In PLR 201652012, the IRS ruled that the gross income of a real estate investment trust (REIT) from positive Section 481(a) adjustments (resulting from a change in a method of accounting for depreciation and amortization) will not constitute gross income for purposes of the 95% and 75% income tests of Sections 856(c)(2) and (c)(3). In addition, the IRS ruled that, to the extent that the Section 481(a) adjustments exceed the correlative E&P adjustments, any distributions of that excess (that are distributed and treated as dividends in the year in which the excess arises) will be treated as made from E&P.

Facts

Taxpayer is a REIT that acquires, leases, purchases, develops, and builds large storage buildings and licenses storage space within those buildings to tenants. Taxpayer acquired the stock of an affiliated group of domestic corporations that files a consolidated tax return (Target) as a taxable REIT subsidiary. Target was subsequently restructured and Target's assets (the Assets) became a part of Taxpayer in a carryover basis transaction through the merger and liquidation of Target into a disregarded entity of Taxpayer.

Taxpayer caused Target to submit Forms 3115, Application for Change in Accounting Method, to change its methods of accounting for depreciation and amortization of the Assets (the Method Changes). As a result, Taxpayer represents that it will be required to include positive Section 481(a) adjustments in its taxable income during its Year 1, Year 2, and Year 3 tax years (the Section 481(a) Adjustments).

Taxpayer requested two rulings on the tax treatment of the Section 481(a) Adjustments.

Ruling 1: Treatment of Section 481(a) Adjustments for purposes of REIT income tests

Under Section 481(a), a taxpayer that changes its method of accounting takes into account necessary adjustments in computing its taxable income. Reg. Section 1.481-1(d) requires a Section 481(a) adjustment to 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.

Section 856(c)(2) requires a REIT to derive at least 95% of its annual gross income from dividends, interest, rents from real property and certain other prescribed items of passive income. Section 856(c)(3) requires a REIT to derive at least 75% of its annual gross income from interest from mortgage loans, rents from real property, and certain other prescribed sources of real-estate related income.

Income from a Section 481(a) adjustment is not specifically enumerated as a qualifying source of income in Section 856(c) (2) or (3).

Section 856(c)(5)(J) authorizes the IRS, to the extent necessary to carry out the purposes of the REIT provisions of the Code, to determine whether any item of income or gain that does not otherwise qualify under the 95% or 75% REIT income tests may nevertheless may be considered as: (i) not constituting gross income for purposes of the 95% or 75% REIT income tests, or (ii) gross income that qualifies for purposes of the 95% or 75% REIT income tests.

Under Section 856(c)(5)(J)(i) authority, the IRS ruled that the Section 481(a) adjustments are not gross income for purposes of the 95% and 75% REIT income tests because excluding the income does not interfere with the congressional policy objectives behind enactment of the income tests.

Ruling 2: Treatment of correlative E&P adjustments in computing REIT E&P

Taxpayer represents that it will take the correlative adjustments arising from the Method Changes in computing depreciation and amortization for E&P purposes into account ratably over the same period as the Section 481(a) adjustments, consistent with Revenue Procedure 79-47. Due to differences in computing depreciation for E&P purposes versus income tax purposes, Taxpayer's correlative adjustments to its E&P are lower than its Section 481(a) adjustments.

Sections 857(d)(1) and 562(e) provide special E&P adjustment rules that in most cases ensure that a REIT's current E&P, as computed for purposes of determining the dividends paid deduction, will be at least equal to the REIT's taxable income (computed prior to the dividends paid deduction (DPD)) such that the REIT can obtain a DPD that completely offsets its taxable income. These rules do not, however, expressly address when an item of gross income (that is not gain on sale of real property) exceeds the correlative E&P income.

In its analysis of this matter in PLR 201652012, the IRS noted that 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 [tax] year would not be less than its real estate [investment] trust taxable income for the [tax] year (without regard to the dividends paid deduction), since the conferees believe that this provision is a restatement of present law." H.R. Conf. Rep. No. 99-841, at 218 (1986).

The IRS explained, therefore, that 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."

To the extent that the Section 481(a) adjustments exceed the correlative E&P adjustments arising from the change in computing depreciation and amortization, the IRS ruled, any distributions of that excess (that are distributed and treated as dividends by Taxpayer in the year in which the excess arises) will be treated as made from E&P.

Implications

PLR 201652012 is the fifth private letter ruling in which the IRS has ruled that a positive Section 481(a) adjustment relating to depreciation may be excluded from the REIT income tests. See PLRs 201537020 (Tax Alert 2015-1829), 201503010 (Tax Alert 2015-359), 201301007 (Tax Alert 2013-92) and 200115023 (Tax Alert 2001-263).

In addition, PLR 201652012 is the third private letter ruling in which the IRS has applied a broad reading of Section 857(d)(1), taking into account the underlying legislative history, to allow a REIT that would otherwise have current E&P that is less than its pre-DPD taxable income to obtain a DPD for distributions sufficient to offset its entire pre-DPD taxable income. See PLRs 201537020 (Tax Alert 2015-1829) and 201503010 (Tax Alert 2015-359).

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