In each of three substantially similar private letter rulings (201816001, 201816002 and 201816003), the IRS ruled that annual incentive payments to be received by a real estate investment trust (REIT) and attributable to the development of a retail shopping center constitute qualifying income for purposes of the 95% and 75% income tests of Section 856(c)(2) and (3).

In addition, the IRS ruled that the REIT's right to receive the incentive payments 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).

Facts

Taxpayer is a REIT in the business of owning and renting commercial real estate. Taxpayer owns an interest in a partnership (Partnership) that owns land upon which the Partnership is developing a mixed-use shopping center (the Project). Taxpayer represents that, upon completion of construction, the Project will qualify as real property under Section 856 and that Taxpayer will generate qualifying rents from real property under Section 856(c)(2) and (3) from Partnership's leasing of space in the Project to third-party tenants.

The city (City) where the Project is located determined that the Project's development would benefit the public, and entered into an agreement (Agreement) with Partnership under which City agreed to make payments to Partnership to partially offset the costs of the Project (Total Payment).

Per City's policy for reinvestment, no more than [E] percent of the net new tax revenues collected by City as a result of a project may be reinvested for purposes of offsetting project costs. City defines net new tax revenues as tax revenues that: (1) are actually paid to City after completion of a specific project; (2) are directly attributable to the development and operation of the project; and (3) exceed revenue already received by City. This includes property taxes and any sales or use taxes.

Per the Agreement, City will create a special fund to deposit annually an amount equal to [E] percent of net new tax revenues generated by the Project's development. From the fund, City will annually pay Partnership an amount comprising a rebate of City's share of property taxes paid by Partnership (the Annual Rebate Amount) and an additional amount (the Annual Refund Amount) that is [E] percent of net new tax revenues over Annual Rebate Amount. The total amount due to Partnership in a single year is referred to as the Total Annual Payment. The payment will terminate upon the earliest of: (i) 25 years, (ii) the date on which Partnership has received the Total Payment, or (iii) the termination of the Agreement.

Each year, Partnership will record unpaid claims for the year's Total Annual Payment as a receivable for GAAP purposes.

Law and analysis

Asset test

Section 856(c)(4)(A) requires at least 75% of the value of a REIT's total assets at the close of each quarter of its tax year to consist of real estate assets, cash and cash items (including receivables) and government securities. Treas. Reg. Section 1.856-2(d)(1)(iii) states that, for purposes of Section 856(c)(4)(A), the term "receivables" means only those receivables arising in the ordinary course of a REIT's operation and does not include receivables purchased from another person.

The IRS ruled that Taxpayer's right to receive its share (through its interest in Partnership) of the Total Annual Payment is a receivable that arises in the ordinary course of Taxpayer's operations as owner and lessor of real property within the meaning of Treas. Reg. Section 1.856-2(d)(1) and is therefore a receivable for purposes of Section 856(c)(4). Accordingly, the receivable is a qualifying asset for purposes of the 75% asset test, and is not subject to the 5% or 10% asset tests of Section 856(c)(4)(B)(iv).

Income test

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 income sources.

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, gain from the sale of REIT stock, and 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.

The IRS explained that Taxpayer's share of the Annual Rebate Amount is "tied to" the payment of real property taxes by Taxpayer because the basis for the Annual Rebate Amount is the actual payment of real property taxes previously paid by Partnership. Therefore, the IRS ruled that Taxpayer's share of the Annual Rebate Amounts constitutes a refund of taxes on real property under Section 856(C)(2)(E) and (3)(E) and thus, is qualifying income for purposes of the 75% and 95% REIT income tests.

The IRS explained that Taxpayer's share of the Annual Refund Amount is not tied to the payment of taxes on real property and does not derive from any other source of qualifying income enumerated in Section 856(c)(2) or (3). Based on all of the facts and circumstances, including Taxpayer's representation that the rental income generated by the Project will be qualifying income under Section 856(c)(2) and (3), the IRS concluded that treating Taxpayer's share of the Annual Refund Amount as qualifying income does not interfere with or impede the objectives of Congress in enacting Section 856(c)(2) and (3). Accordingly, the IRS ruled under its Section 856(c)(5)(J) authority that Taxpayer's share of the Annual Refund Amount is considered qualifying income for purposes of the 75% and 95% REIT income tests.

Implications

PLRs 201816001, 201816002 and 201816003 are the fifth, sixth and seventh private letter rulings, respectively, to address incentive-type payments received by a REIT from a state (or jurisdiction thereof) in connection with developing real property that will be held as rental investment property. See PLRs 201716043 (Tax Alert 2017-0717), 201518010 (Tax Alert 2015-0984) and 201428002 (Tax Alert 2014-1304), in which the IRS ruled, under its Section 856(c)(5)(J) authority, that income attributable to the receipt of incentive grants or refundable tax credits related to the development of real property constitutes qualifying income for purposes of the REIT income tests.

REITs and their advisors also may want to note PLR 200926014 (Tax Alert 2011-0981), in which the IRS ruled that income attributable to a particular refundable tax credit constituted a refund of real property taxes under Section 856(c)(2)(E) and (c)(3)(E) when the credit was "tied to" the payment of real property taxes. In addition, in PLR 200403023, 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 in which 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 under Section 856(c)(2)(E).

PLRs 201816001, 201816002 and 201816003 are also the third, fourth and fifth private letter rulings, respectively, that address whether a REIT's right to payment as described here 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). See PLRs 201518010 and PLR 201428002. See also PLR 200926014, 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).

It is good news that the IRS continues to take a favorable view under the REIT income tests regarding "incentives" received by a REIT in connection with developing real property that will be held for the production of qualifying rental income. The conclusions in PLRs 201816001, 201816002 and 201816003, however, are based, in part, on the IRS's exercise of its discretionary authority under Section 856(c)(5)(J). Thus, REITs with similar situations will want to consider whether to seek their own rulings.

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