Forest carbon offsets produced qualifying income for a REIT

Plain-English summary

A company intending to elect REIT status owned commercial forestland and participated in a verified carbon-sequestration project. It agreed to long-term limits on timber harvesting and other land uses, and a registry issued carbon offsets based on the additional carbon expected to be stored because of those restrictions. The IRS viewed the offsets as similar to payment for granting a term easement over real property. It ruled that income from issuance of the offsets would count toward the REIT income tests under section 856(c)(2) and (c)(3). For accrual timing, the income would generally be included when the offsets were first earned, received, or due, unless section 451(b)(1)(A) required earlier inclusion. The ruling did not treat later gains from selling the offsets as qualifying income or decide whether the company otherwise qualified as a REIT.

Ruling snapshot

• Question: When did income from forest carbon offsets accrue, and did issuance of those offsets produce qualifying REIT income?
• Outcome: approved
• Key authorities: IRC §§ 451, 856(c)(2), 856(c)(3), 856(c)(5)(J)(ii); Treas. Reg. §§ 1.856-3, 1.856-4, 1.856-10

Full text (IRS public release)

Internal Revenue Service                                  Department of the Treasury
                                                           Washington, DC 20224

 Number: 202402002                                         Third Party Communication: None
 Release Date: 1/12/2024                                   Date of Communication: Not Applicable
 Index Number: 856.00-00                                   Person To Contact:
                                                           -------------, ID No. -----------------
 ------------                                              Telephone Number:
 ---------------------------                               --------------------
 -------------------------------                           Refer Reply To:
 -------------------------                                 CC:FIP:B03
 --------------------                                      PLR-107823-23
                                                           Date:
                                                           October 6, 2023



Legend

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

Registry                           =   -----------------------------------

Subsidiary                         =   -------------------------------------------

Intermediary                       =   ------------------------------------------------------------------------

Agreement                          =   ------------------------------------------------------------------------
                                       ------------------------------

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

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

a                                  =   -----------

b                                  =   ---------

c                                  =   ---

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

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


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

        This responds to a letter dated April 4, 2023, and subsequent correspondence,
submitted on behalf of Taxpayer. For purposes of its status as a real estate investment
trust (“REIT”) under § 856 of the Internal Revenue Code (“Code”), Taxpayer requests

PLR-107823-23                                 2

certain rulings regarding the treatment of income from Registry’s issuance of the Offsets
(defined below) to Taxpayer in exchange for Taxpayer agreeing to the restrictions in the
Agreement:

       (1) Unless § 451(b)(1)(A) requires earlier inclusion, income with respect to
       the issuance of the Offsets accrues under § 451 upon the earliest of the
       following events to occur: the Offsets are earned, the Offsets are received,
       or the Offsets are due; and

       (2) Pursuant to § 856(c)(5)(J)(ii), income from the issuance of the Offsets
       will be considered qualifying income under § 856(c)(2) and (c)(3).

                                          FACTS

      Taxpayer is a State A limited liability company that intends to elect to be taxed as
a REIT for federal income tax purposes.

       Taxpayer wholly owns Subsidiary, a State A limited liability company that is
disregarded as separate from Taxpayer for federal income tax purposes. Taxpayer
owns approximately a acres of commercial forestland in State B, of which Subsidiary
owns approximately b acres (the acreage owned in State B by Subsidiary, the “Site”).
The Site qualifies as real property within the meaning of § 856, and substantially all of
the Site is land, including unsevered natural products of the land (e.g., trees), within the
meaning of § 1.856-10(c) of the Income Tax Regulations.

       Taxpayer uses an accrual method of accounting for federal income tax purposes,
and its taxable year is the calendar year.

        Registry is a greenhouse gas registry and emissions tracking system used by
members to transparently register project-based verified emissions reductions and
removals as serialized offsets and to record the issuance, retirement, and cancellation
of these offsets. Taxpayer (through Subsidiary) participates in a carbon sequestration
project involving the development and implementation of forestland management
parameters on the Site designed to enhance the Site’s long-term capacity to sequester
atmospheric carbon (the “Project”). Pursuant to the Agreement between Intermediary
and the prior owner of the Site (the “Seller”), Intermediary developed the Project for the
Seller in compliance with the requirements of Registry. As of Date 1, Subsidiary had
acquired the Site from the Seller and had assumed all rights, title, and interests in the
Agreement and succeeded the Seller with respect to the Project. The Project is
expected to end no earlier than Date 2.

        The Agreement establishes the framework under which Intermediary, as
Taxpayer’s technical consultant, will develop projects on the Site for Taxpayer and sets
forth the respective rights and obligations of the owner of the Site and Intermediary with
respect to the Project. Development of the Project involves calculating the estimated

PLR-107823-23                                  3

quantity of additional carbon that can be sequestered at the Site through improved
forest management (e.g., harvesting at levels below those otherwise allowable under
existing law, regulations, and other restrictions) and submitting those calculations and
estimates for independent verification in accordance with the standards of Registry.
Once the quantity of additional carbon estimated to be sequestered at the Site under
the Project is verified, the Project is eligible for carbon emission offsets (the “Offsets”).
The quantity of Offsets for which the Project is eligible is directly linked to the
sequestration of additional carbon resulting from the improved forest management
identified in the Project.

        The Site is all of the land currently owned by Subsidiary. The Site is described in
detail in the Project documents. The owner of the Site agrees to comply with the
Project’s improved forest management requirements associated with the Offsets. The
Restrictions are restrictions that could be recorded as easements under local law.
Restrictions from the Project include the following land use restrictions (the
“Restrictions”):

       1. Not to conduct any activities that will result in a reversal of sequestered
          carbon or the ability of the Site to generate specified Offsets;

       2. Not to harvest above a specified volume of timber each year or a
          volume in excess of a specified amount of growth in a single year;

       3. Not to conduct activities on the Site that will result in material
          reductions of Offsets arising from Taxpayer’s voluntary activities that
          result in the aggregate harvest levels exceeding the aggregate
          projected harvest on the project by more than c percent; and

       4. To manage the Site in a manner to ensure compliance with the
          requirements of the program in which the Site is enrolled.

        Taxpayer has committed to the Restrictions until at least Date 2, unless Taxpayer
sells the Site and the new owner properly assumes Taxpayer’s obligations. The
Restrictions apply only to property that is subject to the Project under the Agreement
and, upon registration of the Offsets, are binding on the Site for the duration of the
Project. Taxpayer may add additional parcels of land under the Agreement that may
also generate Offsets if included in future carbon sequestration projects or an expansion
of the Project. The Registry requires Taxpayer to assess the risk of reversal of the
Offsets and select a risk mitigation mechanism for the Project. Taxpayer has elected to
participate in the Registry’s buffer pool. In order to participate in the Registry’s buffer
pool, Taxpayer must contribute a risk-adjusted number of Offsets to the Pool. In the
event of an unintentional reversal of Offsets (e.g., a forest fire) that exceeds the number
of Offsets that Taxpayer has contributed to the Buffer Pool, Taxpayer will be required to
contribute Offsets equal to a percentage of the excess of reversed Offsets over the
contributed Offsets. In the event of an unintentional reversal of Offsets, Taxpayer is not

PLR-107823-23                                4

otherwise required to replenish its buffer pool contribution. On the other hand, in the
event of an intentional reversal of Offsets, Taxpayer will be required to replace all
reversed Offsets.

        Pursuant to the Agreement, Intermediary analyzes the Site and develops
forestland development parameters complying with the Registry’s standards to ensure
that the Site complies with the Project’s requirements to be eligible to generate the
Offsets. The Project is filed with the Registry, and the Offsets are issued based on the
quantity of additional carbon that can be sequestered at the Site due to the Restrictions.
After verification of the quantity and type of Offsets attributable to the Site each
reporting period, the Offsets attributable to that reporting period are registered by the
Registry. Upon registration of the Offsets by the Registry, the Registry awards Offsets
to Taxpayer, Taxpayer transfers the Offsets to Intermediary, and Intermediary markets
the Offsets for sale to third parties that are unrelated to Taxpayer (each a “Buyer”).
Under the Agreement, Intermediary agrees to aggregate, market, and ultimately sell the
Offsets to Buyers under one or more independently operated carbon service credit
trading regimes. Taxpayer bears the benefits and burdens of ownership of the Offsets
from the issuance of the Offsets to Taxpayer until the sale of the Offsets by Intermediary
to Buyers. Neither Taxpayer nor its subsidiaries intend to hold the Offsets for the
purposes of speculating on future appreciation.

        Taxpayer represents that Taxpayer will include the fair market value of the
Offsets upon issuance in gross income. Income from the Offsets is intended to
compensate Taxpayer for the loss of revenue from otherwise permissible timber sales
and the decrease in value and income resulting from Taxpayer’s adherence to the
Restrictions. Upon the eventual sale of the Offsets, proceeds are remitted to Taxpayer
with Intermediary retaining a portion of the proceeds as commission. Taxpayer will treat
any gain from the sale of the Offsets as income not qualifying under § 856(c)(2) and
(c)(3).

                                  LAW AND ANALYSIS

       Section 61(a) defines gross income as “income from whatever source derived,”
except as otherwise provided by law. See § 1.61-1(a). Gross income includes income
realized in any form, whether in money, property, or services. Id. This definition
encompasses all “accessions to wealth, clearly realized, and over which the taxpayers
have complete dominion.” Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431
(1955).

       Section 451 and the regulations thereunder provide rules for determining the
taxable year of inclusion for items of gross income.

       Under an accrual method of accounting, unless § 451(b)(1)(A) requires earlier
inclusion, an item of gross income is generally includible when all the events have
occurred which fix the right to receive such income and the amount thereof can be

PLR-107823-23                                5

determined with reasonable accuracy. All the events that fix the right to receive income
generally occur upon the earliest of the following: (1) the required performance takes
place, (2) payment is due, or (3) payment is made. See Schlude v. Commissioner, 372
U.S. 128 (1963); Rev. Rul. 2003-10, 2003-1 C.B. 288. However, § 451(b)(1)(A) sets
forth special rules requiring earlier inclusion in the case of certain accrual-method
taxpayers.

        Section 856(c)(2) provides that for a corporation to qualify as a REIT for any
taxable year, at least 95 percent of its gross income (excluding gross income from
prohibited transactions) must be derived from sources that 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,
certain commitment fees, and gain from certain sales or other dispositions of real estate
assets.

        Section 856(c)(3) provides that for a corporation to qualify as a REIT for any
taxable year, 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 real property, gain from the sale or other disposition
of real property (other than property in which the corporation is a dealer), dividends from
REIT stock 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, gain from certain sales or other dispositions of real estate assets, and qualified
temporary investment income.

        Section 856(d)(1) provides that rents from real property include (subject to
exclusions provided in § 856(d)(2)): (A) rents from interests in real property; (B) charges
for services customarily furnished or rendered in connection with the rental of real
property, whether or not such charges are separately stated; and (C) rent attributable to
personal property leased under, or in connection with, a lease of real property, but only
if the rent attributable to the personal property for the taxable year does not exceed 15
percent of the total rent for the taxable year attributable to both the real and personal
property leased under, or in connection with, the lease.

        Section 856(c)(5)(J) provides that to the extent necessary to carry out the
purposes of part II of subchapter M of Chapter 1 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 § 856(c)(2) or (c)(3) may be considered as
not constituting gross income for purposes of § 856(c)(2) or (c)(3), or (ii) whether any
item of income or gain that otherwise constitutes gross income not qualifying under §
856(c)(2) or (c)(3) may be considered as gross income that qualifies under § 856(c)(2)
or (c)(3).

PLR-107823-23                                6

       Section 1.856-4(a)(1) provides that, subject to the exceptions of § 856(d) and
§ 1.856-4(b), the term “rents from real property” means, generally, the gross amounts
received for the use of, or the right to use, real property of the REIT.

        Under § 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 § 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 § 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, 86 th
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.”

        Taxpayer earns the Offsets as a result of agreeing to and complying with
Restrictions that satisfy Registry’s standards for carbon sequestration at the Site. The
Agreement imposes land-use restrictions by requiring Taxpayer to abstain from certain
uses of its land and perform certain actions on its land. Taxpayer has represented that
such land-use restrictions are restrictions that could be recorded as easements under
local law. Under the Agreement, Taxpayer will incur penalties if it does not abide by the
Restrictions to which it has agreed. For these reasons, the Offsets are akin to receiving
payment for granting an easement for a term of years with respect to the real property.
Cf. Wineberg v. Commissioner, 326 F.2d 157, 169-70 (9th Cir. 1963) (holding amount
received for granting 10-year right to use a road was rent rather than sale of an interest
in land), aff’g T.C. Memo. 1961-336; Nay v. Commissioner, 19 T.C. 114, 119 (1952)
(concluding amount received for granting a “right of way” for a term not to exceed three
years is ordinary income because such a “limited easement” does not constitute sale of
real property). Under these circumstances, treating Taxpayer’s income with respect to
the issuance of the Offsets as qualifying income does not interfere with or impede the
objectives of Congress in enacting § 856(c)(2) and (c)(3).

                                    CONCLUSIONS

       Based on the information submitted and representations made, we rule as
follows:

      (1) Unless § 451(b)(1)(A) requires earlier inclusion, income with respect to the
issuance of the Offsets will accrue under § 451 upon the earliest of the following events

PLR-107823-23                                  7

to take place: the Offsets are earned, the Offsets are received, or the Offsets are due;
and

      (2) Pursuant to § 856(c)(5)(J)(ii), income from the issuance of the Offsets will be
considered qualifying income under § 856(c)(2) and (c)(3).

        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 with
regard to whether Taxpayer otherwise qualifies as a REIT under subchapter M of the
Code. Furthermore, no opinion is expressed with respect to the tax consequences of
any dispositions of the Offsets, including whether a sale of the Offsets gives rise to
qualifying income under § 856(c)(2) or (c)(3) and whether such a sale constitutes a
prohibited transaction as described in § 857(b)(6)(B)(iii). This letter ruling relates only to
those Offsets earned by Taxpayer, and no opinion is expressed regarding any Offsets
earned by, or issued to, Seller that Taxpayer received after purchasing the Site.

      The rulings contained in this letter are based upon information and
representations submitted by Taxpayer and accompanied by a penalty of perjury
statement 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 requesting it. Section 6110(k)(3) of
the Code provides that it may not be used or cited as precedent.

PLR-107823-23                                            8

         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,



                                                Jason D. Kristall
                                                Chief, Branch 3
                                                Office of Associate Chief Counsel
                                                (Financial Institutions & Products)


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