Cancellation-of-Debt Rules for Qualified Real Property Business Indebtedness

InRev. Rul. 2016-15, the IRS ruled on two situations involving individual taxpayers who had debt forgiven on property used in their real property trades or businesses. In the first, the taxpayer was able to defer the gain on debt forgiven on the real property indebtedness, while the second taxpayer was not.

Under Sec. 108(a)(1)(D), a taxpayer that is not a C corporation may exclude from gross income cancellation-of-debt (COD) income if the canceled debt is qualified real property business indebtedness (QRPBI). Sec. 108(c)(3) defines QRPBI as indebtedness that (1) is incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by that 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) the taxpayer elects to exclude from gross income.

Under Sec. 108(c)(4), “qualified acquisition indebtedness” is defined as indebtedness incurred or assumed to acquire, construct, reconstruct, or substantially improve the real property. Amounts excluded under that provision must be applied to reduce the basis of the real property under Sec. 1017. Thus, this provision results in deferred income rather than an outright exclusion.

The first situation discussed in the revenue ruling involves an individual who borrowed $10 million from a bank and used it to build an apartment building for use in the taxpayer’s rental trade or business. Before the loan matured, the taxpayer reduced the loan principal to $8 million but was unable to pay it off on the maturity date. The building’s fair market value was $5 million, and the taxpayer’s adjusted basis was $9.4 million. The bank agreed to accept $5.25 million to forgive the loan. The taxpayer was not insolvent or bankrupt when the loan was forgiven. The taxpayer elected to exclude $2.75 million under Sec. 108(a)(1)(D).

Because the taxpayer held the property for use in a trade or business and was allowed to depreciate the property, the debt is qualified real property indebtedness and the taxpayer can exclude the gain from gross income and reduce the basis in the building.

In the second situation, the taxpayer borrowed $10 million to construct a residential community, which the taxpayer subdivided and held for sale. The rest of the facts are the same, and the taxpayer wants to exclude the $2.75 million of forgiven debt from gross income. But, because the qualified real property indebtedness rules require a corresponding reduction in the basis of the property, they cannot be applied to property that is not depreciable in the taxpayer’s hands, which is the case for property primarily held for sale to customers. Therefore, the second taxpayer does not qualify to exclude the income under Sec. 108(a)(1)(D).

In addition, the IRS announced that it was making obsolete Rev. Rul. 76-86, which held that a taxpayer could exclude income arising from indebtedness incurred to buy merchandise for resale. The IRS explained that it was making the revenue ruling obsolete because the current versions of Secs. 108 and 1017 are materially different from the versions in effect when it was issued; thus, the revenue ruling no longer reflects current law.