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).
Rev. Rul. 2016-15 [PDF 24 KB] concludes that:
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.
The IRS examined two factual situations in today’s revenue ruling. The facts in the first situation are as follows:
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:
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:
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:
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).
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