A county's development incentive payment counts as qualifying REIT income

Plain-English summary

A real estate investment trust (REIT) gets its favorable tax treatment only if almost all of its income is passive real estate income: at least 95% and 75% of gross income must come from rents and other listed real-estate sources under sections 856(c)(2) and (c)(3). Income that does not fit those categories can jeopardize REIT status. Here a REIT, through a partnership and disregarded subsidiaries, agreed to demolish a building and build a mixed-use office, retail, and residential development to support a county economic-development project. As an incentive, the county agreed to reimburse the costs (above a floor and capped at a ceiling) of buying out the old building's existing tenants, called the "County Payment." That reimbursement is not one of the income types listed in the REIT rules. The REIT asked the IRS to use its authority under section 856(c)(5)(J), which lets the Secretary treat otherwise-nonqualifying income as qualifying when doing so does not undercut Congress's goal of keeping REIT income passive. The IRS ruled that the REIT's share of the County Payment (except any part attributable to easements it granted the county) is qualifying income for the 95% and 75% tests. The IRS pointedly did not rule that the taxpayer actually qualifies as a REIT or that its other income qualifies. This helps REITs accept government development incentives without tripping the income tests.

Ruling snapshot

• Question: Is a county's incentive payment reimbursing tenant-buyout costs qualifying income for the REIT 95% and 75% gross-income tests under section 856(c)(5)(J)?
• Outcome: approved (the payment, except any part attributable to conveyed easements, is qualifying income)
• Key authorities: IRC §§ 856(c)(2), 856(c)(3), 856(c)(5)(J); Treas. Reg. §§ 1.856-3(g), 1.856-10

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201910002                                              Third Party Communication: None
Release Date: 3/8/2019                                         Date of Communication: Not Applicable
Index Number: 856.01-00
                                                               Person To Contact:
-------------------                                            --------------, ID No. -----------------
------                                                         Telephone Number:
-------------------------------------                          ---------------------
------------------------                                       Refer Reply To:
-------------                                                  CC:FIP:B01
----------------------------------------                       PLR-118810-18
                                                               Date: December 04, 2018




Legend:

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

Partnership                         =        -----------------------------------------

DE1                                 =        --------------------------------

DE2                                 =        --------------------------------------------

State A                             =        -------------

State B                             =        -------------

County                              =        ---------------------------

Site                                =        ------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------

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

Month A                             =        ------------

Month B                             =        ------
PLR-118810-18                                 2

Year A                     =      -------

Year B                     =      -------

Structure                  =      ---------------------------------------

Facility                   =      ---------------------------------------

A                          =      ---------

B                          =      --------------

C                          =      --------------


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

       This letter is in reply to a letter dated May 31, 2018, in which Taxpayer requests
a ruling that pursuant to Section 856(c)(5)(J)(ii) Taxpayer’s income attributable to the
receipt or accrual of the County Payment (as defined below) is considered qualifying
income for purposes of Sections 856(c)(2) and (3).

Facts:

      Taxpayer is a domestic corporation that elected to be taxed as a real estate
investment trust (REIT) under Sections 856 through 860 on Date 1. Taxpayer owns A
percent of the interests in Partnership, a State A limited partnership treated as a
partnership for U.S. federal income tax purposes. The remainder of Partnership is
owned by unrelated third parties. Partnership owns 100% of DE1. DE1 owns 100% of
DE2. DE1 and DE2 are disregarded as entities separate from Partnership for federal
income tax purposes. DE2 owns Site.

        The County, as part of its economic development plan, wished to facilitate the
construction of Facility and Structure. A building existed on Site. It was determined that
the most expeditious means for developing this project was for DE2 to demolish the
existing building and construct a multi-use office, retail, and residential development on
Site (the “Property”). Taxpayer represents that, upon completion, the Property will
qualify as real property as defined in Section 1.856-10 and that Taxpayer will lease the
Property to third party tenants for the purpose of generating qualifying rents from real
property under Section 856(c)(2) and (3).

      The Property will also include Structure (which will be a part of the Property’s
foundation), which DE2 will design and build. DE2 has granted a permanent easement
to County for Structure and an easement to facilitate connecting Structure to other
assets that qualify as real property under Section 1.856-10 and as real estate assets
under Section 856(c)(5)(B). DE2 will also construct the shell of Facility on Site and pay
PLR-118810-18                                 3

for the construction of at least one elevator and stairs (and an escalator if possible) for
Facility. DE2 will own and maintain Facility’s shell (which will also be part of Property’s
foundation). DE2 will not own or maintain the improvements within Facility or provide
services to County with respect to the easements.

        A financial analysis submitted by Taxpayer in connection with this ruling request
indicates that the proposed project will result in increased economic activity and tax
revenue for the County and State B. To encourage the redevelopment of Site to include
Facility and Structure, County considered incentives to the owner of Site, including an
increase in zoning capacity. The building on Site had several tenants with leases that
had to be bought out in order to proceed with the development. A study conducted by a
real estate consulting firm for County determined that, taking into account the cost of
buying out existing tenants, increasing the zoning capacity would likely be insufficient to
induce the owner of Site to demolish the current building and develop the Property. The
study estimated the value of additional inducements that may be needed. In Month A of
Year A, County council passed a resolution with inducements to encourage the
redevelopment of Site.

        In Month B of Year B, DE2 entered into an agreement with County (the
“Agreement”) to develop Site. Under the Agreement, DE2 will, among other things,
(i) design and build Structure, develop Site to support Structure, provide permanent
easements to County for Structure, and cooperate with County in the event that County
decides to connect Structure to other infrastructure (for which DE2 will bear no
expense); and (ii) enter into an agreement with State B to construct the shell of Facility,
provide access to Facility, and provide all easements to State B that are necessary to
accommodate Facility.

        The Agreement provides for an incentive payment by County of costs in excess
of B dollars incurred by Partnership to terminate leases of tenants of the existing
building that was at Site (the “County Payment”). The amount of the County Payment
will be limited to C dollars. The County Payment will be paid in part upon the
completion of a construction milestone with the remainder to be paid upon the earlier of
another construction milestone or a date specified in the Agreement. Both of these
payments are conditioned on Taxpayer providing satisfactory evidence of the buyout
costs, conveyance of all required easements, and evidence of required improvements to
Site.

        Taxpayer represents that the rental income that will be generated by the Property
will be qualifying income for purposes of Sections 856(c)(2) and (3). Taxpayer further
represents that substantially all of the income generated by the Property (other than
income arising from the County Payment) will be qualifying income for purposes of
Section 856(c)(2) and (3).
PLR-118810-18                                4

Law and Analysis:

       Section 856(c)(2) provides that in order for a corporation to qualify as a REIT, at
least 95 percent of the corporation's gross income (excluding gross income from
prohibited transactions) must be derived from certain enumerated sources, which
include dividends, interest, rents from real property, gain from the sale or other
disposition of stock, securities, and real property (other than property in which the
corporation is a dealer), abatements and refunds of taxes on real property, income and
gain derived from foreclosure property, and certain commitment fees.

       Section 856(c)(3) provides that in order for a corporation to qualify as a REIT, at
least 75 percent of the corporation's gross income (excluding gross income from
prohibited transactions) must be derived from certain enumerated sources, which
include rents from real property, interest on obligations secured by real property, gain
from the sale or other disposition of real property (other than property in which the
corporation is a dealer), distributions on and gain from the sale of REIT stock,
abatements and refunds of taxes on real property, income and gain derived from
foreclosure property, certain commitment fees, and qualified temporary investment
income.

       Section 1.856-3(g) provides that a REIT that is a partner in a partnership is
deemed to own its proportionate share of each of the assets of the partnership and to
be entitled to the income of the partnership attributable to such share. For purposes of
Section 856, the interest of a partner in the partnership's assets is determined in
accordance with the partner's capital interest in the partnership. The assets and items
of gross income of the partnership retain their character in the hands of the partners for
purposes of Section 856.

       Section 856(c)(5)(J) provides that to the extent necessary to carry out the
purposes of Part II of Subchapter M of the Code, the Secretary is authorized to
determine, solely for purposes of such part, (i) whether any item of income or gain that
does not otherwise qualify under Sections 856(c)(2) or (3) may be considered as not
constituting gross income for purposes of Sections 856(c)(2) or (3), or (ii) whether any
item of income or gain that otherwise constitutes gross income not qualifying under
Sections 856(c)(2) or (3) may be considered as gross income that qualifies under
Sections 856(c)(2) or (3).

       The legislative history underlying the tax treatment of REITs indicates that a
central concern behind the gross income restrictions is that a REIT’s gross income
should largely be composed of passive income. For example, H.R. Rep. No. 2020, 86th
Cong., 2d Sess. 4 (1960) at 6, 1960-2 C.B. 819, at 822-23 states, “[o]ne of the principal
purposes of your committee in imposing restrictions on types of income of a qualifying
real estate investment trust is to be sure the bulk of its income is from passive income
sources and not from the active conduct of a trade or business.”
PLR-118810-18                                5


        Income attributable to the receipt or accrual of the County Payment, to the extent
not attributable to the easements conveyed by DE2 to County, is not derived from any
source listed in Section 856(c)(2) or (3). Pursuant to Section 856(c)(5)(J), the Secretary
has the authority to determine that such income be considered as qualifying gross
income for purposes of those provisions. On the basis of all of the facts and
circumstances, including Taxpayer’s representations that the Property will generate
rents from real property and that substantially all of the income generated by the
Property will be qualifying income for purposes of Section 856(c)(2) and (3), treating
Taxpayer’s income attributable to its receipt or accrual of its share of the portion of the
County Payment that is not attributable to the easements conveyed by DE2 to County
as qualifying income does not interfere with or impede the objectives of Congress in
enacting Section 856(c)(2) and (3).

Conclusion

         We hereby rule that, pursuant to Section 856(c)(5)(J), Taxpayer’s income
attributable to the receipt and accrual of its share of the County Payment, to the extent
that it is not attributable to the easements conveyed by DE2 to County, is considered
qualifying income for purposes of Section 856(c)(2) and (c)(3).

        This ruling's application is limited to the facts, representations, Code Sections,
and regulations cited herein. Except as specifically ruled upon above, no opinion is
expressed concerning any federal income tax consequences related to the facts herein
under any other provisions of the Code. Specifically, we do not rule whether Taxpayer
qualifies as a REIT under Part II of Subchapter M of Chapter 1 of the Code, whether
substantially all income from the Property is qualifying income, or whether any of the
County Payment is attributable to the easements conveyed by DE2.

       This ruling is directed only to the taxpayer that requested it. Section 6110(k)(3)
provides that it may not be used or cited as precedent. In accordance with the
provisions of a Power of Attorney on file, we are sending a copy of this ruling letter to
your authorized representatives.
PLR-118810-18                                  6

      The rulings contained in this letter are based upon information and
representations submitted by the taxpayer and accompanied by a penalty of perjury
statement executed by an appropriate party. Although this office has not verified any of
the material submitted in support of the request for rulings, it is subject to verification on
examination.

                                        Sincerely,


                                        Steven Harrison
                                        Chief, Branch 1
                                        Office of Associate Chief Counsel
                                        (Financial Institutions & Products)