QRPBI exclusion limit applies property by property

Plain-English summary

A taxpayer owned two business properties, each financed by debt whose proceeds were used only for that particular property, although both debts were secured by both properties. One debt was partially discharged, raising a dispute over the section 108(c)(2) limit on the qualified real property business indebtedness exclusion. Chief Counsel concluded that the calculation starts with the fair market value of the single property for which the discharged debt is QRPBI. That value is reduced only by other debt that is both secured by and QRPBI with respect to that same property. Because the other debt financed the second property, it did not reduce the first property's fair market value, and the taxpayer could exclude only the redacted amount produced by the property-specific formula.

Ruling snapshot

• Question: Which property values and debts enter the section 108(c)(2) net-fair-market-value formula?
• Outcome: Use only the property tied to the discharged QRPBI and other QRPBI tied to that same property
• Key authorities: IRC §§ 108(a)(1)(D), 108(c), and 1017; Treas. Reg. §§ 1.108-6(a) and 1.1017-1(c)(1)

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           Memorandum
           Number: 201623009
           Release Date: 6/3/2016
           CC:ITA:B05:JBLovelace
           POSTF-139972-15

 UILC:     108.01-04

  date:    March 02, 2016

     to:   Donna L. Crosby
           Senior Attorney, (San Diego)
           (Large Business & International)

  from:    William A. Jackson
           Branch Chief, Branch 5
           (Income Tax & Accounting)

           John B. Lovelace
           General Attorney, Branch 5
           (Income Tax & Accounting)


subject:   Limitation on the Exclusion for Discharges of Qualified Real Property Business
           Indebtedness

           This Chief Counsel Advice responds to your request for assistance. This advice may
           not be used or cited as precedent.


           LEGEND

           Taxpayer = --------------------------------------
           Property A = --------------------------
           Property B = ------------------------
           Debt C = --------------------------------
           Debt D = -------------------------------
           $a = -----------------
           $b = -----------------
           $c = ---------------
           $d = ---------------
           $e = -----------------
           $f = ---------------
POSTF-139972-15                              2

$g = ------------

ISSUES

You have asked whether, in determining the net fair market value of real property under
the qualified real property business indebtedness (QRPBI) exclusion of section
108(a)(1)(D), the exclusion limitation formula in section 108(c)(2) and § 1.108-6(a) takes
into account all real property held by a taxpayer with respect to which there is some
QRPBI and all debts that are QRPBI with respect to any item of real property held by
the taxpayer.

The Taxpayer and the field disagree over the proper interpretation of the “net fair market
value” formula in the QRPBI exclusion limitation of section 108(c)(2)(A). The Taxpayer
takes the position that the starting point for this calculation, described in the Code as
“the fair market value of the real property described in paragraph (3)(A)”, is the fair
market value of the single item of real property for which the discharged debt is QRPBI.
The field interprets this clause to refer to the fair market value 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 agree that the net fair market value formula in the QRPBI
exclusion limitation requires the fair market value be reduced by the total of all other
debts that are QRPBI with respect to any item of real property held by the Taxpayer.


CONCLUSIONS

The formula for the QRPBI exclusion limitation in section 108(c)(2) and § 1.108-6(a)
begins with the total fair market value of the single item of real property to which the
discharged debt is QRPBI and then reduces that total by the sum of all other debts that
are secured by, and QRPBI with respect to, that item of real property.

The alternative view advanced by the Taxpayer that the net fair market value is the fair
market value of the single item of real property to which the discharged debt is QRPBI,
reduced by the amount of other debt secured by such property but that is QRPBI with
respect to any item of real property held by the taxpayer is in error.

The field’s interpretation, which aggregates all of the real property with respect to which
some debt is QRPBI to determine the fair market value and then subtracts the
aggregate of all QRPBI from that amount to obtain the net fair market value is also in
error.
POSTF-139972-15                                   3

FACTS

The Taxpayer owns two items of real property used in a trade or business, Property A
and Property B. At the time of the of the debt forgiveness at issue, Property A had a fair
market value of $a and was security on Debt C with a principal amount of $b. At the
same time, Property B had a fair market value of $c and was security on Debt D with a
principal amount of $d. Debt D was also secured by Property A, and Debt C was
secured by Property B. The proceeds from Debt C were used to improve Property A
and were not used for Property B. The proceeds from Debt D were used to construct or
improve Property B and not used for Property A.

Debt C was reduced to $e, reflecting a discharge amount of $f. In its calculation of the
maximum exclusion amount under section 108(c)(2), the Taxpayer has reduced the fair
market value of Property A by Debt D without also adding the value of Property B to
Property A. On this basis, the Taxpayer has excluded the entire amount of Debt C that
was discharged. Neither Debt C nor Debt D were incurred or assumed before January
1, 1993.


LAW

Section 108(a)(1)(D) provides that gross income does not include discharged amounts if
“the indebtedness discharged is qualified real property business indebtedness.”

Section 108(c)(3) defines “qualified real property business indebtedness” to mean:

      indebtedness which—
              (A) 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,
              (B) was incurred or assumed before January 1, 1993, or, if incurred or assumed
              on or after such date, is qualified acquisition indebtedness, and
              (C) with respect to which such taxpayer makes an election to have this
              paragraph apply.

“Qualified acquisition indebtedness” is defined in section 108(c)(4), which provides:

      For purposes of paragraph (3)(B), the term “qualified acquisition indebtedness” means,
      with respect to any real property described in paragraph (3)(A), indebtedness incurred or
      assumed to acquire, construct, reconstruct, or substantially improve such property.

Section 108(c)(2)(A) limits the amount excluded under section 108(a)(1)(D). It provides:

               The amount excluded under subparagraph (D) of subsection (a)(1) with respect to any
      qualified real property business indebtedness shall not exceed the excess (if any) of –
              (i)     the outstanding principal amount of such indebtedness (immediately
              before the discharge), over
POSTF-139972-15                                       4

                 (ii)     the fair market value of the real property described in paragraph (3)(A)
                 (as of such time), reduced by the outstanding principal amount of any other
                 qualified real property business indebtedness secured by such property (as of
                 such time).

Treas. Reg. § 1.108-6(a) provides, in part:

         With respect to any qualified real property business indebtedness that is discharged, the
         amount excluded from gross income under section 108(a)(1)(D) (concerning discharges
         of qualified real property business indebtedness) shall not exceed the excess, if any, of
         the outstanding principal amount of that indebtedness immediately before the discharge
         over the net fair market value of the qualifying real property, as defined in § 1.1017-
         1(c)(1), immediately before the discharge. For purposes of this section, net fair market
         value means the fair market value of the qualifying real property (notwithstanding section
         7701(g)), reduced by the outstanding principal amount of any qualified real property
         business indebtedness (other than the discharged indebtedness) that is secured by such
         property immediately before and after the discharge.

Treas. Reg. § 1.1017-1(c)(1) provides, in part:

         Furthermore, for basis reductions under section 108(c), a taxpayer must reduce
         the adjusted basis of the qualifying real property to the extent of the discharged
         qualifying real property business indebtedness before reducing the adjusted
         bases of other depreciable real property. The term qualifying real property
         means real property with respect to which the indebtedness is qualified real
         property business indebtedness within the meaning of section 108(c)(3).


ANALYSIS

To understand the QRPBI exclusion limitation, it is necessary to look at each element of
it in the context of the entire QRPBI exclusion limitation provision.

The QRPBI exclusion limitation in section 108(c)(2)(A) consists of four different
elements, divided up as follows:

   (1)           The amount excluded under subparagraph (D) of subsection (a)(1) with
                 respect to any qualified real property business indebtedness shall not
                 exceed the excess (if any) of—

   (2)           (i) the outstanding principal amount of such indebtedness (immediately
                 before the discharge), over

   (3)           (ii) the fair market value of the real property described in paragraph (3)(A)
                 (as of such time),
POSTF-139972-15                                 5

      (4)         reduced by the outstanding principal amount of any other qualified real
                  property business indebtedness secured by such property (as of such
                  time).


(1)         The amount excluded under subparagraph (D) of subsection (a)(1) with
            respect to any qualified real property business indebtedness shall not
            exceed the excess (if any) of—

The first element is the introductory language that provides, “The amount excluded
under subparagraph (D) of subsection (a)(1) with respect to any qualified real property
business indebtedness shall not exceed the excess (if any) of--“. For debt amounts to
be excluded, they must first be discharged. Thus, this introductory phrase refers to the
amount of the discharged debt that is QRPBI with respect to a single item of real
property.

(2)         (i) the outstanding principal amount of such indebtedness (immediately
            before the discharge), over

The second element of the QRPBI exclusion limitation provides, “(i) the outstanding
principal amount of such indebtedness (immediately before the discharge), over”. The
amount referred to in this element is the principal amount of the debt referred to in the
introductory language, i.e. the discharged debt that is QRPBI with respect to a single
item of real property. Accordingly, the same real property referenced in the first element
is implicitly referenced in the second element.

(3)         (ii) the fair market value of the real property described in paragraph (3)(A)
            (as of such time),

The third element of the QRPBI exclusion limitation provides, “(ii) the fair market value
of the real property described in paragraph (3)(A) (as of such time)”. “Paragraph (3)(A)”
is the first requirement of three in the definition of “qualified real property business
indebtedness” in section 108(c)(3) (i.e. section 108(c)(3)(A)). This requirement is that
debt be incurred or assumed by the taxpayer “in connection with real property used in a
trade or business.”

There are two permissible interpretations of the “real property described in paragraph
(3)(A).” Under the first interpretation, “the real property described in paragraph (3)(A)”
refers to all real property held by a taxpayer for which there is some debt that is QRPBI.
When a taxpayer has two items of real property, each with its own associated QRPBI,
the fair market value of both properties would, under this interpretation, be taken into
account in determining the QRPBI exclusion limitation.

Under the second interpretation, “the real property described in paragraph (3)(A)” refers
to the single item of real property with respect to which the discharged debt referenced
POSTF-139972-15                                   6

in the first two elements is QRPBI. When a taxpayer has two items of real property,
each with its own associated QRPBI, the fair market value of only the item of real
property with respect to which the discharged debt is QRPBI would be taken into
account in determining the QRPBI exclusion limitation.

The proposed adjustment aggregates the values of the Taxpayer’s real property, and
thus relies on the first interpretation. The Taxpayer’s position takes into account only
the value of the single item of real property with respect to which the discharged debt is
QRPBI, and thus relies on the second interpretation.

The Taxpayer’s interpretation of the third element is the better of the two. On its face,
“the property described in paragraph (3)(A)” refers to a single item of property, literally
“the property.” Were Congress to have intended “the property” to refer to more than
one property, it would have made more sense to use the term “any property” or, even
more clearly, “all properties.” An unmodified singular term used in combination with the
article “the” usually refers to a single item rather than all items of that type.

This interpretive principle is at work in the immediately following fourth element, where
the Code draws in more than one debt through use of the qualifying word “any” before
“other qualifying real property business indebtedness secured by such property.” While
“any” as used in the fourth element is arguably unnecessary, its use makes it quite clear
that the fair market value of the real property is to be reduced more than one debt. The
absence of a similar qualifier in front of the word “property” in the third element suggests
that “the property” refers to the single item of real property for which the discharged debt
is QRPBI.

More support for this can be found in section 108(c)(2)(B), which imposes a second,
overall limitation on the amount that may be excluded under the QRPBI discharge
exclusion. Section 108(c)(2)(B) provides:

       The amount excluded under subparagraph (D) of subsection (a)(1) shall not exceed the
       aggregate adjusted bases of depreciable real property (determined after any reductions
       under subsections (b) and (g)) held by the taxpayer immediately before the discharge
       (other than depreciable real property acquired in contemplation of such discharge).

Here, the singular term “depreciable real property” does refer to more than one item of
depreciable real property, but this is made clear by the use of the terms “aggregate” and
“bases” which draw together the bases of all depreciable real property held by a
taxpayer to establish the overall limitation. Thus, elsewhere in this provision where the
Code refers to more than one item of real property by using the singular “property,” the
language contains a modifier to make it clear that the Code is referring to more than one
item of real property. Where the Code does not do this, the better interpretation is that
Congress intended “property” to refer to one and only one item of real property.
POSTF-139972-15                                    7

The regulations also support the interpretation under which “the real property described
in paragraph (3)(A)” is the real property to which the discharged debt is QRPBI. Treas.
Reg. § 1.108-6(a) provides, in part:

       With respect to any qualified real property business indebtedness that is discharged, the
       amount excluded from gross income under section 108(a)(1)(D) (concerning discharges
       of qualified real property business indebtedness) shall not exceed the excess, if any, of
       the outstanding principal amount of that indebtedness immediately before the discharge
       over the net fair market value of the qualifying real property, as defined in § 1.1017-
       1(c)(1), immediately before the discharge. For purposes of this section, net fair market
       value means the fair market value of the qualifying real property (notwithstanding section
       7701(g)), reduced by the outstanding principal amount of any qualified real property
       business indebtedness (other than the discharged indebtedness) that is secured by such
       property immediately before and after the discharge.

In these regulations, “the real property described in paragraph (3)(A)” is referred to as
“the qualifying real property, as defined in § 1.1017-1(c)(1).” Treas. Reg. § 1.1017-
1(c)(1) provides, in part:

       Furthermore, for basis reductions under section 108(c), a taxpayer must reduce the
       adjusted basis of the qualifying real property to the extent of the discharged qualifying
       real property business indebtedness before reducing the adjusted bases of other
       depreciable real property. The term qualifying real property means real property with
       respect to which the indebtedness is qualified real property business indebtedness within
       the meaning of section 108(c)(3).

Accordingly, the “the real property described in paragraph (3)(A)” is the “real property
with respect to which the indebtedness is qualified real property business indebtedness
within the meaning of section 108(c)(3).” “The indebtedness” here refers to the
indebtedness described in the immediately preceding sentence, i.e. the discharged
indebtedness. The qualifying real property then is the item of real property for which the
discharged debt is QRPBI and does not include any other items of real property with
respect to which debts other than the discharged debt are QRPBI.

(4)    reduced by the outstanding principal amount of any other qualified real
       property business indebtedness secured by such property (as of such
       time).

The fourth and last element of the QRPBI exclusion limitation provides, “reduced by the
outstanding principal amount of any other qualified real property business indebtedness
secured by such property (as of such time).” “Such property” at the end of the clause
refers to the same item of real property as the third element, which, as previously
discussed, is the single item of real property with respect to which the discharged debt
is QRPBI.

The other important piece of the fourth element is the phrase, “any other qualified real
property business indebtedness.” Both the Taxpayer and the field interpret this phrase
to refer to any debt that qualifies as QRPBI with respect to any item of real property held
POSTF-139972-15                               8

by a taxpayer, whether or not that item of real property is the item of real property
referred to directly or indirectly in the first three elements and “such property” of the
fourth element.

There is, however, a second, better interpretation of this clause. “[A]ny other qualified
real property business indebtedness” could refer to all debts other than the discharged
debt that are QRPBI with respect to the same item of real property referred to in the first
three elements and “such property” of the fourth element. The term “qualified real
property business indebtedness” used here in the fourth element is a term that is
defined, in part, by the same paragraph (3)(A) that is used to describe the real property
with respect to which the discharged debt is QRPBI. If, as is most likely, the language
“real property described in paragraph (3)(A)” in the third element refers only to the item
of real property to which the discharged debt is QRPBI, the only consistent reading of
the fourth element’s use of the term “qualified real property business indebtedness” – a
term whose definition incorporates paragraph (3)(A) -- is that it refers only to debts that
are QRPBI with respect to the same item of real property of the third element.

As described above, the proceeds of Debt C were used to improve Property A and were
not used for Property B. Consequently, Debt C is qualified acquisition indebtedness
(within the meaning of section 108(c)(4)) only for Property A and not Property B. Thus,
Debt C is QRPBI only with respect to Property A. Similarly, the proceeds of Debt D
were used to construct or improve Property B and were not used for Property A. Debt D
is qualified acquisition indebtedness only for Property B, and thus is QRPBI only with
respect to Property B and not Property A.

The only QRPBI with respect to Property A is Debt C. Because Debt C is the debt
discharged, the fair market value of Property A is not reduced by any amount under the
formula for the net fair market value in § 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 ($b) exceeds the net fair market value of Property A ($a).
Consequently, the Taxpayer may exclude $g of the amount of Debt C that was
discharged ($f).


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