In today’s real estate market, lenders in many cases have agreed to forgive a portion of real estate debt. While this discharge of indebtedness would normally result in taxable income for the real estate owner in the year of the discharge, the Internal Revenue Code generally allows an individual to exclude this income if the debt is “qualified real property business indebtedness,” i.e., certain debt which is secured by real property used in a trade or business. In a recent private letter ruling, the IRS considered whether mezzanine financing, where debt is secured by interests in an entity that owns real property but not by the real property itself, can be qualified real property business indebtedness.
Background
If a lender cancels all or a portion of a borrower’s indebtedness, the borrower generally has taxable income equal to the amount of the discharge. However, section 108 allows certain taxpayers (e.g., if the taxpayer is insolvent or in bankruptcy) to exclude discharge of indebtedness income (cancellation of indebtedness or “COD” income), generally in exchange for a reduction in basis or other tax attributes of the taxpayer.
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