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In Private Letter Ruling 201428002, the IRS ruled that a real estate investment trust's (REIT's) right to receive a state franchise tax refund attributable to certain tax credits arising from the redevelopment of real property constitutes a qualifying "receivable" arising in the ordinary course of the REIT's operations within the meaning of Reg. Section 1.856-2(d)(1)(iii), and thus a qualifying asset for purposes of the 75% asset test of Section 856(c)(4)(A).

In addition, the IRS ruled that the income attributable to the receipt of the tax credits constitutes qualifying income for purposes of the 95% and 75% income tests of Sections 856(c)(2) and (3).

Facts

Taxpayer, an entity that has elected to be taxed as a REIT, owns through a series of partnerships a mixed-use real estate development project. The project involves the demolition of an existing building and construction of new retail buildings on contaminated land. To promote the cleanup and redevelopment of contaminated land, the state established two tax credits for entities that successfully complete remedial activities and receive a Certificate of Completion (CoC) from a particular state agency.

Having received a CoC from the state agency for the remediation project, Taxpayer will now be eligible to claim State Tax Credits 1 and 2. The credits are deemed to be overpayments of state franchise tax and refundable to the extent that the credits exceed Taxpayer's liability for franchise tax for the year. Taxpayer records unpaid claims for credits as receivables for purposes of generally accepted accounting principles (GAAP).

The amount of Tax Credit 1 is equal to the sum of a percentage of three types of expenditures:

1. cost of site preparation;

2. cost (or other basis for federal tax purposes) of qualified tangible property placed in service on the site; and

3. cost of on-site groundwater remediation.

Tax Credit 2 is equal to the product of the:

1. benefit period factor

2. employment number factor; and

3. eligible real property taxes imposed on the site.

Taxpayer claimed the credits in the year at issue and anticipates claiming additional credits for up to 10 years, in accordance with the statute. Taxpayer is concerned that: 1) If the value of its claim for refunds generated by the credits is considered to be an "asset" for purposes of Section 856(c)(4)(A), it could exceed 25% of the value of its total assets, resulting in a violation of the asset tests; and 2) To the extent the credits or refunds based on the credits are includable in the Taxpayer's gross income, the income might not qualify under the 95% and 75% income tests of Sections 856(c)(2) and (c)(3).

Law and Analysis

Section 856(c)(4)(A) requires that, at the close of each quarter of its tax year, at least 75% of value of a REIT's total assets must consist of real estate assets, cash and cash items (including receivables) and government securities.

Reg. Section 1.856-2(d)(1)(iii) provides that for purposes of Section 856(c)(4)(A), the term "receivables" means only those receivables which arise in the ordinary course of a REIT's operation and does not include receivables purchased from another person.

Section 856(c)(2) requires a REIT to derive at least 95% of its gross income (excluding gross income from prohibited transactions) from dividends, interest, rents from real property, certain gains from the sale of stock, securities, and real property, and abatements and refunds of taxes on real property, as well as certain other sources of income.

Section 856(c)(3) requires a REIT to derive at least 75% of its gross income (excluding gross income from prohibited transactions) from rents from real property, interest on obligations secured by real property, gain from the sale or other disposition of real property, dividends from REIT stock and gain from the sale of REIT stock, abatements and refunds of taxes on real property, as well as certain other sources of income.

Section 856(c)(5)(J) indicates that, to the extent necessary to carry out the purposes of the REIT provisions, the IRS may determine whether any item of income or gain that does not constitute qualifying income under the 95% or 75% REIT income tests may nevertheless be treated as qualifying income or ignored for purposes of the 95% or 75% REIT income tests. The legislative history of the REIT provisions show that the primary concern of the REIT income tests is to ensure that a REIT's gross income is largely passive income.

In PLR 201428002, the IRS explained that Taxpayer's right to receive the franchise tax refunds stems from the redevelopment of contaminated land in connection with Taxpayer's leasing business, and noted that Taxpayer will own and lease the redeveloped site to generate qualifying rents from real property under Section 856(c)(2). The IRS determined that Taxpayer's right to receive the franchise tax refund attributable to the credits constitutes a receivable arising in the ordinary course of the Taxpayer's operations under Reg. Section 1.856-2(d)(1)(iii), and thus constitutes a qualifying asset for purposes of the 75% asset test of Section 856(c)(4)(A).

In addition, the IRS reasoned that the income attributable to the Tax Credit 2 constitutes gross income tied to the payment of real property taxes by Taxpayer since the basis for Tax Credit 2 is the actual payment of real property taxes imposed on the site. Accordingly, the IRS ruled that the income attributable to Tax Credit 2 is a refund of real property taxes under Sections 856(c)(2)(E) and (c)(3)(E) and thus, qualifying income for purposes of the 95% and 75% income tests of Sections 856(c)(2) and (3).

On the other hand, the IRS explained that income attributable to the receipt of Tax Credit 1 does not constitute qualifying income under Sections 856(c)(2) or (c)(3) because it is not tied to the payment of real property taxes and does not otherwise meet the qualifying requirements of Sections 856(c)(2) or (c)(3). Noting Taxpayer's representation that the rental income generated by the project will constitute qualifying income, and that Tax Credit 1 does not interfere with or impede the objectives of Congress in enacting Section 856(c)(2) and (c)(3), the IRS ruled, pursuant to Section 856(c)(5)(J), that income attributable to Taxpayer's receipt of Tax Credit 1 is considered qualifying income for purposes of Sections 856(c)(2) and (c)(3).

Implications

PLR 201428002 is the first private letter ruling, or recent guidance of any type, that addresses whether a particular receivable constitutes a "receivable arising in the ordinary course of a REIT's operation" within the meaning of Reg. Section 1.856-2(d)(1)(iii), and thus, gives REITs and their advisors insight into the IRS thinking on the "ordinary course receivable" standard.

PLR 201428002 may also indicate a shift by the IRS to first seek out an avenue to treat an asset as a qualifying asset under existing authority rather than turning to its discretion under Section 856(c)(5)(J). For example, contrast PLR 201428002 with (i) PLR 200926014 (Tax Alert 2011-0981), in which the IRS ruled, pursuant to Section 856(c)(5)(J), that a claim brought by a REIT for just compensation for property taken by eminent domain will not be considered in determining whether the REIT satisfies the asset tests of Section 856(c)(4), and (ii) PLR 200916014 (Tax Alert 2009-0654), in which the Service ruled, pursuant to Section 856(c)(5)(J), that a REIT's claim for a refund of state taxes as a result of state tax credits for remediation and development on a contaminated site will not be considered in determining whether the REIT satisfies the 75% asset test under Section 856(c)(4)(A).

PLR 201428002 is also the second private letter ruling to address the treatment of income from state credits/refunds for purposes of the REIT income tests. The conclusion in PLR 201428002 that income attributable to Tax Credit 1 is considered qualifying income for purposes of the 95% and 75% income tests, pursuant to Section 856(c)(5)(J), can be compared with PLR 200528004 (Tax Alert 2005-0577), as supplemented by PLR 200614024, in which the IRS ruled that income attributable to state tax credits for construction on a hazardous waste site will not be considered in determining whether the REIT satisfies the 95% or 75% income tests under Sections 856(c)(2) and (c)(3). PLR 200528004 involves a tax year prior to the enactment of Section 856(c)(5)(J).

The conclusion in PLR 200926014 that income attributable to Tax Credit 2 is a refund of real property taxes under Sections 856(c)(2)(E) and (c)(3)(E) because the credit is "tied to" the payment of real property taxes has similarities with PLR 200403023 in which the IRS ruled that amounts received by a REIT from a municipality as reimbursement for certain costs incurred by the REIT in redeveloping a property (and where the reimbursement was limited to the incremental real property tax assessed against development site) is treated as an abatement and refund of taxes on real property within the meaning of Section 856(c)(2)(E).

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