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Recent IRS Ruling Provides Insight On Defining Real Property Used In Trade Or Business

Recent IRS Ruling Provides Insight On Defining Real Property Used In Trade Or Business

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The Internal Revenue Service (IRS) recently issued Rev. Rul. 2016-15 concerning deferral of cancellation of debt (COD) income related to real property trades or businesses.

IRS Code Sections 108 and 1017 together permit a taxpayer that is not a C corporation to elect to defer COD income recognition (subject to certain limitations) resulting from the cancellation of qualified real property business indebtedness (QRBI) by excluding COD income under Section 108 and reducing the basis of the asset in the same amount under Section 1017.

QRBI is indebtedness incurred or assumed by the taxpayer in connection with real property used in a trade or business and secured by such real property, incurred or assumed before January 1, 1993, or, if incurred or assumed on or after that date, is qualified acquisition indebtedness, and with respect to which the taxpayer makes an election to exclude from gross income.

“Qualified acquisition indebtedness” is defined by Section 108(c)(4) as indebtedness incurred or assumed to acquire, construct, reconstruct, or substantially improve the real property.

The revenue ruling describes the following two fact patterns:

  • A sole proprietor obtained a $10 million bank loan to construct an apartment building to be used in the taxpayer’s trade or business. The taxpayer could not pay off the remaining $8 million balance at maturity.  The fair market value of the building was $5 million and the taxpayer’s adjusted basis was $9.4 million.  The bank agreed to cancel the loan in exchange for $5.25 million in cash.  The taxpayer elected to exclude $2.75 million ($8 million-$5.25 million) of COD income as a result of the loan cancellation.
  • The facts are the same as above except the taxpayer obtained the $10 million bank loan to construct a residential community, which was subdivided into lots held primarily for sale.

Under the first fact pattern, the IRS upheld the deferral of the $2.75 million of COD income under Section 108(a)(1)(D) with the corresponding reduction in the building’s basis.  As the building was used in the business and the taxpayer was permitted to depreciate the building, the debt qualified as QRBI.

Under the second fact pattern, the deferral of the COD income was disallowed.  Because the lots were held primarily for sale, the taxpayer could not depreciate the lots.  The property is, in essence, inventory.  Under Section 108(c)(1), the exclusion of COD income must reduce basis in the property by the same amount under Section 1017 which would require the lots to be depreciable.  The IRS held that 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.”

Jim Mulroy, CPA, PSA, CGFM, CGMA, Team Leader- Affordable Housing Jim Mulroy, CPA, PSA, CGFM, CGMA
T (732) 828 1614
jmulroy@withum.com

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The information contained herein is not necessarily all inclusive, does not constitute legal or any other advice, and should not be relied upon without first consulting with appropriate qualified professionals for your individual facts and circumstances.

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