Qualifications for the Cancellation of Real Property Debt to be Excluded From Income
The IRS recently shed some light on the exclusion of cancellation of debt (COD) income generated from qualified real property used in a trade or business. The IRS Code Section 108(c)(3)(A) revenue ruling clarified under what circumstances a real estate developer was allowed to exclude this COD income. The primary takeaway is that real property held primarily for sale to customers in an ordinary course of business does not qualify for the exclusion. This cancellation of debt exclusion does not apply to C Corporations, but can be particularly beneficial to real estate developers who have all or a portion of their real property loans forgiven by their lender.
The easiest way to understand this ruling is by looking at the following examples:
When Cancellation of Debt Qualifies to Be Excluded From Income
XYZ Development, LLC receives a loan for $5,000,000 to build an apartment building that it plans to manage and rent to future tenants. The loan is a balloon loan where the principal balance is due in full after two years. At the loan maturity date, XYZ is unable to pay the loan off in full and can only pay $4,000,000 (the amount XYZ has in their cash account) of the $5,000,000 note. The fair market value of the apartment building is only $3,000,000, so the bank decides to settle the loan for the $4,000,000 in cash and forgive the difference of $1,000,000. XYZ is not in bankruptcy proceedings or insolvent. In this case, XYZ is allowed to exclude the cancellation of debt amount from income because the property was depreciable real property used in a trade or business.
When Cancellation of Debt Does Not Qualify For Exclusion
Assume the same facts as above, however, XYZ intends to build the apartment building and then immediately list it for sale rather than renting the units out and managing the property. In this scenario, the cancellation of debt income cannot be excluded because the building is held primarily for sale, thus it is non-depreciable inventory rather than depreciable property held for use in a trade or business.
At first glance, it appears that the IRS is allowing forgiveness of the cancellation of debt income entirely. However, when looking at the rules closely, it’s apparent that the income is deferred, not forgiven. Under Section 108(c)(1), it’s required that the taxpayer must reduce the basis of the depreciable property by the amount of the debt forgiven. This reduction in basis will create a larger gain on the property if it is ever sold and also reduce the amount of depreciation that can be taken on the property. However, most of the gain on the sale would be taxed at a more favorable capital gains tax rate, depending on how long the building was owned.
If you have any questions about how the exclusion may apply to you, please contact an Anders advisor.