October 18, 2018 Grant proceeds received for redeveloping rental buildings constitute qualifying REIT income In PLR 201841002, the IRS ruled, under its discretionary authority in Section 856(c)(5)(J)(ii), that income that a real estate investment trust (REIT) receives under a state government grant program for redeveloping rental real property is qualifying income for purposes of the 95% and 75% income tests under Section 856(c)(2) and (c)(3). Facts Taxpayer is a corporation that has elected to be taxed as a REIT. Taxpayer, through an operating partnership, purchased "Center," which, although located in a revitalized area, suffers from a high vacancy rate with buildings in derelict condition. Taxpayer plans to redevelop Center, modernizing the buildings to offer retail, residential and other amenities that will provide economic benefits to the area (the Redevelopment). To fund the Redevelopment, Taxpayer applied for a grant through a program authorized by legislation for economic development projects (the Program). To qualify for grants under the Program, developers must complete an application process and their projects must increase or maintain employment, tax revenue and other economic measures across a region. Once a developer's application to the Program is approved, a Program grant is established between the state and the developer. As the developer incurs and pays construction costs, the state will reimburse the developer, provided documentation requirements are met. The Program funds are primarily intended to be used for construction costs, although they may also be used for interest and certain other costs related to the construction. If Taxpayer is awarded a grant by the Program, it will use the proceeds to reimburse construction costs that it incurred. Taxpayer represents that Center, after the Redevelopment, will qualify as a real estate asset for purposes of Section 856 and that substantially all of the income (excluding the grant income) Taxpayer derives from Center will be qualifying income for purposes of Section 856(c)(2) and (c)(3). Law 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% income tests may nevertheless be (i) disregarded for purposes of the 95% or 75% income tests or (ii) treated as qualifying income for purposes of the 95% or 75% 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. Ruling The IRS explained that a grant from the Program constitutes gross income that is not listed as a source of qualifying income under Section 856(c)(2) or (c)(3). The IRS noted, however, that Center, after the Redevelopment, will qualify as a real estate asset for purposes of Section 856 and that substantially all the income (excluding the grant income) Taxpayer derives from Center will be qualifying income for purposes of Section 856(c)(2) and (c)(3). It further noted that Taxpayer will earn the grant for developing real property in accordance with the Program. Accordingly, the IRS determined that treating income from the Program grant as qualifying income does not interfere with or impede the objectives of Congress in enacting Section 856(c)(2) and (c)(3). Therefore, the IRS ruled, under its discretionary authority in Section 856(c)(5)(J)(ii), that income from the grant is considered qualifying income for purposes of Section 856(c)(2) and (c)(3). Implications PLR 201841002 is the latest private letter ruling to address incentive-type payments received by a REIT from a state (or jurisdiction thereof) in connection with developing real property. See PLRs 201816001, 201816002 and 201816003, addressing the receipt of payments relating to the development of a retail shopping center (Tax Alert 2018-0960); PLR 201716043, addressing the receipt of grant payments relating to the development of mixed-use rental property (Tax Alert 2017-0717); PLR 201518010, addressing receipt of refundable state tax credits relating to development of apartment complexes (Tax Alert 2015-0984); and 201428002, addressing the receipt of refundable state tax credits relating to development of retail buildings (Tax Alert 2014-1304). In these rulings, as in PLR 201841002, the IRS ruled, under its Section 856(c)(5)(J) authority, that income attributable to the receipt of grants (or similar payments, including refundable tax credits) related to the development of real property that is expected to produce qualifying rents will constitutes qualifying income for purposes of the REIT income tests. In PLR 201742018 (Tax Alert 2017-1803) the IRS ruled, under its Section 856(c)(5)(J) authority, that incentive payments received by a REIT from a utility company in connection with the installation of a solar PV system on the roof of the REIT's retail property will be considered qualifying income for purposes of the REIT income tests. Also, see PLRs 201816001, 201816002, 201816003 and 200926014 (Tax Alert 2011-0981), in which the IRS ruled that income attributable to the receipt of a refundable tax credit constituted a refund of real property taxes under Section 856(c)(2)(E) and (c)(3)(E), and thus qualifying income for purposes of the 95% and 75% income tests, 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). In addition, in PLRs 201816001, 201816002, 201816003, 201518010, and 201428002, the IRS concluded that a REIT's right to receive an incentive-type payment 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, a qualifying asset for purposes of the 75% asset test. See also PLR 200926014, in which the IRS 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 conclusion in PLR 201841002, however, is based 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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