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In two substantially similar private letter rulings (PLRs 201929014 and 201929015), the IRS ruled that, based on its discretionary authority under IRC Section 856(c)(5)(J)(ii), a grant payment received by a real estate investment trust (REIT) from a governmental entity relating to the development of a shopping center will be considered qualifying income for purposes of the 95% and 75% income tests under IRC Section 856(c)(2) and (c)(3).

Facts

Taxpayer in each ruling is an entity that has elected to be treated as a REIT under IRC Sections 856 through 859. The two Taxpayers formed three joint ventures (collectively, Owners) to redevelop a property as a regional shopping center (Property). Owners own the individual properties that comprise Property, which is constructed on land leased from City. The redevelopment of the Property will be funded by a grant through a program administered by State.

Under the program, Agency, on behalf of City, will apply for periodic project payments from State to cover a portion of paid eligible and reimbursable project expenses, including construction costs, land acquisition costs, and interest costs paid as a result of the use of interim or bridge financing for the project during construction. The amounts received from the grant will then be used to subsidize the Owners for costs directly associated with the development of the Property.

Each Taxpayer represented that: (1) after redevelopment, the Property will qualify as a real estate asset for purposes of IRC Section 856; (2) substantially all of the income (excluding the grant payments) Taxpayer derives from the Property will constitute qualifying income for purposes of the 95% and 75% income tests of IRC Section 856(c)(2) and (c)(3); (3) substantially all of the grant payments will be for the construction of real property at the Property; and (4) Taxpayer will report its allocable share of the grant payments as gross income under IRC Section 61 and take its share of the payments into account for the tax year in which the income is recognizable.

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) provides 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 shows that the primary concern of the REIT income tests is to ensure that a REIT's gross income is largely passive income.

In PLRs 201929014 and 20192915, the IRS noted that although the income from the grant constitutes gross income that is not qualifying income under the 95% and 75% income tests, each Taxpayer nonetheless represented that, after redevelopment, the Property will qualify as a real estate asset under IRC Section 856 and that substantially all of the income that each Taxpayer derives from the Property will constitute qualifying income for purposes of the 95% and 75% income tests. The IRS determined that treating the income from the grant as qualifying income does not interfere with or impede Congress's objectives in enacting the 95% and 75% tests and, thus ruled, pursuant to IRC Section 856(c)(5)(J)(ii), that each Taxpayer's income attributable to receipt of the grant payments is considered qualifying income for purposes of IRC Section 856(c)(2) and (c)(3).

Implications

PLRs 201929014 and 201929015 are the latest private letter rulings to address incentive-type payments received by a REIT from a state (or jurisdiction thereof) in connection with developing rental real property. See PLR 201910002 (Tax Alert 2019-0822), addressing the receipt of an incentive payment from the development of a multi-use office, retail and residential development; 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 the 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 PLRs 201929014 and 201929015, 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 is qualifying income for purposes of the 95% and 75% income tests, where 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) are 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 PLRs 201929014 and 201929015, 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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