SECTION 2. BACKGROUND

.01 Often borrowers incur debt in connection with real property used in a trade or business. If the debt is later discharged, the income from the discharge of indebt

edness may be excluded from gross income if certain requirements are met. In some cases, the real property is held by the borrower in an entity that is wholly owned by the borrower, and is, for federal tax purposes, disregarded as an entity separate from its owner. In these cases, the debt may be secured by the borrower’s ownership interest in the disregarded entity holding the real property.

.02 Section 61(a)(12) provides that gross income includes income from the discharge of indebtedness.

.03 Section 108(a)(1)(D) excludes income from the discharge of indebtedness from gross income if, in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness (“QRPBI”).

.04 To qualify as QRPBI, § 108(c)(3) requires that the indebtedness must be incurred or assumed by the taxpayer in connection with real property used in a trade or business and be secured by such real property. The taxpayer must make an election to treat the indebtedness as QRPBI. QRPBI does not include qualified farm indebtedness. Section 108(c)(3)(B) provides that QRPBI must be indebtedness that was incurred or assumed before January 1, 1993, or if the indebtedness was incurred or assumed on or after January 1, 1993, it must be qualified acquisition indebtedness. Section 108(c)(3) also provides that indebtedness under § 108(c)(3)(B) includes indebtedness resulting from the refinancing of indebtedness under § 108(c)(3)(B), but only to the extent it does not exceed the amount of indebtedness being refinanced.

.05 Section 108(c)(4) defines qualified acquisition indebtedness as indebtedness incurred or assumed to acquire, construct, reconstruct, or substantially improve real property used in a trade or business.

.06 Section 108(c)(2)(A) limits the amount that may be excluded from gross income with respect to a discharge of QRPBI to the excess of (i) the outstanding principal amount of the QRPBI immediately before the discharge, over (ii) the fair market value of the real property reduced by the outstanding principal amount of any other QRPBI secured by the property at the time of discharge.

.07 Section 108(c)(1) provides that the basis of depreciable real property of a taxpayer shall be reduced by the amount excluded from gross income under § 108(a)(1)(D).

.08 Neither the statute nor the legislative history contains any explanation of or definition for the term “secured by such real property” used in § 108(c)(3)(A). Mortgages are commonly used by lenders to secure an interest in real estate. The legislative history does not suggest, however, that mortgages are the exclusive form of security for § 108(c)(3)(A). See H.R. Rep. No. 103–111 (1993), 1993–3 C.B. 167, 622–625. The fact that the statutory language does not limit the § 108 security interest to a mortgage indicates an intent to include a broader range of security interests.

.09 Section 301.7701–3(b)(1)(ii) of the Procedure and Administration Regulations provides that certain entities (including limited liability companies) with a single member that do not elect to be treated as corporations are disregarded as entities separate from their owners for federal tax purposes (“disregarded entity”).

.10 In other contexts, the Service has, where certain conditions are satisfied, treated debt as secured by real property when the debt is secured by the sole membership interest in a disregarded entity that holds the real property. See Rev. Proc. 2003–65, 2003–2 C.B. 336.