In June 2016, the IRS issued Rev. Rul. 2016-15 to clarify the correct and uniform application of tax laws for treatment of qualified real property business indebtedness (QRPBI) on real property used in a trade or business. This revenue ruling provides that real property developed and held by a taxpayer for lease in its leasing business is "real property used in a trade or business," but real property held primarily for sale to customers in the ordinary course of business is not "real property used in a trade or business," under Sec. 108(c)(3)(A).
How is the real property used in trade or business defined? If a taxpayer develops and holds the real property for lease in the leasing business, is the real property classified as used in a trade or business under Sec. 108(c)(3)(A)? On the other hand, if a taxpayer develops and holds the property primarily for sale to customers in the ordinary course of business, is the real property classified as used in a trade or business under Sec. 108(c)(3)(A)?
In general, gross income includes any amount that would be includible by reason of discharge of a taxpayer's indebtedness. However, Sec. 108(a)(1)(D) provides that a taxpayer that is not a C corporation may exclude from gross income a discharge of indebtedness if the canceled debt is QRPBI. QRPBI is defined in Sec. 108(c)(3) as indebtedness that (1) is incurred or assumed by the taxpayer in connection with real property used in a trade or business and that is secured by such real property; (2) was incurred or assumed before Jan. 1, 1993, or, if incurred or assumed on or after that date, is qualified acquisition indebtedness; and (3) with respect to which the taxpayer makes an election to exclude from gross income. Qualified acquisition indebtedness is generally defined as indebtedness incurred or assumed to acquire, construct, reconstruct, or substantially improve the real property.
Under Sec. 1017, if a taxpayer excludes cancellation-of-debt (COD) income from QRPBI, the taxpayer must reduce its basis in depreciable real property by the same amount. In some circumstances, a taxpayer can elect to treat as depreciable property real property that is stock in trade or other property included in inventory or held by a taxpayer primarily for sale to customers in the ordinary course of its trade or business. However, this election does not apply in the case of any amount applied to reduce basis under Sec. 108(c)(1) (relating to QRPBI).
Sec. 167(a) says that a depreciation deduction is allowed as a reasonable allowance for the exhaustion, wear and tear, and obsolescence of property used in the taxpayer's trade or business or of property that is held by the taxpayer for the production of income. Under Sec. 168(e)(2)(A), residential rental property is depreciable property and thus is considered as used in a trade or business. Under Regs. Sec. 1.167(a)-2, inventories and stock in trade do not qualify for a depreciation deduction. Thus, they are not considered to be used in a trade or business.
Furthermore, under Sec. 108(c)(1) and Sec. 1017(b)(3), the COD income that was excluded from gross income must be used to reduce the basis in depreciable real property by the same amount.
Application of Secs. 108(c)(1) and 1017(b)(3) to Rental Property
Example: A is a single-member LLC that owns a piece of land. Five years ago, interest rates were very low, and the apartment leasing market was quite strong. Thus, A obtained a loan of $5 million from a bank and used the full amount to construct an apartment building for use in A's leasing business. A secured the loan with the apartment building. Presently, A reduces the principal of the loan to $4 million. By the loan's maturity date, A has only $3 million in cash, so A is not able to pay the bank the full $4 million of principal. The apartment building's fair market value is $2,500,000 with an adjusted basis of $5,500,000. After negotiating with the bank, A agreed to pay the bank $3 million cash in exchange for cancellation of the $4 million principal of the loan. At the time of the loan cancellation, A was neither under the jurisdiction of a bankruptcy court nor insolvent and therefore could not qualify to exclude the COD income under Sec. 108(a)(1)(A) or (B).
Under Sec. 108(a)(1)(D), the $1 million of COD income is excluded from gross income for the tax year during which the bank cancels the loan. After the COD transaction, the adjusted basis of the apartment building, which is depreciable real property used in A's business, is decreased to $4,500,000 ($5,500,000 ‒ $1,000,000). As a result, when the taxpayer sells the building, the deferred COD income will be recognized. While the above example involves an apartment building, the results would be the same if the building were an office building held for lease, because the building is nonresidential real property that is subject to depreciation.
What If A's Business Is Flipping Houses Instead of Leasing?
On the other hand, if A holds houses primarily for sale to customers in A's business, A is not allowed to depreciate those houses in accordance with the Code and regulations. The houses are not real property used in a trade or business for purposes of Sec. 108(c)(3)(A). Consequently, if the other facts are the same as in the above example, the discharge of indebtedness is not QRPBI. Thus, A cannot elect to exclude the $1 million of COD income under Sec. 108(a)(1)(D).
Effect on Current Law
Rev. Rul. 76-86 was obsoleted by Rev. Rul. 2016-15. According to the earlier ruling, which was based on prior law Secs. 108 and 1017, an individual taxpayer could exclude the COD income if the business was purchasing merchandise for resale. Obviously, the prior law under Secs. 108 and 1017 is quite different when compared to the current law.
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 Sec. 108(c)(3)(A). The COD income is excluded from gross income in the tax year of discharge, and the property's basis is reduced by the same amount. On the contrary, 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 purposes of Sec. 108(c)(3)(A).
Mark Cook is the lead tax partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-261-8600 or email@example.com.
Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.