Last summer, the Internal Revenue Service (“IRS”) took a look at the gross income exclusion for forgiveness of qualified real property business indebtedness (“QRPBI”) when it issued Revenue Ruling 2016-15. The ruling provided both a critical clarification under Internal Revenue Code (“IRC”) § 108(a)(1)(D) and also left some ambiguity for those looking to take advantage of the QRPBI exclusion.
Of particular importance to those in the real estate development industry, IRC § 108(a)(1)(D) provides that a cancellation of indebtedness is not includable in gross income to the extent the indebtedness discharged is QRPBI and the taxpayer is not a C corporation. In order to qualify as QRPBI, the indebtedness must be: (1) incurred or assumed by the taxpayer in connection with real property used in a trade or business; (2) incurred or assumed before January 1, 1993, or if assumed after 1993, be qualified acquisition indebtedness; and (3) the taxpayer must elect to exclude the QRPBI from gross income. The exclusion for QRPBI is not a permanent exclusion; however, when taxpayers exclude the cancellation of indebtedness (“COD”) income, they must reduce their tax basis in depreciable real property by an amount equal to the COD.
The critical clarification coming out of Rev. Rul. 2016-15 provides that the QRPBI exclusion is largely only available to those taxpayers who develop properties and hold them for leasing in a business in which the taxpayer operates, i.e., a trade or business. The rationale behind this position is that the taxpayer is actually engaged in the trade or business of leasing properties, not real estate development, and that the property is used in a trade or business. Conversely, the IRS stated that a taxpayer that develops and holds property primarily for sale to customers in the course of its business is not entitled to the QRPBI exclusion. The distinction appears to be splitting hairs, but property held for sale in the course of business is not the same as being “used in a trade or business.” Property held for sale in the course of one’s business is not depreciable and, therefore, cannot qualify for the QRPBI exclusion.
Criticism of this ruling has come from all sides and has challenged the IRS on two separate fronts. First, the IRS failed to define the term used in a trade or business. The statutory authority and legislative history do little to clarify the term, and other than in the leasing context, taxpayers are unclear on what qualifies as being used in a trade or business as opposed to used in the course of business. Additionally, the IRS made no clarification on what happens if property transitions in use over time. For example, questions have been raised about how the IRS will treat property that was originally purchased for sale, but then becomes a leasing property. The IRS has admitted that the ruling lacks some specificity, but has encouraged those seeking a QRPBI exclusion to seek clarity from the IRS, moving forward, with specifics on their individual situation.