In PLR 201904005, the IRS ruled, under its discretionary authority in IRC Section 856(c)(5)(J)(ii), that a lump-sum rent subsidy payment received by a real estate investment trust (REIT) from a city to compensate the REIT for agreeing to rent a certain number of apartment units to low- and moderate-income residents at below-market rental rates constitutes qualifying income for purposes of the 95% and 75% income tests under IRC Section 856(c)(2) and (c)(3).

Facts

Taxpayer is a REIT that owns, through a subsidiary partnership (Partnership), an apartment complex (Property) located in City.

The original redevelopment of Property was financed through a series of bonds issued by Agency. The Agency and Partnership entered into certain agreements, including a Participation Agreement that required Partnership to make a certain number of apartment units available to occupants of low or moderate income until a specified date. Upon that date, Partnership was no longer required to provide below-market-rate housing, although Agency had the right to rent up to a specified number of units from Partnership at market rents, thereby causing the units to remain at below-market rents by providing a subsidy to Partnership in the amount of the difference between the below-market rent and the market rent for each unit.

To ensure the long-term availability of affordable housing in the area and to prevent the displacement of low- and moderate-income residents residing at Property upon the expiration of the Participation Agreement, City and Partnership entered into Subsidy Agreement, providing that Partnership would (1) maintain the current affordability levels of all units with respect to the tenants currently residing in those units and (2) create permanent restrictions on a specified number of those units so they remain affordable to any future tenants. Under the Subsidy Agreement, City made a lump-sum payment (Payment) to Partnership. The Subsidy Agreement references the right of the City under the Participation Agreement to cause the units to remain at below-market rental rates by providing a subsidy to Partnership in the amount of the difference between the below-market rental rate and the market-rate rent for each selected unit.

Law and analysis

IRC 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.

IRC 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.

IRC 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.

In PLR 201904005, the IRS explained that the Payment was calculated specifically with the intent to compensate Partnership for the difference between the below-market rental rate and the market rental rate for specific units throughout the remaining life of Property, and thus, the Payment approximates the net present value of the rent foregone by keeping certain units at below-market rental rates. The IRS reasoned that the Payment is considered as being "in the nature of, or substitute for, actual rent," and pointed out that, if the Payment instead were received as monthly payments from tenants paying market rent, such income would constitute qualifying income under the 95% and 75% income tests of IRC Sections 856(c)(2) and (c)(3). Thus, although the Payment is not specifically enumerated as qualifying income in IRC Sections 856(c)(2) or (c)(3), the IRS explained that treating the Taxpayer's allocable share of the Payment as qualifying income for purposes of IRC Sections 856(c)(2) and (c)(3) does not interfere with or impede the objectives of Congress in enacting IRC Sections 856(c)(2) and (c)(3).

Accordingly, the IRS ruled, under its discretionary authority of IRC Section 856(c)(5)(J)(ii), that Taxpayer's proportionate share of income from Payment will be considered as qualifying income for purposes of the 95% and 75% income tests under IRC Sections 856(c)(2) and (c)(3).

Implications

PLR 201904005 is the first private letter ruling to address the receipt of a "rent subsidy payment" from a city and is welcome news. The conclusion that the lump-sum rent subsidy payment constitutes qualifying income for purposes of the 75% and 95% income tests, however, is based on the IRS's exercise of its discretionary authority under IRC Section 856(c)(5)(J). Thus, REITs with similar situations will want to consider whether to seek their own rulings.

Of interest, in PLRs 9428033 and 9607012, the IRS ruled that a REIT's receipt of housing assistance payments from the Department of Housing and Urban Development (HUD) that are "made on behalf of the REIT's tenants" (in an amount equal to the difference between the rent a lower-income family pays and the fair rental value rent for a specific apartment unit) are treated as qualifying "rents from real property" for purposes of IRC Section 856(c). HUD payments appear to be directly tied to, and paid on behalf of, actual tenants occupying specific apartment units, and thus, appear to differ from the subsidy addressed in PLR 201904005, which resulted in the IRS need to look to IRC Section 856(c)(5)(J).

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