June 23, 2016

IRS Clarifies When a Real Estate Developer May Exclude Cancellation of Debt Income (article)

The IRS has issued guidance (Rev. Rul. 2016-15) clarifying when a real estate developer may exclude cancellation of debt (COD) income under the qualified real property business indebtedness (QRPBI) exclusion in Code Sec. 108(a)(1)(D). Real property developed and held by a taxpayer for lease in its leasing business is "real property used in a trade or business" for these purposes. However, real property developed and held by a taxpayer primarily for sale to customers in the ordinary course of business is not "real property used in a trade or business" for these purposes.

QRPBI is debt that (1) was incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by such real property, and (2) if incurred or assumed on or after January 1, 1993, is qualified acquisition debt. The taxpayer must elect to exclude cancellation of QRPBI from gross income.

If a taxpayer excludes COD income as QRPBI, the taxpayer must reduce basis in depreciable real property by the same amount. Code Secs. 108 and 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.

Rev. Rul. 2016-15 provides examples to clarify that QRPBI includes debt related only to depreciable property used in a taxpayer’s trade or business, and not property held for sale to customers. The examples provide that debt 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, debt incurred or assumed in connection with this type of property is not QRPBI, and thus is not excludable under Code Sec. 108.

Rev. Rul. 2016-15 obsoletes Rev. Rul. 76-86, 1976-1 CB 37, 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 debt incurred in purchasing merchandise for resale. The current versions of Code Secs. 108 and 1017 are materially different from Code Secs. 108 and 1017 as in effect when Rev. Rul. 76-86 was issued. Thus, Rev. Rul. 76-86 no longer reflects current law.

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