United States: Debt Secured By Inventory Real Property Is Not QRPBI

Last Updated: July 8 2016
Article by Elizabeth M. Fialkowski Stieff

In the recently released Revenue Ruling 2016-15, the IRS determined that discharge of debt income generated by the forgiveness of debt secured by real property constituted excludable qualified real property business indebtedness ("QRPBI") where the secured real property was used by the taxpayer in his leasing business; the debt did not constitute QRPBI where the secured real property was residential property built in lots held for sale by the taxpayer in his real estate development business.

The Revenue Ruling provides advice on two similar factual scenarios.  In both scenarios, the taxpayer is a sole proprietor that obtains a bank loan of $10,000,000 to construct real property. The loan is secured by the real property. Before the maturity date, the taxpayer reduces the loan principal to $8,000,000. On the maturity date, the real property has a fair market value of $5,000,000; the taxpayer's adjusted basis is $4,900,000 and the taxpayer has $5,500,000 of cash. The bank cancels the loan in exchange for the taxpayer's payment of $5,250,000 of cash. The taxpayer excludes $2,750,000 ($8,000,000 - $5,250,000) of cancellation of indebtedness income as QRPBI. In the first scenario, the taxpayer is in the business of developing and leasing real property; he uses the loan proceeds to build an apartment building that he will lease. In the second scenario, the taxpayer is in the business of developing and holding real property for sale; he uses the loan proceeds to construct residential properties on subdivided units of the underlying property.

Gross income includes income from the discharge of a taxpayer's indebtedness. Discharge of indebtedness income is excluded from an individual taxpayer's gross income if the debt discharged is QRPBI. QRPBI is debt that (a) the taxpayer incurs in connection with, and is secured by, real property used in a trade or business; (b) is qualified acquisition indebtedness; and (c) the taxpayer elects to exclude from gross income. Qualified acquisition indebtedness is debt incurred to acquire, construct, reconstruct or substantially improve real property.  

If a taxpayer excludes discharge income because it is QRPBI, the taxpayer must reduce the basis of its depreciable real property by the amount of income excluded. The basis reduction must be applied first to the property securing the debt that is discharged, then to other depreciable real property. Depreciable real property includes residential real property but does not include inventories or stock in trade. The amount that a taxpayer can exclude is limited to (1) the outstanding principal of the QRPBI; less (2) the fair market value of the real property less any other QRPBI on the property. The amount excluded cannot exceed the taxpayer's total adjusted basis of depreciable real property (i.e., the taxpayer can only exclude the income to the extent he can reduce his basis in depreciable real property).  

In the first scenario, the IRS determined that the taxpayer could exclude $2,750,000 of debt discharge as QRPBI. The taxpayer must reduce its basis in the property to $2,150,000.  In the second scenario, the taxpayer cannot exclude any amount of the discharge as QRPBI. In the second scenario, the lots constitute inventory held primarily for sale to customers in the taxpayer's course of business and as such, are not depreciable.

Real estate professionals should be aware of the IRS's guidance in Revenue Ruling 2016-15. In both scenarios in the ruling, the taxpayer was engaged in a trade or business involving real property. However, when the real property is held primarily for sale to customers in the ordinary course of business, the taxpayer was not entitled to exclude any debt discharge income attributable to such property as QRPBI. Accordingly, professionals that desire to use the QRPBI exclusion must carefully analyze not only whether the underlying property is used in a trade or business but also the specific uses of the property (i.e., as a business asset or as inventory for sale).  

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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