In Private Letter Ruling 201939001, the IRS addressed the determination of a REIT's "capital interest" in a partnership that is used under the look-through rule of Treas. Reg. Section 1.856-3(g) in determining the REIT's share of assets and gross income of the partnership for purposes of applying the REIT asset and income tests under IRC Section 856(c)(2), (3), and (4).

The IRS ruled that the REIT's capital interest on a given date was equal to the REIT's percentage share of the fair market value of distributions that the REIT would be entitled to receive from the partnership upon a hypothetical liquidation of the partnership, thus effectively concluding that the capital interest was determined with reference to the REIT's fair market value capital account.

Facts

Taxpayer intends to elect to be taxed as a REIT under IRC Section 856.

A government entity and one or more non-governmental partners formed, and made capital contributions to, several partnerships (Partnerships). The Partnerships lease and operate certain rental properties in the United States. Taxpayer intends to acquire certain partnership interests in each Partnership from a non-governmental partner in exchange for cash equal to the fair market value of the particular interest.

Seven of the 10 Partnerships maintain capital accounts in accordance with the capital account maintenance rules of Treas. Reg. Section 1.704-1(b)(2)(iv), however, Taxpayer represents that Taxpayer's capital account in these partnerships do not fairly reflect what Taxpayer would receive upon a liquidation of the Partnerships.

Taxpayer intends to determine its "capital interest" (for purposes of the look-through rule of Treas. Reg. Section 1.856-3(g)) for each Partnership on a given date by: (i) deeming the Partnership to have made a distribution in complete liquidation of all of the partners' interests in an amount equal to the fair market value of the partnership assets on that date less the partnership liabilities as of that date, and (ii) computing the percentage of that deemed distribution to which Taxpayer would be entitled (Percentage Share).

Law and analysis

IRC Section 856(c)(2) requires that a REIT derive at least 95% of its annual gross income (excluding gross income from prohibited transactions) from specified sources, including dividends, interest, rents from real property, gain from the sale or other disposition of stock, securities, and real property (other than IRC Section 1221(a)(1) property), and certain other specified sources of income.

IRC Section 856(c)(3) requires that a REIT derive at least 75% of its annual gross income (excluding gross income from prohibited transactions) from rents from real property, interest on obligations secured by mortgages on real property, gain from the sale or other disposition of real property (other than IRC Section 1221(a)(1) property), dividends from REIT stock and gain from the sale of REIT stock, and certain other specified sources of income.

IRC Section 856(c)(4) requires that at the close of each quarter of a REIT's taxable year, a REIT must satisfy certain asset tests.

Treas. Reg. Section 1.856-3(g) provides that, in the case of a REIT that is a partner in a partnership, the REIT will be deemed to own its proportionate share of each of the assets of the partnership and will be deemed to be entitled to the income of the partnership attributable to such share. For purposes of IRC Section 856, the interest of a partner in a partnership's assets shall be determined in accordance with the partner's capital interest in the partnership. The character of the various assets in the hands of the partnership and items of gross income of the partnership shall retain the same character in the hands of the partners for all purposes of IRC Section 856.

In the analysis section of PLR 201939001, the IRS noted that Treas. Reg. Section 1.856-3(g) does not define the term "capital interest," and explained that because none of the Partnerships maintains a capital account that accurately reflects Taxpayer's interest in the assets of the Partnership, Taxpayer will determine the Percentage Share for each Partnership. Specifically, the IRS ruled:

• Solely for purposes of IRC Section 856(c), Taxpayer's capital interest in each Partnership, within the meaning of Treas. Reg. Section 1.856-3(g), will equal its Percentage Share for that Partnership.
• Solely for purposes of IRC Section 856(c)(2) and (3), Taxpayer's share of each item of gross income of each Partnership will equal the product of the amount of that item and the Percentage Share determined for that Partnership.
• Solely for purposes of IRC Section 856(c)(4), Taxpayer's share of each asset of a Partnership will equal the product of the value of that asset and the Percentage Share determined for that Partnership.

Implications

The partnership look-through rule of Treas. Reg. Section 1.856-3(g) was promulgated in 1962, and has never been subsequently updated, even though partnerships have become much more complex entities (often with complex allocation and distribution sharing) and even though the partnership allocation rules of Subchapter K have been substantially developed since 1962. Thus, some uncertainties exist in applying the partnership look-through rule for purposes of the REIT income and asset tests.

PLR 201939001 is important guidance because it provides insight on a regulation that has not been updated in over 50 years, nor been the subject of significant interpretative guidance. The conclusion that Taxpayer may determine its capital interest in a Partnership on a particular date based on Taxpayer's FMV capital account seems to be a very reasonable approach given the representations by Taxpayer that capital accounts in these Partnerships do not fairly reflect what Taxpayer would receive upon a liquidation of the Partnerships. In many situations, determining a REIT's capital interest based on tax basis capital accounts or IRC Section 704(b) capital accounts (that are not otherwise booked to FMV) will not differ from using FMV capital accounts. However, as in the ruling, there may be instances where IRC Section 704(b) capital accounts do not fairly reflect a partner's capital interest for purposes of Treas. Reg. Section 1.856-3(g). The ruling provides another approach to determine a REIT's "capital interest" in a partnership under the look-through rule of Treas. Reg. Section 1.856-3(g). It is noted that the ruling does not elaborate on whether the REIT's share of gross income of a Partnership for purposes of the REIT income tests is based on its average FMV capital account for the year, end-of-year FMV capital account, or some other convention.

For prior guidance in this area, see PLRs 9452032 and 200310014 (REIT may use IRC Section 704 capital account in determining its capital interest for purposes of the look-through rule) and PLR 201115017 (REIT must use the look-through rule in determining its share of gross income of a partnership for purposes of the 75% and 95% income tests, even though apparently the partnership agreement may have provided for certain special allocations of income).

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