United States

IRS rules on debt discharges for developer-held properties

Distinguishes leased real property from real property held for sale

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In a recent revenue ruling (Rev. Rul. 2016-15), the IRS addressed several types of developer-held properties in relation to the election to exclude income from the discharge of qualified real property business indebtedness (QRPBI) under section 108(a)(1)(D). Taxpayers may elect to exclude income from the discharge of this indebtedness, in exchange for reducing the basis of the property by the amount excluded (if the basis of this property is insufficient, the basis of other depreciable business real property is reduced). Indebtedness eligible for this exclusion is generally debt incurred or assumed to acquire, construct, reconstruct or substantially improve real property used in a trade or business and secured by that same property. This ruling focuses on the definition of real property used in a trade or business as it applies to real estate developers.

The IRS first addressed the case of a developer who builds an apartment building, holds it for use in a leasing business, and is therefore allowed to depreciate it. The IRS holding was that this constitutes real property used in a trade or business, and related discharge of indebtedness would qualify for the exclusion from gross income, if all other qualifications have been met.

The IRS next addressed the case of a developer who builds a residential community and holds the lots for sale to customers. In contrast to the apartment building, the residential community is not subject to depreciation as it is considered to be inventory of the developer. The IRS used this distinction to conclude that it would not be qualifying real property used in a trade or business for purposes of allowing the exclusion.

In reaching this conclusion, the IRS noted the interaction of sections 108 and 1017, the latter of which provides the rules for applying the basis reduction required by section 108 excluding income from the discharge of QRPBI. Section 1017 provides that the reduction in basis must come from depreciable real property. Since the property in question is not subject to depreciation, its basis could not be reduced to correspond to the exclusion allowed under section 108. Therefore, the IRS reasoned that treating the property as qualifying real property would be out of line with congressional intent, as it would create tax deferrals that could greatly exceed the holding period of the property secured by the discharged debt.

This ruling obsoletes an older ruling (Rev. Rul. 76-86) that allowed an individual taxpayer to exclude income from the discharge of indebtedness incurred in purchasing merchandise for resale. The IRS stated that sections 108 and 1017 have undergone material changes since that ruling was published and it no longer reflects current law.

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