Real Estate Developers: IRS Guidance on the Treatment of Reduction of Debt
Berdon Tax Team
11.03.2016 | Client Alert
The IRS recently issued Revenue Ruling 2016-15 which offers guidance on the circumstances under which real estate developers realize income as a result of a reduction in debt. The ruling clarifies that developers that subsequently lease the property may be eligible to exclude the income realized. However, the ruling comes to a different conclusion for developers that subsequently hold the developed property for sale to customers. In such case, the IRS view is that the income is not eligible for exclusion.
Generally, taxpayers realize gross income upon a reduction in the amount owed under a debt obligation. This type of income is commonly referred to as cancellation of debt (COD) income. There are exceptions to realization for taxpayers that are insolvent or in bankruptcy.
There is an additional exception to realization of COD income for the discharge of qualified real property business indebtedness (QRPBI). The QRPBI exception only applies to taxpayers that are not C corporations. Debt will generally meet the requirements of being QRPBI if:
- The debt was incurred (or assumed) in connection with real property used in a trade or business,
- The debt is secured by such real property, and
- The debt was incurred (or assumed) to acquire, construct, reconstruct, or substantially improve the property.
The amount of the exclusion of COD income with respect to QRPBI is limited to the total adjusted basis of all depreciable real property held by the taxpayer immediately before the discharge. The amount excluded is further limited to the excess of the amount of QRPBI secured by the property over the fair market value of the property such excess computed immediately before the discharge.
The exclusion of COD income with respect to QRPBI is elective. If the taxpayer chooses to exclude the income, he or she is required to reduce the basis of depreciable real property, generally, at the end of the taxable year. As a result, the elective provisions for QRPBI only serve to defer the tax on the COD income.
Impact of the IRS Ruling
Revenue Ruling 2016-15 provides for two different situations. In the first, the taxpayer is an individual engaged in the business of developing and leasing real property. The taxpayer obtained a bank loan to finance the construction of a building. After the building is completed, the bank forgives some of the loan. The IRS ruled that the taxpayer could treat the debt as QRPBI and exclude the COD income since the property was secured by a loan that was used in a trade or business.
Taxpayers that purchase real estate for lease are not covered by the ruling and will need to determine if the property is used in a trade or business. Taxpayers that actively manage the leased property generally appear to meet the trade or business requirement. At the other extreme, the IRS might treat a taxpayer that holds a triple net lease as not meeting the requirement.
In the second situation, the taxpayer is an individual engaged in the business of developing residential subdivisions and holding real property for sale. The taxpayer obtained a bank loan to finance the construction of the subdivision. After the subdivision is completed, the bank forgives some of the loan. The IRS ruled that the taxpayer could not treat the debt as QRPBI and exclude the COD income since the property secured by the loan was not used in a trade or business. The basis for the ruling was that property held for sale to customers is not treated as depreciable real property and is not eligible for basis reduction. Therefore, treating the debt as QRPBI would be contrary to the intent of the statute.
The ruling in the second situation attempts to close down a position that some taxpayers were taking with respect to debt that was incurred to finance property that was held for sale to customers (e.g., subdivisions and condominium apartments). Such taxpayers were claiming the QRPBI exclusion when the debt was reduced or forgiven and reducing the basis of other real property held (that was not held for sale to customers and was depreciable).
While the position has technical merits, the IRS views it as an unintended result. It remains to be seen whether the courts will agree with the IRS on this point.
Questions? Contact your Berdon advisor. Berdon LLP, New York Accountants