A REIT's accounting-method adjustments are excluded from its income tests and treated as paid from E&P

Plain-English summary

A real estate investment trust (REIT) earns nearly all of its income through a partnership that owns communications towers and related real estate. The partnership discovered it had been depreciating certain tower assets using the wrong (personal-property) methods and filed to change to the correct methods for land improvements. That change produced positive section 481(a) adjustments, which are catch-up amounts of income the REIT must report over several years. The REIT asked the IRS two things. First, it asked that its share of those adjustments be ignored when applying the REIT gross-income tests (which require 95% and 75% of income to come from real-estate and other passive sources), since catch-up income is not one of the listed good categories. The IRS agreed under its authority in section 856(c)(5)(J). Second, it asked that, where the taxable catch-up income exceeds the matching adjustment to earnings and profits (E&P), distributions of that excess be treated as coming out of E&P (so they count as dividends). The IRS agreed with that too. This matters because it lets the REIT fix its depreciation without accidentally flunking its income tests and keeps its distributions treated as dividends.

Ruling snapshot

• Question: Are a REIT's share of partnership section 481(a) adjustments excluded from the REIT income tests, and are distributions of any excess over correlative E&P adjustments treated as made from E&P?
• Outcome: Approved (both rulings granted)
• Key authorities: IRC § 856(c)(2), (3), (5)(J); § 481(a); § 704; § 857(d); Treas. Reg. § 1.856-3(g); Rev. Proc. 79-47

Full text (IRS public release)

 Internal Revenue Service                                       Department of the Treasury
                                                                Washington, DC 20224

 Number: 202235006                                              Third Party Communication: None
 Release Date: 9/2/2022                                         Date of Communication: Not Applicable
 Index Number: 856.00-00, 856.01-00,
               857.00-00, 857.05-00                             Person To Contact:
                                                                -------------, ID No. -----------------
 -----------------------                                        Telephone Number:
 ------------------------------------                           --------------------
 ------------------------------------------------               Refer Reply To:
 ---------------------------                                    CC:FIP:B03
 ------------                                                   PLR-124812-21
 -------------------------                                      Date:
 ----------------------------                                   June 03, 2022




Legend

Taxpayer          =         -----------------------------------------------------------------------------------------
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State             =        -------------

Year 1            =        -------

Year 2            =        -------

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

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

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

OP                =        --------------------------


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

       This letter responds to a letter dated November 16, 2021, and supplemental
correspondence, requesting rulings on behalf of Taxpayer. Taxpayer requests two
rulings with respect to inclusions under section 481(a) of the Internal Revenue Code
(Code) and earnings and profits (E&P) associated with those inclusions:

     1. Pursuant to section 856(c)(5)(J)(i), Taxpayer’s share of the OP Section 481(a)
        Adjustments (defined below), determined in accordance with section 1.856-3(g)
PLR-124812-21                                 2

        of the Income Tax Regulations, will not be taken into account for purposes of
        section 856(c)(2) and (3).

    2. For purposes other than section 856(c)(2) and (3), if and to the extent that
       Taxpayer’s distributive share, determined in accordance with section 704, of the
       OP Section 481(a) Adjustments exceeds the correlative E&P adjustments arising
       from the Method Changes (defined below), any distributions of such excess (that
       are distributed and treated as dividends by Taxpayer in the year in which such
       excess arises) will be treated as made from E&P.

                                            FACTS

        Taxpayer was organized as a State limited liability company in Year 1 when
Taxpayer elected to be taxed as a real estate investment trust (REIT) under sections
856 through 860. Taxpayer’s overall method of accounting is an accrual method, and
its taxable year is the calendar year. Taxpayer has been a partner in OP, a partnership
for federal income tax purposes, during all periods from and after Year 1. Taxpayer’s
revenue arises almost exclusively from its investment in OP. OP’s real estate rental
business is described below.

      OP is an independent owner of properties (the “Sites”) consisting of multi-
tenanted communications towers, distributed antenna system networks, and other
communications-related real estate such as land parcels and rooftop sites. OP’s
primary business is the leasing of space on and at the Sites to a diverse group of
tenants in different industries.

       After a majority of the interests in OP were acquired (including indirectly through
the acquisition of Taxpayer) in Year 2, Taxpayer conducted a review of Taxpayer’s
books and records. Taxpayer concluded that OP had been improperly depreciating or
amortizing certain cellular and broadcast towers (and ancillary depreciable property
such as site improvements, landscaping, fencing, and roads) placed in service between
the tax years ended Date 1 and Date 2 (the “Tower Assets”) using cost recovery
methods applicable to personal property. As a result of this review, OP submitted
Forms 3115, Application for Change in Accounting Method, under the automatic change
procedure described in Rev. Proc. 2015-13, 2015-5 I.R.B. 419, to change its methods of
accounting for depreciation and amortization for the Tower Assets to methods
applicable to land improvements under Asset Class 00.3 of Rev. Proc. 87-56, 1987-2
C.B. 674, beginning with the taxable year of change ended Date 3 (the Method
Changes). The Method Changes resulted in positive section 481(a) adjustments (the
OP Section 481(a) Adjustments) that Taxpayer will take into account over the
appropriate section 481(a) adjustment period. The appropriate section 481(a)
adjustment period will generally be the year of change and the next three taxable years
unless an acceleration later applies under certain specified circumstances.1
1 See section 7.03 of Rev. Proc. 2015-13.
PLR-124812-21                                3

Accordingly, Taxpayer will take into account its share of the OP Section 481(a)

Adjustments, in accordance with section 1.856-3(g) for purposes of section 856(c)(2)
and (3) and section 704 for all other purposes, for a particular taxable year with
corresponding changes to Taxpayer’s E&P.

       Taxpayer makes the following representations:

       1. The Sites are comprised of real property or interests in real property within
          the meaning of section 1.856-10.

       2. The OP Section 481(a) Adjustments relate to assets that will be depreciated
          or amortized pursuant to methods that conform and align more closely with
          the applicable assets constituting real property and interests in real property
          for purposes of sections 856 and 1.856-10.

       3. Taxpayer will take the correlative adjustments arising from the change in
          computing depreciation and amortization for E&P purposes into account
          ratably over the same period as the OP Section 481(a) Adjustments are taken
          into account, in accordance with Rev. Proc. 79-47, 1979-2 C.B. 528.

       4. Taxpayer’s share of the OP Section 481(a) Adjustments will not be subject to
          the section 1374 built-in gains tax, which tax (where applicable) is not
          eliminated or reduced by the dividends paid deduction per sections 337(d)
          and 1374 as well as sections 1.337(d)-7 and 1.1374-4(b), (d), and (i),
          because Taxpayer’s share of the OP Section 481(a) Adjustments relates to
          depreciation and amortization previously taken by Taxpayer as a REIT (and
          not to depreciation or amortization previously taken as a non-REIT
          C corporation).

                                  LAW AND ANALYSIS

Ruling Request #1: Pursuant to section 856(c)(5)(J)(i), Taxpayer’s share of the OP
Section 481(a) Adjustments, determined in accordance with section 1.856-3(g),
will not be taken into account for purposes of section 856(c)(2) and (3).

       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 dividends; interest; rents from real
property; gain from the sale or other disposition of stock, securities, and real property
(other than property described in section 1221(a)); abatements and refunds of taxes on
real property; income and gain derived from foreclosure property; commitment fees to
make loans secured by mortgages on real property or on interests in real property or to
PLR-124812-21                                4

purchase or lease real property; gain from certain sales or other dispositions of real
estate assets; and certain mineral royalty income.

       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 rents from real property; interest on
obligations secured by mortgages on real property or on interests in real property; gain
from the sale or other disposition of real property (other than property described in
section 1221(a)); certain dividends or distributions on, and gains from the sale or
disposition of, shares in other REITs; abatements and refunds of taxes on real property;
income and gain derived from foreclosure property; commitment fees to make loans
secured by mortgages on real property or on interests in real property or to purchase or
lease real property; gain from certain sales or other dispositions of real estate assets;
and qualified temporary investment income.

       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, whether any item of income or gain which
(i) does not otherwise qualify under section 856(c)(2) or (3) may be considered as not
constituting gross income for purposes of section 856(c)(2) or (3), or (ii) otherwise
constitutes gross income not qualifying under section 856(c)(2) or (3) may be
considered as gross income which qualifies under section 856(c)(2) or (3).

       Section 481(a) provides that a taxpayer that changes its method of accounting
takes into account necessary adjustments in computing its taxable income to prevent
amounts from being duplicated or omitted.

       Section 1.481-1(d) provides that a section 481(a) adjustment must be properly
taken into account for purposes of computing gross income, adjusted gross income, or
taxable income in determining the amount of any item of gain, loss, deduction, or credit
that depends on gross income, adjusted gross income, or taxable income.

       Under section 1.856-3(g), 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 that 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 character of the various assets in the
hands of the partnership and items of gross income of the partnership retain the same
character in the hands of the partners for all purposes of section 856.

       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
PLR-124812-21                                5

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.”

        As noted above, OP submitted Forms 3115 to change its methods of accounting
for its Tower Assets. The Method Changes resulted in OP Section 481(a) Adjustments
that will be includible in OP’s gross income and, in accordance with section 1.856-3(g),
will be includible proportionately in Taxpayer’s gross income in accordance with
Taxpayer’s capital interest in OP. Section 856(c)(2) and (3) lists the sources of
permissible income for a REIT. Income from a section 481(a) adjustment is not
specifically enumerated in section 856(c)(2) or (3).

       Based on all the facts and circumstances, excluding Taxpayer’s share of the OP
Section 481(a) Adjustments, determined in accordance with section 1.856-3(g), from
Taxpayer's gross income for purposes of sections 856(c)(2) and (3), does not interfere
with Congressional policy objectives in enacting the income tests under those
provisions. Accordingly, based on the information submitted and representations made,
we rule that pursuant to section 856(c)(5)(J)(i), Taxpayer’s share of the OP Section
481(a) Adjustments, so determined, will not constitute gross income for purposes of
section 856(c)(2) and (3).

Ruling Request #2: For purposes other than section 856(c)(2) and (3), if and to
the extent that Taxpayer’s distributive share, determined in accordance with
section 704, of the OP Section 481(a) Adjustments exceeds the correlative E&P
adjustments arising from the Method Changes, any distributions of such excess
(that are distributed and treated as dividends by Taxpayer in the year in which
such excess arises) will be treated as made from E&P.

       Section 561(a) provides that the deduction for dividends paid shall be the sum of
the dividends paid during the year and consent dividends for the taxable year.

        Section 562(a) provides that the term “dividend” shall include only dividends as
described in section 316. Section 316(a) defines the term “dividend” to mean any
distribution of property made by a corporation to its shareholders out of either current
year or accumulated E&P.

       Section 704 generally provides that a partner’s distributive share of partnership
income, gain, deduction, loss, or credit is determined by the partnership agreement or,
in certain cases, in accordance with the partner’s interest in the partnership (determined
by taking into account all facts and circumstances), with other rules and exceptions not
relevant here.

       Section 857(a)(1) requires, in part, that a REIT's deduction for dividends paid for
a taxable year equals at least 90 percent of its REIT taxable income for the taxable
year, determined without regard to the deduction for dividends paid (as defined by
section 561) or any net capital gains.
PLR-124812-21                                         6


      Section 857(b)(2)(B) provides that in determining a REIT's taxable income, the
deduction for dividends paid (as defined in section 561) shall be allowed.

        Section 857(d)(1)(A) provides that the E&P of a REIT for any taxable year (but
not its accumulated earnings) shall not be reduced by any amount that is not allowable
in computing the REIT's taxable income for such taxable year.

        Section 857(d)(2) provides that a REIT is generally deemed to have sufficient
E&P to cover any distribution that it treats as a dividend to the extent the distribution,
when combined with other distributions in the same calendar year, does not exceed the
distributions required by section 4981.

        Section 4981 generally levies an excise tax on REITs that do not make required
distributions under that section during the calendar year. In general, a REIT's required
distribution equals at least 85 percent of its current year ordinary income and at least 95
percent of its current year capital gain net income. The remaining percentage of the
REIT's current year ordinary income (up to 15 percent) and its current year capital gain
net income (up to 5 percent) are included in its required distribution in the following
year. For purposes of section 4981, “ordinary income” equals the REIT's taxable
income as determined under section 857(b)(2) without regard to the section
857(b)(2)(B) dividends-paid deduction.

       The House Conference Report for the Tax Reform Act of 1986 states the
following in discussing its rejection of a Senate amendment to section 857:

        The conference agreement does not contain the provision from the Senate
        amendment under which a REIT's [E&P] for a taxable year would not be less
        than its real estate [investment] trust taxable income for the taxable year (without
        regard to the dividends paid deduction), since the conferees believe that this
        provision is a restatement of present law.2

H.R. Conf. Rep. No. 99-841, at 218-19 (1986). Therefore, the regime governing the
taxation of REITs, which requires distributions of taxable income, is intended to match
the REIT's E&P to that income.

       As noted above, Taxpayer represents that it will take the correlative adjustments
arising from the Method Changes in computing depreciation and amortization for E&P


2 Prior to enactment of the Tax Reform Act of 1986, a version of the bill amended and passed by the

Senate included a provision stating that “the earnings and profits of a real estate investment trust for any
taxable year (but not its accumulated earnings) . . . shall not be less than its real estate investment trust
taxable income for such taxable year determined without regard to the deduction for dividends paid (as
defined in section 561).” See H.R. 3838, 99th Cong. § 1434(b) (as passed by the Senate, June 24, 1986).
PLR-124812-21                                  7

purposes into account ratably over the same period as its distributive share of the OP
Section 481(a) Adjustments. Due to differences in computing depreciation and
amortization for E&P purposes versus for income tax purposes, Taxpayer's correlative
adjustments to its E&P may be lower than its distributive share of the OP Section 481(a)
Adjustments.

       Taxpayer represents that its share of the OP Section 481(a) Adjustments will not
be subject to the section 1374 built-in gains tax, which tax (where applicable) is not
eliminated or reduced by the dividends-paid deduction per sections 337(d) and 1374 as
well as sections 1.337(d)-7 and 1.1374-4(b) and (d), because Taxpayer’s share of the
OP Section 481(a) Adjustments relates to depreciation and amortization previously
taken as a REIT (and not to depreciation or amortization previously taken as a non-
REIT C corporation).

       Based on the information submitted and representations made, we rule that to
the extent Taxpayer’s distributive share, determined in accordance with section 704, of
the OP Section 481(a) Adjustments exceeds the correlative E&P adjustments arising
from the Method Changes, any distributions of such excess (that are distributed and
treated as dividends by Taxpayer in the year in which such excess arises) will be
treated as made from E&P.

                                         CAVEATS

       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 or implied regarding
whether Taxpayer otherwise qualifies as a REIT under part II of subchapter M of
chapter 1 of the Code. Additionally, we express no opinion on whether the Sites are
comprised of real property or interests in real property within the meaning of section
1.856-10, the propriety of the amounts of the OP Section 481(a) Adjustments, or the
propriety of the Method Changes.

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

      This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3)
provides that it may not be used or cited as precedent.
PLR-124812-21                                            8

        In accordance with the power of attorney on file with this office, copies of this
letter are being sent to your authorized representatives.



                                                    Sincerely,


                                                    ___________________________
                                                    Bernard Audet
                                                    Senior Technician Reviewer, Branch 3
                                                    Office of Associate Chief Counsel
                                                    (Financial Institutions & Products)


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