Excluding cancellation of debt income, by real estate developers

Rev. Rul. 2016-15: Excluding cancellation of debt

The IRS today released an advance version of Rev. Rul. 2016-15 as guidance for determining when a real estate developer may exclude cancellation of debt (COD) income under the “qualified real property business indebtedness” exclusion of section 108(a)(1)(D).

Related content

Rev. Rul. 2016-15 [PDF 24 KB] concludes 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 section 108(c)(3)(A); but 
  • Real property developed and held by a taxpayer primarily for sale to customers in the ordinary course of business is not such “real property used in a trade or business.”

As explained by the IRS in a transmittal message, Rev. Rul. 2016-15 includes examples to clarify that “qualified real property business indebtedness” (QRPBI) includes indebtedness relating only to depreciable property used in a taxpayer’s trade or business—and not property held for sale to customers. The discussion provides that indebtedness incurred or assumed in connection with property held by a real estate developer as rental property will qualify as QRPBI because the property is depreciable.  On the other hand, because property held for sale to customers is not depreciable, indebtedness incurred or assumed in connection with this type of property is not QRPBI, and thus is not excludable under section 108.

Background

The IRS examined two factual situations in today’s revenue ruling. The facts in the first situation are as follows:

  • A sole proprietor is engaged in the business of developing and leasing real property. 
  • In 2016, the taxpayer obtains a bank loan of $10 million and uses the entire loan proceeds to construct an apartment building for use in the taxpayer’s leasing business. The taxpayer secures the loan with the apartment building. The taxpayer then leases units in the apartment building through its leasing business.  
  • Before the loan’s maturity date, the taxpayer reduces the principal of the loan to $8 million. On the loan's maturity date, the taxpayer is unable to repay the full $8 million of principal owed to the bank (the taxpayer only has $5.5 million in cash). The fair market value of the apartment building is $5 million, and the taxpayer’s adjusted basis is $9.4 million.
  • The bank agrees to cancel the loan on the apartment building in exchange for $5.25 million in cash. At the time of the loan cancellation, the taxpayer is not under the jurisdiction of a bankruptcy court or insolvent. 
  • For the tax year in which the bank cancels the loan, the taxpayer elects to exclude under section 108(a)(1)(D) an amount of $2.75 million ($8 million less $5.25 million) of cancellation of debt (COD) income arising from the cancellation of the loan. 

The facts in the second situation are the same, except that 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. Accordingly:

  • The taxpayer obtains the $10 million loan from a bank to construct a residential community and subdivides the residential community into lots and holds the lots primarily for sale. 
  • The taxpayer secures the loan with the residential community real property.

Rev. Rul. 2016-15

Rev. Rul. 2016-15 explains that under section 108(a)(1)(D), 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). Section 108(c)(3) defines QRPBI as indebtedness that is: 

  • 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  
  • Was incurred or assumed before January 1, 1993, or, if incurred or assumed on or after that date, is qualified acquisition indebtedness 
  • With respect to which the taxpayer makes an election to exclude from gross income

Section 108(c)(4) generally defines "qualified acquisition indebtedness" as indebtedness incurred or assumed to acquire, construct, reconstruct, or substantially improve the real property.  

Section 108(c)(1) provides that if a taxpayer excludes COD income under section 108(a)(1)(D), the taxpayer must reduce the basis in depreciable real property by the same amount.  

In the revenue ruling, the IRS referenced a number of provisions that it believes imply that section 108(a)(1)(D) is to apply only to debt incurred in connection with depreciable property—for example:

  • Section 108(c)(1) providing that a taxpayer must reduce basis of depreciable property to the extent COD income is excluded under section 108(a)(1)(D);
  • Section 1017(b)(3)(F)(ii) providing that taxpayers may not elect to treat section 1221(a)(1) property as depreciable property for these purposes
  • Section 108(c)(2)(B) providing that a taxpayer may not exclude COD income related to QRPBI in an amount that exceeds its basis in depreciable real property held immediately before cancellation

The IRS concluded that in the first situation, the taxpayer holds the apartment building for use in its business, and is allowed to depreciate the apartment building. As such, the debt incurred to construct the building is QRPBI. The taxpayer may elect to defer the $2.75 million of COD income in the tax year of discharge by excluding the amount from gross income and reducing its basis in the apartment building by the same amount. 

In the second situation—because the taxpayer holds the residential community lots primarily for sale to customers in its business—the taxpayer is not allowed to depreciate the lots, and the debt incurred to construct the residential community may not be treated as QRPBI. Thus, the taxpayer may not elect to exclude the $2.75 million of COD income under section 108(a)(1)(D).

© 2016 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

The KPMG logo and name are trademarks of KPMG International. KPMG International is a Swiss cooperative that serves as a coordinating entity for a network of independent member firms. KPMG International provides no audit or other client services. Such services are provided solely by member firms in their respective geographic areas. KPMG International and its member firms are legally distinct and separate entities. They are not and nothing contained herein shall be construed to place these entities in the relationship of parents, subsidiaries, agents, partners, or joint venturers. No member firm has any authority (actual, apparent, implied or otherwise) to obligate or bind KPMG International or any member firm in any manner whatsoever. The information contained in herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG's Federal Tax Legislative and Regulatory Services Group at: + 1 202 533 4366, 1801 K Street NW, Washington, DC 20006.

Connect with us

 

Request for proposal

 

Submit

KPMG's new digital platform

KPMG's new digital platform