and QRPBI only with respect to Property B. Because Debt C is the debt discharged, the FMV of Property X is not reduced by any amount under the formula for the net FMV in Reg. §1.108-6(a). Under the QRPBI exclusion limitation, the Taxpayer may exclude no more than the amount by which the principal amount of Debt C exceeds the net FMV of Property X.