For example, a bankrupt mortgage debtor who is discharged may exclude COD income. An insolvent mortgage debtor may also exclude COD income to the extent of the insolvency. However, exclusion of COD income from property owned by a limited liability company (“LLC”) is only available for LLC members, not for the LLC. If the LLC’s members are not all bankrupt or insolvent, the most favorable exclusion available may be the federal income tax exclusion for COD income from “qualified real property business indebtedness.”
The qualified real property business indebtedness exclusion (“QRPBIE”) is available for certain solvent owners (or, for example, LLC members) to permit the exclusion of COD income. A major advantage of this exclusion provision is that not all LLC members must be bankrupt or insolvent for the exclusion to apply.
The QRPBIE applies to property used in a trade or business and to certain mortgage debt secured by property used in a trade or business. Generally, the debt must have been incurred or assumed by the owner to acquire, construct, reconstruct or substantially improve the property. The owner must have sufficient tax basis in the depreciable property (and/or other real properties) because one of the QRPBIE’s limitations is that the amount of COD income excluded cannot exceed the owner’s depreciable basis in the subject property and other real properties.
The income tax basis adjustments that must be made are different for the QRPBIE than for the bankruptcy and insolvency exclusions because the QRPBIE exclusion requires that the owner reduce the basis of the property that secures the mortgage debt by the amount of the COD income, before the calculation of gain or loss on the deed in lieu transfer or foreclosure.
Upon determination of the COD income resulting for a taxpayer from a deed in lieu transfer or foreclosure of property, comparison of the tax resulting from a calculation assuming an election to exclude COD income and a calculation not excluding COD income must be made to determine which is better for that taxpayer. Of course, the taxpayer’s other tax circumstances will influence the conclusion.
Assume that a taxpayer LLC member prefers to exclude any COD income incurred on a deed in lieu transfer or foreclosure of the property. If the mortgage debt involved is nonrecourse, no COD income will be recognized, and planning for COD income exclusion may be unnecessary (unless debt conversion occurs). However, if the mortgage debt is recourse, COD income may be recognized by the owner if the debt has been discharged, and the COD income would be allocable to the LLC member. The LLC member may choose to exclude any COD income, by seeking to qualify for the QRPBIE.
Cooperation between a taxpayer’s advisors and early communication in planning to claim the COD income exclusion under the QRPBIE by the LLC member is important because the QRPBIE regulations require an election to reduce basis, and impose other prerequisites that must be complied with before the due date (including extensions) for filing the LLC member’s federal income tax return for the taxable year in which the COD income would be excluded under the QRPBIE. In the case of a deed in lieu transfer or a foreclosure, a preferable time for planning and communicating with all involved concerning the QRPBIE election is substantially sooner than the tax return filing deadline. Planning before the end of the taxable year may be most beneficial.