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In PLR 201910002, the IRS ruled that, under its discretionary authority in IRC Section 856(c)(5)(J), an incentive payment received by a real estate investment trust (REIT) from a governmental entity and related to the REIT's development of a multi-use rental real estate project is 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 interests in Partnership. Partnership owns a site that contains a building.

Partnership has entered into an agreement with County under which Partnership will demolish the building on the existing site and construct a multi-use office, retail and residential development (Property). The Property will also include Structure (which will be a part of the Property's foundation). Partnership will grant a permanent easement to County for Structure and an easement to facilitate connecting Structure to other assets that qualify as real property. Partnership will also construct the shell of Facility on the site and pay for the construction of at least one elevator and stairs (and an escalator if possible) for Facility. Partnership will own and maintain Facility's shell (which will also be part of Property's foundation) but will not own or maintain the improvements within Facility or provide services to County with respect to the easements.

To encourage the redevelopment of the site to include Facility and Structure, County considered incentives to the owner of the site, including an increase in zoning capacity, and agreed to provide an incentive equal to costs in excess of [B] dollars incurred by Partnership to terminate leases of tenants of the existing building on the site to be demolished (the County Payment). The amount of the County Payment will be limited to [C] dollars. The County Payment will be paid in part upon the completion of a construction milestone with the remainder to be paid upon the earlier of another construction milestone or a date specified in the agreement. Both these payments are conditioned on Taxpayer providing satisfactory evidence of the buyout costs, conveyance of all required easements, and evidence of required improvements to the site.

Taxpayer represented that, upon completion, the Property will qualify as real property and that Taxpayer will lease the Property to third-party tenants for purposes of generating qualifying rents from real property under IRC Sections 856(c)(2) and (3).

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 201910002, the IRS first noted that income attributable to the receipt or accrual of the County Payment, to the extent not attributable to the easements conveyed by Partnership to County, is not derived from any source listed as qualifying income in IRC Sections 856(c)(2) or (3). However, the Secretary, under IRC Section 856(c)(5)(J), may to consider such income as qualifying gross income for purposes of those provisions. The IRS determined that treating Taxpayer's income attributable to its receipt or accrual of its share of the portion of the County Payment that is not from the easements conveyed by Partnership to County as qualifying income does not interfere with or impede the objectives of Congress in enacting IRC Section 856(c)(2) and (3). The IRS's determination was based on all the facts and circumstances, including Taxpayer's representations that the Property will generate rents from real property and that substantially all of the income generated by the Property will be qualifying income for purposes of IRC Section 856(c)(2) and (3). Accordingly, the IRS ruled under IRC Section 856(c)(5)(J) that such income is qualifying income for purposes of IRC Section 856(c)(2) and (c)(3).

Implications

PLR 201910002 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 rental real property. See PLR 201845001 (Tax Alert 2019-0090), addressing the receipt of refundable brownfield tax credits from the development of rental real property; PLR 201841002 (Tax Alert 2018-2069), addressing the receipt of a grant relating to the redevelopment of rental real property; PLRs 201816001, 201816002 and 201816003 (Tax Alert 2018-0960), addressing the receipt of payments relating to the development of a retail shopping center; PLR 201716043 (Tax Alert 2017-0717), addressing the receipt of grant payments relating to the development of a mixed-use rental property; PLR 201518010 (Tax Alert 2015-0984), addressing receipt of refundable state tax credits relating to development of apartment complexes; and PLR 201428002 (Tax Alert 2014-1304) addressing the receipt of refundable state tax credits relating to development of retail buildings. In these rulings, as in PLR 201910002, the IRS ruled, under its IRC Section 856(c)(5)(J) authority, that incentive-type payments (including refundable tax credits) related to the development of real property that is expected to produce qualifying rents will constitute qualifying income for purposes of the REIT income tests.

Also, see PLRs 201816001, 201816002, 201816003 and 200926014, in which the IRS ruled that income attributable to the receipt of a refundable tax credit constituted a refund of real property taxes under IRC 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 the development site) is treated as an abatement and refund of taxes on real property under IRC Section 856(c)(2)(E).

It is good news that the IRS continues to take a favorable view under the REIT income tests and asset 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 income test conclusion in PLR 201910002, 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.

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