In PLR 201820012, the IRS ruled that a payment received by a real estate investment trust (REIT) for waiving its right of first offer to acquire a partnership interest is gain from the disposition of an interest in real property within the meaning of Section 856(c)(2)(D) and (3)(C) to the extent that the underlying partnership's assets constitute real property. Accordingly, the applicable portion of such income is treated as qualifying income for purposes of the 95% and 75% income tests of Section 856(c)(2) and (3).

Taxpayer is a REIT that owns the general partner interest in a partnership (Partnership). The Partnership has two other partners, Partner 1 and Partner 2. Partnership owns a residential rental property with some onsite retail tenants (the Property).

The partnership agreement provides each partner with a right of first offer (the Right of First Offer) in the event of a proposed sale of all or part of a partnership interest by another partner. The partnership agreement states that, if any partner wishes to sell all or part of its partnership interest, that partner must first give written notice to the other partners of its intent to sell, the purchase price, and certain other information. The non-selling partners then have [ ] days to purchase the selling partner's partnership interest on the same terms and conditions as are contained in the notice or to elect to have the entire Property sold. If the non-selling partners do not act on the Right of First Offer, the selling partner then has [ ] months to consummate the sale on terms no less favorable to the selling partner than provided in the notice.

Partner 1 proposes to sell its interest in the Partnership to a third party. Under an amendment to the partnership agreement, Taxpayer will waive its Right of First Offer for one year, and Partner 1 may retain an interest in the Partnership that it may dispose of at any time without being subject to the Right of First Offer provisions of the partnership agreement. In exchange for agreeing to the amendment, Partner 1 will pay an amount to Taxpayer out of the closing escrow from the sale of Partner 1's partnership interest.

Law and analysis

Under Section 856(c), a REIT must: (i) derive at least 95% of its gross income (excluding gross income from prohibited transactions) from sources listed in Section 856(c)(2), which includes dividends, interest, rent from real property, gain from the sale or other disposition of stock, securities, and real property (including interests in real property), and certain other items; and (ii) derive at least 75% of its gross income (excluding gross income from prohibited transactions) from sources listed in Section 856(c)(3), which include rents from real property, gain from the sale or other disposition of real property (including interests in real property), and certain other items.

Section 856(c)(5)(C) states that "interests in real property" includes fee ownership and co-ownership of land, leaseholds of land, options to acquire land and options to acquire leaseholds of land or improvements upon any such land.

Treas. Reg. Section 1.856-3(g) deems a REIT that is a partner in a partnership to own its proportionate share of each of the assets of the partnership and to be entitled to the income of the partnership attributable to its share.

The IRS explained that the Right of First Offer represents Taxpayer's future right to purchase interests in a partnership that holds assets that Taxpayer would be treated as owning in proportion to any partnership interests it purchased. Thus, to the extent that Partnership's assets constitute real property, the Right of First Offer is an interest in real property for purposes of Section 856(c)(5)(C) and the payment for the waiver of the Right of First offer is gain from the disposition of an interest in real property within the meaning of Sections 856(c)(2)(D) and (3)(C).

Implications

PLR 201820012 is the first private letter ruling to specifically address the treatment of income recognized by a REIT for waiving a right of first offer to acquire a partnership interest when the underlying partnership owns real property. Section 856(c)(5)(C) broadly defines "interests in real property," which includes "options to acquire land or improvements thereon." PLR 201820012 helps to clarify that a right of first offer to acquire real property, including a right of first offer to acquire a partnership interest (to the extent the partnership's assets consist of real property) constitutes an interest in real property.

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