In Revenue Ruling 2016-15, the IRS has clarified that a taxpayer may exclude cancellation of debt income under the qualified real property business indebtedness exclusion in Section 108(a)(1)(D) only if the real property that secures the debt is held for use in a trade or business and not primarily held for sale.

Background

Section 108(a)(1)(D) allows a taxpayer that is not a C corporation to exclude COD income from gross income if the cancelled debt is "qualified real property business indebtedness" (QRPBI). Section 108(c)(3) defines QRPBI as indebtedness which 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. In addition, if the indebtedness was incurred or assumed on or after January 1, 1993, the indebtedness must have been incurred or assumed to acquire, construct, reconstruct, or substantially improve the real property.

Revenue Ruling 76-86, 1976-1 C.B. 37, interpreted Sections 108 and 1017 to allow a taxpayer to exclude income arising from the discharge of indebtedness incurred in purchasing merchandise for resale. In Revenue Ruling 2016-15, the Service declared that changes to Sections 108 and 1017 render Revenue Ruling 76-86 obsolete.

Revenue Ruling 2016-15

The ruling specifies that real property held for lease in a leasing business is "real property used in a trade or business," while property held for sale in the ordinary course of business (referred to below as "dealer" real property) is not. The ruling includes two examples with the same premise explained below.

A developer obtains a $10 million loan to develop property which secures the loan. On the loan maturity date, the developer has $5.5 million in cash, the fair market value of the building is $5 million, and the developer's adjusted basis is $9.4 million. The developer cannot pay the $8 million outstanding principal balance of the debt. The bank cancels the loan in exchange for $5.25 million in cash.

In example one, the developer constructed an apartment building and then leased the units. The IRS ruled that the developer holds the apartment building for use in its business and can depreciate the building. Accordingly, the debt it incurred to construct the building is QRPBI. The developer may elect to defer the $2.75 million of COD income under Section 108(a)(1)(D).

In example two, the developer constructed a residential community and subdivided the property into lots, which it then held primarily for sale. The IRS ruled that because the developer holds the lots primarily for sale to customers in its business, the developer can't depreciate them. Accordingly, the debt the developer incurred to construct the residential community may not be treated as QRPBI, and the developer may not elect to exclude the $2.75 million of COD income under Section 108(a)(1)(D).

Implications

The statute requires that, for a loan to qualify as QRPBI, the property securing the debt must be "real property used in a trade or business," which is generally viewed as including Section 1231 property but not dealer property. However, some tax advisors suggested that "real property used in a trade or business" could be construed to include dealer real property for this purpose. Revenue Ruling 2016-15 confirms the Service's position to the contrary.

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