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In PLR 201518010, the IRS ruled that the right of a parent real estate investment trust (REIT) (Parent REIT) and each of its subsidiary REITs (Subsidiary REITs) 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

Parent REIT organized the Subsidiary REITs to own, develop, and operate a real estate development project (the Project) in State A. The Project includes the construction of three separate residential rental apartments, which will be developed in three phases. The Project site was required to be subdivided into three separate tax lots for each of the three expected phases of construction.  Such subdivision requiring governmental approvals and the approval process could not be completed until the old buildings standing on the Project site are demolished.  The tax lots attributable to each phase are required to be contributed to a separate Subsidiary REIT.  

State A has a tax-credit program to enhance private-sector cleanups of brownfields and reduce development pressure on "greenfields." The Tax Credit is deemed to be an overpayment of state franchise tax and refundable to the extent that the credits exceed Taxpayer's liability for franchise tax for the year. Each Subsidiary REIT to which the tax lots are attributable will claim the Tax Credit for that lot.  Taxpayer anticipates that the Tax Credit claims will be considered assets that are receivables for purposes of generally accepted accounting principles (GAAP).

The amount of the Tax Credit equals a percentage of three types of expenditures:

1. Cost of site preparation

2. Cost of qualified tangible used by the taxpayer for industrial, commercial, recreational or residential housing (including the commercial development of residential housing)

3. Cost of on-site groundwater remediation

Parent REIT and the Subsidiary REITs sought rulings under the REIT income and asset provisions because: 1) if the value of the claims for refund generated by the Tax Credits are considered to be "assets" for purposes of Section 856(c)(4)(A), it could exceed 25% of the value of Parent REIT and Subsidiary REIT’s total assets, resulting in a violation of the asset tests unless the assets are qualified assets; and 2) to the extent the Tax Credits or refunds based on the credits are includable in the Parent REIT’s or each Subsidiary REIT’s gross income, the income may substantially exceed 5% of the Parent REIT’s or each Subsidiary REIT’s gross income for purposes of 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.

For purposes of Section 856(c)(4)(A), Treas. Reg. Section 1.856-2(d)(1)(iii) defines "receivables" as only those receivables arising in the ordinary course of a REIT's operation. The term 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 and not from the active conduct of a trade or business.

In PLR 201518010, the IRS explained that the Parent REIT and Subsidiary REIT’s right to receive a state franchise refund attributable to the Tax Credits arises from the redevelopment of real property in connection with the leasing business of the Parent REIT and the Subsidiary REITs, and noted that the Parent REIT and the Subsidiary REIT’s will own and lease the Project to generate qualifying rents from real property under Section 856(c)(2). The IRS determined that the Parent REIT and the Subsidiary REIT’s right to receive the franchise tax refund attributable to the Tax Credits constitutes a receivable arising in the ordinary course of the Parent REIT and Subsidiary REIT’s operations under Treas. Reg. Section 1.856-2(d)(1)(iii), and thus is a qualifying asset for purposes of the 75% asset test of Section 856(c)(4)(A).

On the other hand, the IRS explained that income attributable to the receipt of Tax Credit constitutes gross income that is not listed as derived from a qualifying source under Section 856(c)(2) or (c)(3). Noting the representation that the rental income generated by the Project will constitute qualifying income, and that Tax Credit does not interfere with or impede the objectives of Congress in enacting Section 856(c)(2) and (c)(3), the IRS ruled, under Section 856(c)(5)(J), that income attributable to the receipt of Tax Credit is considered qualifying income for purposes of Section 856(c)(2) and (c)(3).

Implications

PLR 201518010 is the second private letter ruling, that addresses whether a particular receivable constitutes a "receivable arising in the ordinary course of a REIT's operation" within the meaning of Treas. Reg. Section 1.856-2(d)(1)(iii). In PLR 201428002 (Tax Alert 2014-1304), the IRS also ruled favorably on similar facts, noting that the right to receive the state tax credits arose from the redevelopment of contaminated land in connection with a REIT’s leasing business and therefore was receivable in the ordinary course of the REIT’s business.  PLR 201518010 and PLR 201428002 can be contrasted with PLR 200926014 (Tax Alert 2011-0981), in which the Service ruled that, under Section 856(c)(5)(J), 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 201518019 is also the third private letter ruling to address the treatment of income from state credits/refunds for purposes of the REIT income tests. The conclusion in PLR 201518010 that income attributable to the Tax Credits is considered qualifying income for purposes of the 95% and 75% income tests, under Section 856(c)(5)(J), is consistent with the conclusion in PLR 201428002 that income from certain state tax credits was qualifying income for purposes of the 95% and 75% income tests. PLR 201518019 can be contrasted 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).

These rulings should be of interest to REITs that are developing real estate projects under a state sponsored program that results in refundable credits.

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