Rev. Proc. 2014-20 - COD income “safe harbor” for indebtedness secured by interest in disregarded entity holding real property 

February 5: The IRS today released an advance copy of long-awaited guidance—Rev. Proc. 2014-20—concerning when a loan secured by an interest in a disregarded entity that holds real property may be treated as “qualified real property business indebtedness” under section 108(c).

Rev. Proc. 2014-20 [PDF 27 KB] provides a safe harbor for treating indebtedness that is secured by 100% of the ownership interest in a disregarded entity holding real property as indebtedness that is secured by real property for purposes of section 108(c)(3)(A).

The safe harbor is effective for taxpayers that make an election under section 108(c)(3) regarding discharged indebtedness on or after February 5, 2014.


In general, 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 is qualified real property business indebtedness (QRPBI).

To qualify as QRPBI, 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. However, the term “secured by such real property” is not defined in section 108.

Rev. Proc. 2014-20

Today’s revenue procedure provides a safe harbor with respect to the discharge of indebtedness of any taxpayer (other than a C corporation) under which the IRS will treat debt as “secured by” real property for purposes of section 108(c)(3)(A), provided that:

  • The taxpayer or a wholly owned disregarded entity of the taxpayer incurs indebtedness.
  • The taxpayer / borrower directly or indirectly owns 100% of the ownership interest in a separate disregarded entity owning real property, and the taxpayer is not the same entity as the property owner.
  • The taxpayer / borrower pledges to the lender a first priority security interest in the taxpayer’s ownership interest in the property owner, and any further encumbrance on the pledged ownership interest must be subordinate to the lender’s security interest in the property owner.
  • At least 90% of the fair market value of the total assets (immediately before the discharge) directly owned by the property owner must be real property used in a trade or business and any other assets held by the property owner must be incidental to the property owner’s acquisition, ownership, and operation of the real property.
  • Upon default and foreclosure on the indebtedness, the lender will replace the taxpayer / borrower as the sole member of the property owner.

If these conditions are satisfied, the IRS will treat indebtedness as QRPBI and any income from the discharge of such indebtedness will be excluded from the taxpayer’s gross income—i.e., COD income. The basis of depreciable real property of the taxpayer, however, will be reduced by the amount excluded from gross income.

KPMG observation

Given the current trend that lenders determine priority through “structural subordination” (e.g., the holder of first priority takes a direct security interest in the property, the second priority holder takes a security interest in a disregarded entity that owns the property, etc.) rather than “legal subordination” (i.e., first mortgage, second mortgage, etc.), the issue of whether debt was secured by real property was relevant in many of the workouts that occurred during the economic downturn when investors wanted to take advantage of section 108(c).

Rev. Proc. 2014-20 appears to provide a safe harbor only for a single level of structurally subordinated security interest—that is, the safe harbor appears to sanction only a security interest in the disregarded entity that actually owns the property.

In complex lending arrangements, there often will be multiple tiers of disregarded entities that serve as security interests. For instance, tax professionals have observed there have been lender arrangements in which the taxpayer has had multiple (for example, eight) tiers of disregarded entities—each one up the chain supporting a lender that was more structurally subordinated. According to today’s revenue procedure:

If a taxpayer does not meet the requirements of this safe harbor, it is not precluded from arguing, based on facts and circumstances, that its debt satisfies the ‘secured by’ requirement of § 108(c)(3)(A).

This statement might be read as an acknowledgment by the IRS and Treasury that a direct security interest in the disregarded entity that owns the property is not required in order to satisfy the “secured by” requirement. Today’s guidance, nevertheless, states that taxpayers still may argue that arrangements outside the scope of Rev. Proc. 2014-20 may satisfy the “secured by” requirement.

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