REIT's late interest-rate hedge identification was inadvertent

Plain-English summary

A REIT subsidiary entered into an interest-rate cap required by a floating-rate loan used to acquire or carry real estate. The REIT's accounting firm mistakenly believed that no tax hedge identification was needed because the cap was a loan condition rather than a separate investment. After tax counsel discovered the issue, the REIT promptly executed a retroactive identification and adopted a procedure for identifying future hedges on the day they are entered. The IRS concluded that the failure was an inadvertent error under the hedge regulations. If the other identification requirements were satisfied, the REIT could treat the cap as identified from its original date for purposes of excluding qualifying hedge income from the REIT gross-income tests.

Ruling snapshot

• Question: Could the REIT treat a late identification of its interest-rate cap as timely because the omission was inadvertent?
• Outcome: approved, subject to all other hedge-identification requirements
• Key authorities: IRC §§ 856(c)(5)(G), 1221(a)(7), 1221(b)(2); Treas. Reg. §§ 1.1221-2(f), 1.1221-2(g)(2)

Full text (IRS public release)

 Internal Revenue Service                                       Department of the Treasury
                                                                Washington, DC 20224

 Number: 202419004                                              Third Party Communication: None
 Release Date: 5/10/2024                                        Date of Communication: Not Applicable
 Index Numbers: 856.01-00, 1221.12-02
                                                                Person To Contact:
                                                                ------------------, ID No. -----------------
                                                                Telephone Number:
 -------------------------                                      --------------------
 -------------------------                                      Refer Reply To:
 -----------------------------------                            CC:FIP:B03
 ----------------------------------------                       PLR-116233-23
 -------------------------                                      Date:
                                                                February 09, 2024




LEGEND:


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

Funds                      =        --------------------------------------------------------------------------------
         ---------
                                    ---------------------------------------------------------------------------------
                                    ----------------------------

Company A                  =        -------------------------------------

Company B                  =        ------------------------------

Counterparty               =        -------------------------------------

Property                   =        ------------------------------------------------------

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

Law Firm                   =        -----------------------------
PLR-116233-23                                             2



Accounting Firm          =        ------------------------------

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

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

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

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

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

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

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

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

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

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

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

b                        =        --

c                        =        -----

d                        =        ---------

e                        =        ---



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

        This letter responds to a letter dated August 8, 2023, and subsequent
correspondence, requesting a ruling on behalf of Taxpayer. Taxpayer requests a ruling
that its failure to identify an interest rate cap as a hedging transaction under § 1.1221-
2(f)(1) and (2) of the Income Tax Regulations (the “Regulations”) was due to Taxpayer's
inadvertent error.
PLR-116233-23                                3


                                         FACTS

       Taxpayer is a State limited liability company that was formed on Date 1.
Taxpayer elected to be treated as a real estate investment trust (“REIT”) under §§ 856
through 859 of the Internal Revenue Code (the “Code”) beginning with its initial taxable
year that ended Date 2. Since Date 3, Funds have collectively owned 100 percent of
the common shares of Taxpayer.

        Company A, a State limited liability company, also formed on Date 1, is a wholly
owned subsidiary of Taxpayer. At all times since its formation, Company A has been
classified as a disregarded entity of Taxpayer for federal income tax purposes.

        On Date 4 (the “Note Execution Date”), Company A issued a debt instrument (the
“Note'') to Company B (the “Lender”). The terms of the Note, provide for a principal
commitment amount of a, a term of b years, and a floating interest rate equal to c basis
points plus the applicable d average of the secured overnight financing rate. Company
A issued the Note to the Lender to obtain financing to acquire or carry real estate
assets, which are the land and improvements thereon located at Property. Additionally,
Taxpayer represents that in each taxable year, beginning with Taxpayer’s first REIT
taxable year, at least e percent of the gross income derived from Property has qualified
as rents from real property within the meaning of § 856(d) of the Code.

        Under the terms of the Note, Company A was required to enter into an interest
rate cap agreement as a condition precedent for issuing the Note. Accordingly, on the
Note Execution Date, Company A entered into an interest rate cap agreement with a
duration of b years with Counterparty to manage the risk of interest rate fluctuations with
respect to the floating interest rate payments Company A is required to make under the
Note (the “Interest Rate Cap”). Under the terms of the Interest Rate Cap, Counterparty
is obligated to pay Company A certain amounts to the extent the market interest rate
rises above a target interest rate.

       Starting Date 5, the floating interest rate payable by Company A to Company B
under the Note has exceeded the target interest rate under the Interest Rate Cap.
Accordingly, under the terms of the Interest Rate Cap, beginning on Date 6,
Counterparty has made monthly payments to Company A (“Interest Rate Cap Income").

       Law Firm provides Funds with REIT tax advice. During Date 7, in connection
with a due diligence inquiry conducted by Law Firm for Funds on another entity besides
Taxpayer, Law Firm raised an issue about the proper identification of certain hedging
transactions similar to Taxpayer’s Interest Rate Cap. Funds informed Law Firm that
they were unaware of any hedge identification requirements and, therefore, none of
their entities had identified similar interest rate caps.
PLR-116233-23                                 4

       Members of Accounting Firm, the external accountants for Funds, are generally
familiar with and knowledgeable about the rules regarding REIT compliance matters.
Nevertheless, Accounting Firm erroneously believed at the time of the Note Execution
Date, that identification of a hedging transaction was not required because the Interest
Rate Cap was not a separate, strategic investment from the Note, but rather was
entered into by Taxpayer as a condition precedent for Lender to make the loan.

       On Date 8, Funds provided Law Firm with a description of the Interest Rate Cap
entered into by Taxpayer, and informed Law Firm that Taxpayer had not identified the
Interest Rate Cap in accordance with the federal tax hedge identification requirements
of § 1221(f)(7) of the Code and § 1.1221-2(f) of the Regulations (“Hedge Identification
Requirements”). Upon learning that Taxpayer had not identified the Interest Rate Cap
in accordance with the Hedge Identification Requirements, Law Firm promptly notified
Funds and Taxpayer that they were required to comply with the Hedge Identification
Requirements so that amounts that may become payable under the Interest Rate Cap
are excluded from gross income for purposes of the REIT gross income tests. Law Firm
advised Funds and Taxpayer to promptly identify the Interest Rate Cap as a hedge in
order to comply as closely as possible with the Hedge Identification Requirements.

      On Date 9, Taxpayer executed a hedge identification for the Interest Rate Cap
dated as of the Note Execution Date, that satisfied the Hedge Identification
Requirements (except for the timing requirements).

        Taxpayer represents that it treated the Interest Rate Cap as a hedging
transaction within the meaning of § 1221(b)(2)(A) for all open years and that the Interest
Rate Cap is the only hedging transaction within the meaning of § 1221(b)(2)(A) entered
into by Taxpayer during any taxable year open under the statute of limitations on
assessment. Taxpayer further represents that it has (i) accounted for and will continue
to account for gain or loss resulting from the Interest Rate Cap in accordance with
§ 1.446-4(e)(4) of the Regulations, and (ii) accounted for and intends to continue to
account for gain or loss resulting from the Interest Rate Cap as excluded from the
definition of gross income for purposes of applying § 856(c)(2) and (3).

        Furthermore, to avoid another failure to timely identify a hedge in the future, after
Law Firm informed Funds and Taxpayer of the Hedge Identification Requirements,
Funds and Taxpayer established a procedure whereby any subsequent hedge entered
into by Taxpayer will result in the completion of a form provided by Law Firm (the
“Hedge Identification Form”) that is designed to ensure that the Hedge Identification
Requirements are satisfied. The procedure requires Taxpayer to execute the Hedge
Identification Form on the day the applicable hedge is entered into by Taxpayer.

       On Date 10, the controller of Funds prepared an internal memorandum on behalf
of Taxpayer memorializing Taxpayer’s belief that its failure to identify the Interest Rate
Cap as a hedging transaction and the applicable interest rate risk with respect to the
interest rate on the Note as a hedged item in accordance with the Hedge Identification
PLR-116233-23                                 5

Requirements was due to inadvertent error. Accounting Firm believed that entering into
a tax identification consistent with the Hedge Identification Requirements was not
necessary because the Interest Rate Cap was not a strategic investment separate from
the Note, but was only entered into because it was required by Lender. Because
Taxpayer relied on Accounting Firm’s expertise and advice, Taxpayer did not follow the
Hedge Identification Requirements at the time it entered into the Interest Rate Cap. The
memorandum concludes that consequently, Taxpayer’s failure to identify the Interest
Rate Cap as a hedging transaction was not deliberate, but rather was an accidental
oversight. The memorandum also states that Taxpayer has accounted for and will
continue to account for gain or loss attributable to the Interest Rate Cap in accordance
with § 1.446-4(e)(4).

                                  LAW AND ANALYSIS

      Section 61 of the Code provides that, except as otherwise provided, gross
income includes all income from whatever source derived.

       Section 856(c)(2) provides that at least 95 percent of a REIT’s gross income
(excluding gross income from prohibited transactions) must be derived from dividends,
interest, rents from real property, and certain other specifically enumerated items.

       Section 856(c)(3) provides that at least 75 percent of a REIT’s gross income
(excluding gross income from prohibited transactions) must be derived from rents from
real property and certain other specifically enumerated items (together with § 856(c)(2),
the “REIT Gross Income Tests”).

       Section 856(c)(5)(G)(i) generally provides that any income from a hedging
transaction (as defined in clause (ii) or (iii) of § 1221(b)(2)(A)) including gain from the
sale or disposition of such a transaction, shall not constitute gross income for purposes
of the REIT Gross Income Tests to the extent that the transaction hedges any
indebtedness incurred or to be incurred by the REIT to acquire or carry real estate
assets.

       Section 856(c)(5)(G)(iv) provides that § 856(c)(5)(G) shall not apply with respect
to any transaction unless such transaction satisfies the identification requirement
described in § 1221(a)(7) (determined after taking into account any curative provisions
provided under the Regulations referred to therein).

       Section 1221(a)(7) provides that the term “capital asset” does not include a
hedging transaction which is clearly identified as such before the close of the day on
which it was acquired, originated, or entered into (or such other time as the Secretary
may by regulations prescribe).

      Section 1221(b)(2)(A) provides that the term “hedging transaction” means any
transaction entered into by the taxpayer in the normal course of the taxpayer’s trade or
PLR-116233-23                                 6

business primarily (i) to manage risk of price changes or currency fluctuations, with
respect to ordinary property which is held or to be held by the taxpayer, (ii) to manage
risk of interest rate or price changes or currency fluctuations with respect to borrowings
made or to be made, or ordinary obligations incurred or to be incurred, by the taxpayer,
or (iii) to manage such other risks as the Secretary may prescribe in regulations.

        Section 1.1221-2(d)(2) provides that a transaction that economically converts an
interest rate from a fixed rate to a floating rate or that converts an interest rate from a
floating rate to a fixed rate manages risk.

      Section 1.1221-2(f)(1) provides that a taxpayer that enters into a hedging
transaction must clearly identify it as a hedging transaction before the close of the day
on which the taxpayer acquired, originated, or entered into the transaction.

        Section 1.1221-2(f)(2)(i) provides that a taxpayer that enters into a hedging
transaction must identify the item, items, or aggregate risk being hedged. Identification
of an item being hedged generally involves identifying a transaction that creates risk,
and the type of risk that the transaction creates.

        Section 1.1221-2(f)(2)(ii) provides that an identification required by § 1.1221-
2(f)(2) must be made substantially contemporaneously with entering into the hedging
transaction. A hedge identification is not substantially contemporaneous for this
purpose if it is made more than 35 days after entering into the hedging transaction.

        Section 1.1221-2(g)(2)(i) provides that except as provided in § 1.1221-2(g)(2)(ii)
and (iii), the absence of an identification that satisfies the requirements of § 1.1221-
2(f)(1) is binding and establishes that a transaction is not a hedging transaction.

        Section 1.1221-2(g)(2)(ii) provides that if a taxpayer does not make an
identification that satisfies the requirements of § 1.1221-2(f), the taxpayer may treat gain
or loss from the transaction as ordinary income or loss under § 1.1221-2(a)(1) or (2) if
(A) the transaction is a hedging transaction (as defined in § 1.1221-2(b)), (B) the failure
to identify the transaction was due to inadvertent error, and (C) all of the taxpayer’s
hedging transactions in all open years are being treated on either original or, if
necessary, amended returns as provided in a § 1.1221-2(a)(1) and (2).

        Although Taxpayer represents that the Interest Rate Cap meets the definition of
a hedging transaction within the meaning of § 1.1221-2(b), Taxpayer did not timely
identify the swap in accordance with § 1.1221-2(f). Under § 1.1221-2(g)(2), failure to
identify a hedge as such generally prohibits the transaction from being treated as a tax
hedge, unless the failure was inadvertent and other requirements are met.

      The issue here is the meaning of the term "inadvertent error" in the context of
§ 1.1221- 2(g)(2)(ii). Section 1.1221-2(g)(2)(ii) does not define the term. In the
absence of a specific definition in the regulations, the term “inadvertent error” should be
PLR-116233-23                                7

given its ordinary meaning. See McClelland Farm Equipment Co. v. United States, 601
F.2d 365, 368 (8th Cir. 1979) (“The words of regulations … should be interpreted where
possible in their ordinary, everyday senses."); Bookwalter v. Mayer, 345 F.2d 476, 479
(8th Cir. 1965). The ordinary meaning of the term "inadvertence" is "[a]n accidental
oversight; a result of carelessness." Black’s Law Dictionary (11 th ed. 2019).

        Furthermore, the determination as to whether an act or omission constitutes
inadvertent error must be based on all relevant facts and circumstances. Taxpayer
represents that it relied on the advice and expertise of Accounting Firm. Accounting
Firm mistakenly believed that entering into a tax identification consistent with the Hedge
Identification Requirements was not necessary because the Interest Rate Cap was not
a strategic investment separate from the Note, but was only entered into because it was
required by Lender.

       Additionally, promptly upon learning that Taxpayer had not properly identified the
Interest Rate Cap, Taxpayer made reasonable and substantial efforts to correct the
unidentified Interest Rate Cap in accordance with the Hedge Identification
Requirements (other than with respect to the timing requirements).

       Moreover, upon becoming aware of the Hedge Identification Requirements and
their applicability to the Interest Rate Cap, Funds and Taxpayer established a procedure
to properly and timely identify any future hedge, as required by the Hedge Identification
Requirements.

       Accordingly, after considering all the relevant facts and circumstances, we
conclude that Taxpayer’s failure to identify the Interest Rate Cap was due to inadvertent
error within the meaning of § 1.1221-2(g)(2)(ii).

                                     CONCLUSIONS

       Based on the facts and representations submitted, we rule that Taxpayer's failure
to identify the Interest Rate Cap as required by the Hedge Identification Requirements
was due to Taxpayer's inadvertent error, within the meaning of § 1.1221-2(g)(2)(ii)(B),
and, therefore, the timing of Taxpayer’s identification will not cause the hedging
transaction to be treated as not identified under § 1.1221-2(g)(2)(i). Accordingly, if the
Hedge Identification Requirements have been otherwise properly satisfied, Taxpayer
may treat, for purposes of § 856(c)(5)(G)(iv), the late identification of the Interest Rate
Cap as satisfying the Hedge Identification Requirements, beginning with the date
Taxpayer entered into the Interest Rate Cap.

        Except as expressly provided herein, no opinion is expressed or implied
concerning the federal income tax consequences of the transactions described above.
In particular, no opinion is expressed or implied as to whether Taxpayer otherwise
qualifies as a REIT under § 856. Also, no opinion is expressed or implied regarding
whether Taxpayer’s Interest Rate Cap hedges the interest rate risk of the Note.
PLR-116233-23                                  8

Additionally, no opinion is expressed or implied regarding whether the Interest Rate Cap
is a hedging transaction as defined in § 1.1221-2(b), if Taxpayer has treated on federal
income tax returns its hedging transactions in all open years as provided in § 1.1221-
2(a)(1) and (2), and if Taxpayer met the non-timing requirements of the hedge
identification rules of § 1221(a)(7) and § 1.1221-2. Furthermore, no opinion is
expressed or implied regarding whether Taxpayer’s method of accounting for the
Interest Rate Cap is a method that clearly reflects income under § 1.446-4.

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

       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.



                                                   Sincerely,



                                                   ______________________________
                                                   Andrea M. Hoffenson
                                                   Senior Technician Reviewer, Branch 3
                                                   Office of the Associate Chief Counsel
                                                   (Financial Institutions & Products)




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