Debt on Real Property Primarily Held for Sale to Customers Not Eligible for Exception from COD Income Rules

(Parker Tax Publishing June 2016)

The IRS ruled that, for purposes of excluding cancellation of debt income as qualified real property business indebtedness (QRPBI), debt secured by real property developed and held by a taxpayer in a leasing business is QRPBI, but debt secured by real property held primarily for sale to customers is not QRPBI. As such, income from the cancellation of debt incurred in constructing a residential community that was to be sold in lots cannot be excluded under Code Sec. 108(a)(1)(D). Rev. Rul. 2016-15.

In the revenue ruling, the IRS addressed two situations in which a taxpayer develops or holds real property in order to answer whether such property is "real property used in a trade or business" for purposes of the Code Sec. 108 cancellation of debt (COD) income rules.

Situation 1

Situation 1 involves real property developed and held for lease. In this situation, the taxpayer is a sole proprietor engaged in the business of developing and leasing real property. In 2016, the taxpayer obtains a loan of $10,000,000 from a bank and uses the entire loan proceeds to construct an apartment building for use in her leasing business. The taxpayer secures the loan with the apartment building and leases units through her leasing business.

Before the loan's maturity date, the taxpayer reduces the principal of the loan to $8,000,000. On the loan's maturity date, she is unable to repay the full $8,000,000 of principal because she has only $5,500,000 in cash. The fair market value of the apartment building is $5,000,000 and her adjusted basis is $9,400,000. After negotiations, the bank agrees to cancel the loan on the apartment building in exchange for $5,250,000 in cash.

For the tax year in which the bank cancels the loan, the taxpayer elects to exclude, under Code Sec. 108(a)(1)(D), the $2,750,000 ($8,000,000 - $5,250,000) of COD income arising from the cancellation of the loan.

Situation 2

Situation 2 involves real property developed and held for sale. The facts are the same as those in Situation 1, except in Situation 2, instead of constructing and leasing units in an apartment building, the taxpayer is engaged in the business of developing and holding real property for sale. The taxpayer obtains the $10,000,000 loan from a bank to construct a residential community and subdivides the residential community into lots and holds the lots primarily for sale. She secures the loan with the residential community real property.

Analysis

Code Sec. 108(a)(1)(D) provides that a taxpayer that is not a C corporation may exclude COD income from gross income if the cancelled debt is "qualified real property business indebtedness" (QRPBI). Code Sec. 108(c)(3) defines QRPBI as indebtedness which:

(1) is incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by such real property;

(2) was incurred or assumed before January 1, 1993, or, if incurred or assumed on or after that date, is qualified acquisition indebtedness, and;

(3) with respect to which the taxpayer makes an election to exclude from gross income.

Code Sec. 108(c)(1) provides that if a taxpayer excludes COD income under Code Sec. 108(a)(1)(D), the taxpayer must reduce basis in depreciable real property by the same amount in accordance with Code Sec. 1017. Reg. Sec. 1.1017-1(c)(1) provides that a taxpayer must reduce the adjusted basis of the qualifying real property to the extent of the discharged QRPBI before reducing the adjusted bases of other depreciable real property.

Under Code Sec. 167 and the associated regulations, residential rental property is depreciable real property, but inventories or stock in trade is not depreciable property. Although Code Sec. 1017(b)(3)(E) generally permits a taxpayer to elect to treat Code Sec. 1221(a)(1) real property (i.e. real property that is a capital asset) as depreciable property, Code Sec. 1017(b)(3)(F)(ii) specifically precludes a taxpayer from making this election in the case of QRPBI.

The IRS noted that Code Sec. 108 and Code Sec. 1017 operate together to allow a taxpayer that is not a C corporation to elect to defer the recognition of COD income resulting from the cancellation of QRPBI by excluding COD income under Code Sec. 108 and making a corresponding basis reduction under Code Sec. 1017. Looking to legislative history, the IRS determined that it was Congress' intent that the deferral period generally should correspond to the period that the taxpayer holds the property securing the cancelled debt.

The IRS stated that if debt associated with Code Sec. 1221(a)(1) property were treated as QRPBI, a taxpayer would be unable to reduce the basis of the property securing the debt, much less reduce the basis of that property prior to reducing the bases of depreciable real property used in the taxpayer's trade or business. In addition, the IRS said, the inability to reduce the basis of the Code Sec. 1221(a)(1) property securing the debt would create deferrals of COD income that extend well beyond the period the taxpayer holds the Code Sec. 1221(a)(1) property because the taxpayer would need to reduce the basis of depreciable real property unrelated to the indebtedness, and typically a taxpayer holds depreciable business property substantially longer than it holds Code Sec. 1221(a)(1) property. The IRS thus determined that debt incurred in connection with, and secured by, Code Sec. 1221(a)(1) real property cannot be treated as QRPBI.

Based on its analysis, the IRS held that real property developed and held by a taxpayer for lease in its leasing business is "real property used in a trade or business" for purposes of Code Sec. 108(c)(3)(A), but that real property developed and held by a taxpayer primarily for sale to customers in the ordinary course of business is not.

With regard to the two situations, the IRS ruled that the hypothetical taxpayer must account for the discharge of indebtedness as follows:

In Situation 1, because the taxpayer holds the apartment building for use in her business, the IRS noted she is allowed to depreciate the apartment building. The IRS determined that the debt she incurred to construct the apartment building is QRPBI and ruled that the taxpayer may elect to defer the $2,750,000 of COD income under Code Sec. 108(a)(1)(D) in the tax year of discharge by excluding this amount from gross income and reducing her basis in the apartment building by the same amount.

In Situation 2, because the taxpayer holds the residential community lots primarily for sale to customers in her business, the IRS noted she is not allowed to depreciate the lots. Accordingly, the IRS said, the debt the taxpayer incurred to construct the residential community may not be treated as QRPBI and she may not elect to exclude the $2,750,000 of COD income under Code Sec. 108(a)(1)(D).

Observation: Rev. Rul. 2016-15 obsoletes Rev. Rul. 76-86, which relied on prior law under Code Secs. 108 and 1017 in concluding that an individual taxpayer could exclude income arising from the discharge of indebtedness incurred in purchasing merchandise for resale. The current versions of Code Secs. 108 and 1017 are materially different from those sections as in effect when Rev. Rul. 76-86 was issued. Thus, Rev. Rul. 76-86 no longer reflects current law.

For a discussion of the qualified real property business debt exclusion, see Parker Tax ¶76,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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