What Is Qualified Real Property Business Indebtedness?
Understand a tax election for forgiven business real estate debt that provides immediate relief in exchange for a future tax liability.
When a lender forgives debt, the borrower must often recognize the forgiven amount as taxable Cancellation of Debt (COD) income. However, a provision in Internal Revenue Code Section 108 provides an exception for Qualified Real Property Business Indebtedness (QRPBI). This allows taxpayers, other than C corporations, to exclude COD income from forgiven debt on their business properties.
This tax relief is a deferral, not a permanent forgiveness of the tax liability. The excluded COD income must be used to reduce the tax basis of the taxpayer’s depreciable real property. This basis reduction results in lower annual depreciation deductions and a potentially larger taxable gain when the property is sold.
Determining if Debt Qualifies
For debt to be considered QRPBI, it must meet several specific tests. The primary requirement is that the debt must be connected to real property actively used in a trade or business, not for passive investment or personal use.
The first test is the trade or business test. The real property securing the debt cannot be held for personal use or as speculative raw land. For example, an apartment building operated for rental purposes qualifies, while real property held primarily for sale to customers, such as lots in a residential development, is considered inventory and does not qualify.
Another requirement is the security test. The debt must be directly secured by the real property, meaning the property serves as collateral. The link between the debt and the property must be formally established in the loan documents. Unsecured business loans or loans secured by other assets do not qualify, even if the funds were used for real estate.
The incurrence or assumption test requires the debt to be “qualified acquisition indebtedness.” This means the loan funds must have been used to acquire, construct, reconstruct, or substantially improve the real property. The loan must be directly tied to the physical creation or enhancement of the business property.
Debt from refinancing a qualified acquisition loan can also qualify as QRPBI. This treatment is limited to the principal amount of the original mortgage immediately before the refinancing. Any additional cash taken out in a cash-out refinance that exceeds the old loan balance is not considered qualified acquisition indebtedness.
Calculating the Exclusion Amount
After confirming a debt qualifies as QRPBI, the taxpayer must calculate the maximum excludable COD income. The excludable amount is subject to two separate limitations. The taxpayer must calculate both limits, and the final exclusion is the lesser of the total COD income or these two caps.
The first limitation is the property value limit. The exclusion cannot be greater than the outstanding principal of the debt immediately before cancellation, minus the fair market value (FMV) of the property. When calculating, the property’s FMV must first be reduced by the principal of any other QRPBI secured by it. This ensures the exclusion does not exceed the amount the loan is “underwater.”
The second limitation is the aggregate basis limit. The excluded COD income cannot exceed the taxpayer’s total adjusted basis in all depreciable real property held immediately before the debt cancellation. This includes the basis of the property securing the discharged loan plus the basis of any other depreciable real properties the taxpayer owns.
To illustrate, consider a taxpayer who owns a commercial building used in their business. The building is subject to a $1.2 million mortgage that qualifies as QRPBI. The lender agrees to cancel $300,000 of the debt, reducing the principal to $900,000. Immediately before the cancellation, the building’s fair market value is $1 million, and the taxpayer’s adjusted basis in this building is $700,000. The taxpayer also owns another depreciable rental property with an adjusted basis of $250,000.
First, the taxpayer determines the total COD income is $300,000. Next, they calculate the two limits. The property value limit is the excess of the $1.2 million debt over the $1 million FMV, which equals $200,000. The aggregate basis limit is the sum of the bases of all depreciable real properties, which is $700,000 plus $250,000, totaling $950,000. The final exclusion is the lesser of the COD income ($300,000), the property value limit ($200,000), and the aggregate basis limit ($950,000). In this case, the taxpayer can exclude $200,000 of the COD income, and the remaining $100,000 is recognized as taxable income.
Applying the Basis Reduction
Electing to exclude COD income under the QRPBI rules has a mandatory consequence: the taxpayer must reduce the basis of their depreciable real property. This is not an optional step, but the mechanism that defers the tax on the excluded income rather than forgiving it entirely.
Tax law provides a specific order for this basis reduction. The reduction must first be applied to the basis of the property that secured the discharged debt. If the excluded COD income exceeds that property’s basis, the taxpayer must then reduce the basis of other depreciable real property they own until the full exclusion amount is accounted for.
The timing of the basis reduction is also specified. The reduction is made at the beginning of the tax year following the year the debt discharge occurred. For instance, if a debt was canceled in 2024, the basis is reduced on January 1, 2025. An exception applies if the property is sold in the same year as the discharge; in that case, the basis reduction occurs immediately before the sale.
Reporting the Exclusion
A taxpayer must make an election on their tax return for the year the debt was discharged. This is done by filing Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. This form must be attached to the taxpayer’s main federal income tax return, such as a Form 1040, 1065, or 1120-S.
When completing Form 982, the taxpayer must indicate the reason for the exclusion. For a QRPBI exclusion, the taxpayer must check the box on line 1d. This election is binding and can only be revoked with the consent of the IRS.
The taxpayer must also report the specific financial figures. On line 2 of Form 982, the taxpayer enters the total amount of discharged QRPBI they are excluding from income. In Part II, the taxpayer details the corresponding basis reduction being applied to their depreciable real property on line 10b.
The election must be made on a tax return filed by its due date, including any extensions. Failing to attach a properly completed Form 982 to the return for the year of the debt cancellation means the election has not been made. In that case, the entire amount of canceled debt would be included in gross income.