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Enter Rev. Proc. 2014-20 – Safe Harbor for Indebtedness of Certain Entities

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For all the owners of real property, Rev. Proc. 2014–20 provides a safe harbor provision in regards to indebtedness. The Internal Revenue Service, is issued a Revenue Procedure (Rev. Proc.), the deals with debt of a disregarded entity that is groundbreaking. 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 indebtedness may be excluded from gross income if certain requirements are met.

A disregarded entity, is often a Limited Liability Company (LLC), that has not made an election to be taxed other than a sole proprietorship, or in the case of a rental property, claimed on Schedule E of Form 1040. In the past, a disregarded entity would receive Form 1099-C which is a cancellation of debt. When a debt is canceled by a financial institution, a taxpayer has to pay tax on the amount that was canceled.

There was a problem with this. Some disregarded entities on things such as rental or investment property. The property would be encumbered by a mortgage, or a secured debt that was being canceled. With this new Rev. Proc., the owner of such a property would be allowed to not claim this amount as income. Of course, with any good tax law there are exceptions. I make a living because of the exceptions. IRC § 108 discusses income derived from the discharge of indebtedness. IRC § 108(a)(1)(12) provides a gross income from the discharge of indebtedness, in the case of a taxpayer other than a C Corporation, the indebtedness discharge is qualified real property business indebtedness. To qualify as this IRC § 108(c)(3) requires that the indebtedness be incurred as assumed by the taxpayer in connection with real property used in a trade or business and be secured by such real property. Of course, to qualify as this the taxpayer needs to make an election. What this code section fails to go on and discuss is what is meant by “secured by such real property.”

What all this means in plain language is that if you were to own a piece of property, and it was secured by a debt, and you defaulted on that debt, you would have to pay income tax on the amount that you defaulted by. So, if you have a piece of property that is worth $50,000, and you owe $75,000, then you would have to pay tax on $75,000. You would not be able to take into account what the piece of property was worth, in your calculation of the debt that you owed. With this Rev. Proc. does is allow a disregarded entity to completely disregard the income from the cancellation of the debt, regardless of any amounts that you owed.

If you, are insolvent, and debt is canceled, you do not have to pay tax on the amount that is canceled as an individual. All this Rev. Proc. does is state pretty much the same thing for a disregarded entity as it does for an individual.

If you have any questions you can email Craig W. Smalley, E.A., C.E.P.®, C.T.R.S.®

Craig Smalley is the managing partner of CWSEAPA®, LLP. CWSEAPA®, LLP is a nationally recognized brand of accounting and financial services. CWSEAPA®, LLP is headquartered in Wilmington, DE with offices in Florida and Nevada. You can visit them on their website at

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