REIT liquidation sales are not prohibited transactions

Plain-English summary

A nontraded public REIT raised substantially less capital than expected and faced upcoming debt maturities, possible joint venture buyouts, and high fixed costs relative to its shrinking asset base. Its board adopted a complete liquidation plan and proposed selling all of its multifamily properties through third-party brokers. The REIT represented that it had acquired the properties for long-term rental income and appreciation, had not regularly sold properties, and would distribute the proceeds rather than reinvest them. The IRS ruled that the liquidation sales would not be prohibited transactions under section 857(b)(6), so they would not be subject to the 100 percent prohibited-transaction tax. The ruling did not decide whether the taxpayer otherwise qualified as a REIT.

Ruling snapshot

• Question: Would sales of all the REIT's properties under its complete liquidation plan be prohibited transactions under section 857(b)(6)?
• Outcome: approved, the sales would not be prohibited transactions
• Key authorities: IRC §§ 856(c)(5), 857(b)(6), and 1221(a)(1); Cottle v. Commissioner, 89 T.C. 467 (1987)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201707010 Third Party Communication: None
Release Date: 2/17/2017 Date of Communication: Not Applicable
Index Numbers: 857.02-03
Person To Contact:
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------------------------------- ID No. ------------------
-------------------------------------- Telephone Number:
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--------------------------------------- Refer Reply To:
CC:FIP:B03
PLR-121699-16
Date:
November 18, 2016

LEGEND:

Taxpayer = ------------------------------------------------------------------------

Advisor = -----------------------------------------------

Company = --------------------------------------

State = --------------

Date 1 = ---------------------------

Date 2 = ---------------------------

Date 3 = ---------------------------

Date 4 = ---------------------------

Date 5 = ---------------

Date 6 = ------------------

Date 7 = ----------------------------

Date 8 = -----------------------------------------------

Date 9 = ------------------
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Date 10 = --------------------

Date 11 = -----------------------

Date 12 = -------------------

Date 13 = -------------------

Date 14 = --------------------

Date 15 = ---------------------

Date 16 = -----------------------

Date 17 = ---------------------------

Year 1 = -------

Year 2 = -------

Year 3 = -------

a = ----

b = ----

c = --

d = --

e = ----

f = ----

g = --

h = --

i = --

j = --
PLR-121699-16 3

Dear ---------------:

    This ruling responds to a letter dated July 5, 2016 and a supplemental

submission dated September 26, 2016, submitted on behalf of Taxpayer. Taxpayer
requests a ruling that sales of its real estate assets pursuant to a plan of liquidation
under the circumstances described below will not constitute prohibited transactions
within the meaning of section 857(b)(6) of the Internal Revenue Code (“Code”).

                                      FACTS

    Taxpayer was organized as a State corporation on Date 1. Taxpayer represents

that it elected to be taxed as a real estate investment trust (“REIT”) commencing with
the taxable year ended Date 2. Taxpayer was organized with the investment objectives
of realizing growth in the value of its real estate assets, preserving, protecting and
returning its stockholders’ invested capital, investing in a diversified portfolio of real
estate assets, and exploring liquidity options in the future, including the sale of either
Taxpayer or its assets, potential merger opportunities, or the listing of its common
shares on a national exchange.

   On Date 3, Taxpayer entered into an advisory agreement with Advisor. Advisor

provides advisory services relating to substantially all aspects of Taxpayer's
investments and operations, including real estate transactions, locating, analyzing, and
selecting potential investments, and asset management and other operational matters.

    Taxpayer’s acquisitions were underwritten with a development period of up to a

months with the expectation of reaching expected occupancy stabilization within a
months of completion, and properties becoming partially operational and collecting rent
as buildings within the projects are completed and certificates of occupancy
(“Certificates”) are obtained.

    As of Date 4, Taxpayer owned an interest in b multifamily properties (the

“Properties”). In Date 5, Taxpayer sold its interests in c Properties. In Date 6, Taxpayer
sold its interest in d Property. Therefore, as of Date 7, Taxpayer owned an interest in e
Properties. Of these b Properties, f were owned or are owned through partnerships,
and d Property is wholly owned by Taxpayer. As of Date 7, development on all of the
Properties was substantially complete and the Properties are anticipated to reach
expected occupancy stabilization by Date 8.

   Taxpayer’s initial stock offering (“Initial Offering “) closed on Date 9. Taxpayer’s

second stock offering (“Follow-On Offering”) closed on Date 10. Although Taxpayer
maintained the flexibility to invest in a variety of real estate sectors in domestic and
international markets, in connection with the Follow-On Offering Taxpayer’s investment
PLR-121699-16 4

strategy was revised to focus primarily on multifamily development projects in certain
regions of the United States.

    The amount of capital raised by Taxpayer through its Initial Offering and Follow-

was significantly less than the capital Taxpayer anticipated raising when Taxpayer was
launched in Year 1. Taxpayer believed that this lack of capital would make Taxpayer
likely too small to effectively list on a public exchange in accordance with its investment
objectives. Accordingly, Advisor began to explore strategic alternatives for providing
liquidity to Taxpayer’s investors. On Date 11, the Board appointed a special committee
comprised of Taxpayer’s independent directors (the “Special Committee”) to oversee
the process of exploring and evaluating liquidity options and engaged Company to
advise and assist the Advisor and the Special Committee with this process.

   Moreover, most of the outstanding loans on the Properties will be at or near

maturity within the next d to c years, and repayment or refinancing of the loans will be
required because Taxpayer does not have sufficient capital to meet the current loan
obligations. Additionally, because Taxpayer owns the Properties through joint ventures,
there is a risk the joint venture partners may be unwilling to cooperate in the event of a
refinancing.

   Of the e Properties’ partnership agreements, g contain a provision that limits a

partner’s ability to buy the other partner’s entire interest or sell its entire interest in a
property until a months after the completion of the development of a property (“Buy-Sell
Option”). To the extent a partner chooses to exercise its option to sell its entire interest,
the other partner is permitted to (1) agree to the terms of the proposed sale, or (2) elect
to purchase its entire interest in the property at a price determined under the terms of
the agreement. Taxpayer’s intention when entering into a partnership agreement with a
Buy-Sell Option was to elect to purchase the entire interest in the Property, should the
partner exercise its option to sell under the terms of the agreement. The Advisor
currently anticipates that it is likely that all of the joint venture partners will exercise the
Buy-Sell Option at the end of the a-month period. To the extent a joint venture partner
does exercise the Buy-Sell Option, Taxpayer will not have sufficient capital to buy out
the partner and it is likely Taxpayer would be forced to sell the property under the terms
of the Buy-Sell Option at a price that may not maximize value to its shareholders.

   Another item considered by the Board, Special Committee, Advisor, and

Company is the costs associated with maintaining a non-traded public REIT. As a
result of Taxpayer raising significantly less capital than anticipated in its Initial Offering
and Follow-On Offering, Taxpayer has a small asset base in relation to the costs
associated with maintaining a public company. Because Taxpayer is forced to sell
assets due to debt maturities and joint venture partners exercising the Buy-Sell Options
present within Taxpayer’s partnership agreements, the remaining assets would carry a
higher level of fixed costs with a shrinking asset base.
PLR-121699-16 5

   Based on these considerations, Advisor and Company recommended, and the

Board and the Special Committee agreed, that a plan of dissolution of Taxpayer and
sale of the Properties through multiple transactions would be in the best interest of
Taxpayer’s shareholders.

    In Date 12, Taxpayer began the process of moving forward with a formal plan of

complete liquidation and dissolution pursuant to section 331 of the Code (the “Plan”).
Taxpayer filed the Plan with the SEC on Date 13, and filed the definitive proxy with the
SEC on Date 14. The Plan became effective on Date 15. Taxpayer will take the
actions and perform the activities required for winding up its affairs, preserving the value
of its assets, and distributing its assets to its shareholders in accordance with the Plan.
In anticipation of and simultaneous with the Plan, Taxpayer intends to strategically sell
each of the Properties to maximize shareholder value as recommended by Advisor, the
Board, the Special Committee and Company. The proceeds from the sales will be
distributed to the shareholders through one or more distributions. The first liquidating
distribution was paid on Date 16.

   Taxpayer estimates that h more of the Properties will be sold before Date 17.

Accordingly, i properties will have been sold during Year 2. Taxpayer anticipates that
the remaining j properties will be sold by Date 8. All of the Properties will be sold
through one or more third-party brokers.

    After the sale of its final Property, Taxpayer represents that it will distribute any

remaining assets to its shareholders in a single distribution in accordance with the Plan
and file the final income tax returns and all other tax returns, certificates, documents,
and information required to be filed by reason of the complete liquidation and dissolution
of Taxpayer.

   Taxpayer makes the following additional representations:

1. Taxpayer acquired the Properties with the intent to hold the properties for a long-
   term period and to derive its profits from rental income and capital appreciation,
   consistent with its operation as a REIT.

2. Taxpayer does not intend to reinvest the sales proceeds from the Properties in
   other real estate interests.

3. Taxpayer will take the actions and perform the activities required for winding up
   its affairs, preserving the value of its assets, and distributing its assets to its
   shareholders in accordance with the Plan after all of the Properties have been sold,
   which Taxpayer anticipates to occur in Year 3.
   PLR-121699-16 6

                             LAW AND ANALYSIS
   

   Section 857(b)(6)(A) imposes a 100 percent tax on a REIT's net income from
   prohibited transactions. Section 857(b)(6)(B)(iii) defines the term “prohibited transaction”
   as the sale or other disposition of property described in section 1221(a)(1) that is not
   foreclosure property. Section 1221 (a)(1) property, in turn, consists of property held by
   the taxpayer primarily for sale to customers in the ordinary course of his trade or
   business. Section 857(b)(6)(B)(ii) provides that losses attributable to prohibited
   transactions are not taken into account in determining the amount of net income derived
   from prohibited transactions.

   Section 857(b)(6)(C) excludes certain sales from the definition of a prohibited
   transaction. Under section 857(b)(6)(C), the term “prohibited transaction” does not
   include the sale of property which is a real estate asset (as defined in section
   856(c)(5)(B) and which is described in section 1221(a)(1)) if –

   (i) the REIT has held the property for not less than 2 years;

   (ii) the aggregate expenditures made by the REIT, or any partner of the REIT,
   during the 2-year period preceding the date of sale which are includible in the
   basis of the property do not exceed 30 percent of the net selling price of the
   property;

   (iii) (I) during the taxable year the REIT does not make more than 7 sales of
   property (other than sales of foreclosure property or sales to which section 1033
   applies), or (II) the aggregate adjusted bases (as determined for purposes of
   computing earnings and profits) of property (other than sales of foreclosure
   property or sales to which section 1033 applies) sold during the taxable year
   does not exceed 10 percent of the aggregate bases of all the assets of the REIT
   as of the beginning of the taxable year, or (III) the fair market value of property
   (other than sales of foreclosure property or sales to which section 1033 applies)
   sold during the taxable year does not exceed 10 percent of the fair market value
   of all the assets of the REIT as of the beginning of the taxable year or (IV) the
   REIT satisfies the requirements of subclause (II) applied by substituting “20
   percent” for “10 percent” and the 3-year average adjusted bases percentage for
   the taxable year (as defined in section 857(b)(6)(G)) does not exceed 10 percent,
   or (V) the REIT satisfies the requirements of subclause (III) applied by
   substituting “20 percent” for “10 percent” and the 3-year average fair market
   value percentage for the taxable year (as defined in section 857(b)(6)(H)) does
   not exceed 10 percent;

   (iv) in the case of property, which consists of land or improvements, not acquired
   through foreclosure (or deed in lieu of foreclosure), or lease termination, the
   PLR-121699-16 7

   REIT has held the property for not less than 2 years for production of rental
   income; and
   
   (v) if the requirement of clause (iii)(l) is not satisfied, substantially all of the
   marketing and development expenditures with respect to the property were made
   through an independent contractor (as defined in section 856(d)(3)) from whom
   the REIT itself does not derive or receive any income.
   

   The legislative history underlying section 857(b)(6), which was added to the
   Code by the Tax Reform Act of 1976, indicates that the purpose of that section was to
   “prevent a REIT from retaining any profit from ordinary retailing activities such as sales
   to customers of condominium units or subdivided lots in a development project.” S. Rep.
   No. 938, 84th Cong., 2d Sess. 470 (1976, 1976-3 (Vol. 4) C.B. 508).

   To determine whether a taxpayer holds property “primarily for sale to customers
   in the ordinary course of its trade or business”, the Tax Court has held that several
   factors must be considered, none of which is dispositive. Among those factors are: (1)
   the nature and purpose of the acquisition of the property and the duration of the
   ownership; (2) the extent and nature of the taxpayer's efforts to sell the property; (3) the
   number, extent, continuity, and substantiality of the sales; (4) the extent of subdividing,
   developing, and advertising to increase sales; and (5) the time and effort the taxpayer
   habitually devoted to the sales. Generally, it is the purpose for which property is held at
   the time of the sale that is determinative, although earlier events may be considered to
   decide the taxpayer's purpose at the time of the sale. See Cottle v. Commissioner 89
   T.C. 467, 487 (1987).

   Taxpayer has represented that it acquired the Properties with the intent to hold
   the Properties for a long-term period and to derive its profits from rental income and
   capital appreciation. Taxpayer is only selling the Properties because it is undergoing a
   complete liquidation of all of its assets and a corporate dissolution. Prior to this
   liquidation, Taxpayer did not make numerous, extensive, continuous, or substantial
   sales of properties. Taxpayer has sold and will continue to sell all of the Properties
   through third-party brokers and will not use the proceeds of the Property sale to invest
   in additional real estate assets.

                                        CONCLUSION
   

   Based on the facts presented and representations made by Taxpayer, we
   conclude that the sale of Taxpayer's Properties pursuant to the plan of liquidation as
   described above will not constitute prohibited transactions within the meaning of section
   857(b)(6).1
   1
   Section 4 of Revenue Procedure 2016-3, 2016-1 I.R.B. 126, 133, sets forth those areas in which rulings
   or determination letters will not ordinarily be issued by the Service. “Not ordinarily” means that unique and
   PLR-121699-16 8

   This ruling's application is limited to the facts, representations, Code sections,
   and regulations cited herein. Except as expressly provided herein, no opinion is
   expressed or implied concerning the tax consequences of any aspect of any transaction
   or item discussed or referenced in this letter. In particular, no opinion is expressed
   concerning whether Taxpayer otherwise qualifies as a REIT under subchapter M, part II
   of Chapter 1 of the Code.

   This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of
   the Code provides that it may not be used or cited as precedent.

    In accordance with the Power of Attorney on file with this office, a copy of this
   

   letter is being sent to your authorized representatives.

                                                     Sincerely,
   
                                                     __________________________
                                                     Julanne Allen
                                                     Assistant to the Branch Chief, Branch 3
                                                     Office of Associate Chief Counsel
                                                     (Financial Institutions & Products)
   

compelling reasons must be demonstrated to justify the issuance of a ruling or determination letter. See
Rev. Proc. 2016-3, section 2.01. Section 4.02(5) of Rev. Proc. 2016-3 provides that one of the areas in
which rulings or determination letters will not ordinarily be issued is any matter dealing with the question
of whether property is held primarily for sale to customers in the ordinary course of a trade or business. In
this case, Taxpayer has demonstrated unique and compelling reasons to justify issuance of the ruling.