The discharge of indebtedness generally gives rise to gross income to the debtor-taxpayer. The law, however, provides several exceptions to this general rule. Among these exceptions are rules providing that income from the discharge of indebtedness of the taxpayer is excluded from income if the discharge occurs in a Title 11 case, or if the discharge occurs when the taxpayer is insolvent. The amount excluded from income is applied to reduce various tax attributes of the taxpayer (in other words, there is a price to pay for the benefit).

During the economic downturn of the early 1990s – ah, it seems like yesterday – the value of real property declined in some cases to such a degree that a property could no longer support the debt with which it was encumbered. Many believed that where an individual had discharge of indebtedness that resulted from a decline in value of the business real property securing that indebtedness, it was appropriate to provide for deferral, rather than current income inclusion, of the resulting income.

Congress responded by providing an election to taxpayers (other than C corporations) to exclude from gross income certain income from the discharge of qualified real property business indebtedness (“QRPBI”). The amount so excluded could not exceed the basis of certain depreciable property of the taxpayer and was treated as a reduction in the basis of that property. [See “Impact of the Revenue Reconciliation Act of 1993 on Real Estate,” Special Legislative Alert, by James H. Kenworthy and Louis Vlahos, Matthew Bender, 1994]

Recently, the IRS addressed the issue of whether real property that a taxpayer develops and holds primarily for sale to customers in the ordinary course of the taxpayer-developer’s business constitutes “real property used in a trade or business” for purposes of this exclusion rule. [Rev. Rul. 2016-15]

The Developer Stumbles
C is engaged in the business of developing and holding real property for sale. C obtains the $10 million loan from a bank to construct a residential community and subdivides the residential community into lots; it holds the lots primarily for sale. C secures the loan with the residential community real property.

Before the loan’s maturity date, C reduces the principal of the loan to $8 million. On the loan’s maturity date, C is unable to repay the full $8 million of principal that C owes to the bank because C has only $5.5 million in cash. The FMV of the property is $5 million and C’s adjusted basis for the property is $9.4 million.

After negotiations, the bank agrees to cancel the loan on the property in exchange for $5.25 million in cash. At the time of the loan cancellation, C is neither under the jurisdiction of a bankruptcy court nor insolvent.

For the taxable year in which the bank cancels the loan, C elects to exclude the $2.75 million ($8 million minus $5.25 million) of cancellation of debt (“COD”) income arising from the cancellation of the loan.

Cancellation of QRPBI
The Code provides that a taxpayer that is not a C corporation may exclude COD income from gross income if the cancelled debt is QRPBI.

QRPBI is defined as indebtedness which (A) is incurred or assumed by the taxpayer in connection with real property used in a trade or business, (B) is secured by such real property, (C) is qualified acquisition indebtedness, and (D) with respect to which the taxpayer makes an election to exclude from gross income.

“Qualified acquisition indebtedness” is defined as indebtedness incurred or assumed by the taxpayer to acquire, construct, reconstruct, or substantially improve the real property.

If a taxpayer excludes COD income under the exception for QRPBI, the taxpayer must reduce its basis in depreciable real property by the same amount. In some circumstances, a taxpayer may elect – as the developer tried in the ruling – to treat real property that is held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business as depreciable property for purposes the basis reduction rule, even though such property is not usually treated as depreciable property.

In general, the amount of COD income that a taxpayer may exclude is limited to the excess of the outstanding principal amount of the QRPBI immediately before the cancellation over the FMV of the real property securing the debt. Further, the amount of COD income that a taxpayer may exclude may not exceed the aggregate adjusted bases of depreciable real property held by the taxpayer immediately before the cancellation.

Under a special ordering rule, a taxpayer must reduce the adjusted basis of the “qualifying real property” to the extent of the discharged QRPBI before reducing the adjusted bases of other depreciable real property. For this purpose, “qualifying real property” means the real property with respect to which the indebtedness is QRPBI.

IRS Clarifies the Rules
In effect, these rules allow a qualifying taxpayer to elect to defer the recognition of COD income resulting from the cancellation of QRPBI by excluding the COD income and making a corresponding basis reduction in the taxpayer’s property.

This is consistent with the Congressional intent to provide for deferral of the COD income that does not extend beyond the period that the taxpayer owns the property.

However, the Code provides that debt secured by property held by a taxpayer primarily for sale to customers in the ordinary course of its trade or business (“inventory real property”) is outside the scope of the QRPBI exclusion rules.

A taxpayer that excludes COD income under these rules must make an offsetting basis reduction in depreciable real property. Inventory real property is not depreciable property. The IRS explained that, although the COD exclusion rules generally permit a taxpayer to elect to treat inventory real property as depreciable property, they preclude a taxpayer from making this election in the case of QRPBI.

According to the IRS, the “COD income deferral period” generally should correspond to the period that the taxpayer holds the property securing the cancelled debt. A taxpayer must first reduce basis in the property securing the cancelled debt, and then in other depreciable real property.

If debt associated with inventory real property were treated as QRPBI, the IRS stated, then a taxpayer would be unable to reduce the basis of the property securing the debt, much less reduce the basis of that property prior to reducing the bases of other depreciable real property used in the taxpayer’s trade or business. This result would be inconsistent with the Congressional intent.

Moreover, the inability to reduce the basis of the inventory real property securing the debt would create deferrals of COD income that could extend well beyond the period the taxpayer holds the inventory real property because the taxpayer would need to reduce the basis of depreciable real property unrelated to the indebtedness and, typically, a taxpayer holds depreciable business property substantially longer than it holds inventory real property.

Accordingly, debt incurred in connection with, and secured by, inventory real property cannot be treated as QRPBI.

Time to Pay Up?
The IRS concluded that because C holds the residential community lots primarily for sale to customers in C’s business, C is not allowed to depreciate the lots. Accordingly, the debt C incurred to construct the residential community may not be treated as QRPBI, and C may not elect to exclude from its gross income the $2.75 million of COD income.

Does this necessarily mean that C will be taxed upon the COD income? Probably, unless C qualifies under one of the other exclusions. For example, if C is an individual (a sole proprietorship) or an S corporation, and is insolvent, it may be able exclude the COD income to the extent of such insolvency. If C is a partnership, its members may be able to exclude the COD income if they (as opposed to the partnership) are insolvent.

Alternatively, if C retains ownership of some of the residential community property, it may qualify, in part, for the QRPBI exclusion; for example, if it continues to own and operate any of the common areas of the development, such as a health club, restaurant, etc., or if it holds on to some of the residential units as rentals.

Of course, no one goes into a development project with the expectation that there will be a downturn in the market. That being said, it may be prudent to hedge one’s bets by structuring one’s investment in as tax-advantageous a way as possible, provided, as always, that it makes sense from a business perspective.