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In PLR 201948006, the IRS ruled that, pursuant to its discretionary authority in IRC Section 856(c)(5)(J), amounts included in income of a real estate investment trust (REIT) in accordance with IRC Section 451 from the receipt of transferable tax credits constitute qualifying income for purposes of the 95% and 75% income tests under IRC Section 856(c)(2) and (c)(3). The tax credits were to be received in connection with the REIT's development of a real estate project that is expected to produce qualifying income.

Facts

Taxpayer is a REIT that is engaged in the business of owning and operating rental real estate. Taxpayer, though an operating partnership, is a member of Holding, an entity treated as a partnership for federal tax purposes. Holding was organized to develop, own, manage and lease Project.

Under State C law, Act authorizes the issuance of state tax credits when a developer makes a capital investment in a Qualified Venture within a specified area (Tax Credits). The Tax Credits are based on the developer's capital investment in the Qualified Venture, but are limited to no more than a specified percentage of the capital investment. The Tax Credits are nonrefundable credits that may be used against specified State C taxes. The Tax Credits may also be transferred (by sale or assignment) if the developer applies for and receives a Tax Credit transfer certificate from Authority.

Holding applied for a grant of Tax Credits relating to Project, and Authority approved the issuance of Tax Credits in an amount up to a stated maximum to be received over a period of years. Taxpayer represents that it will include the income from the Tax Credits when required under IRC Section 451. Because Taxpayer has no State C tax liability, Holding has chosen to sell its Tax Credits. Taxpayer represents that the Tax Credits are sold or disposed of by the unextended due date of the federal tax return for the tax year in which the Tax Credits are included in income in accordance with IRC Section 451.

Taxpayer represents that the income from the Tax Credits will be used to offset the actual cost of developing Project. Upon completion of Project, substantially all of Taxpayer's income from Project will be qualifying income for purposes of IRC Section 856(c)(2) and (c)(3), and Project will be a qualified real estate asset under IRC Section 856(c)(5)(B).

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.

IRC Section 451(a) provides that the amount of any item of gross income shall be included in the gross income for the tax year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, such amount is to be properly accounted for as of a different period.

Under an accrual method of accounting, unless IRC Section 451(b)(1)(A) requires earlier inclusion, an item of gross income is includible when all the events have occurred that fix the right to receive such income and the amount thereof can be determined with reasonable accuracy. See IRC Section 451(b) and Treas. Reg. Section 1.451-1(a). All the events that fix the right to receive income generally occur upon the earliest of the following: (i) the required performance takes place, (ii) payment is due, or (iii) payment is made. See Schlude v. Commissioner, 372 U.S. 128 (1963); Revenue Ruling 2003-10, 2003-1 C.B. 288.

In PLR 201948006, the IRS first noted that income attributable to the receipt of the Tax Credits is not listed as qualifying income in IRC Section 856(c)(2) or (c)(3). The IRS then noted that Taxpayer represented that (i) Project will be a qualified real estate asset for purposes of IRC Section 856; (ii) substantially all the income Taxpayer derives from Project will be qualifying income for purposes of IRC Section 856(c)(2) and (c)(3); and (iii) Taxpayer will include the Tax Credits in income when required under IRC Section 451. The IRS explained that the Act provides the Tax Credits as a government incentive to redevelop property that may not otherwise be a profitable venture for the REIT and, therefore, the Tax Credits are received in connection with the development of real property, an activity that is permissible for REITs.

Accordingly, based on the representations and surrounding facts and circumstances, the IRS determined that treating income from receipt of the Tax Credits as qualifying income does not interfere with or impede the objectives of Congress in enacting IRC Section 856(c)(2) and (c)(3). Thus, the IRS ruled that, pursuant to its discretionary authority in IRC Section 856(c)(5)(J)(ii), amounts included in the Taxpayer's income with respect to the Tax Credits in accordance with IRC Section 451 shall be treated as qualifying income for purposes of IRC Section 856(c)(2) and (c)(3).

Implications

PLR 201948006 is the latest private letter ruling in which the IRS has exercised its discretionary authority under IRC Section 856(c)(5)(J) to rule that incentive-type income recognized by a REIT from a governmental entity related to the REIT's development of real property that is expected to produce qualifying rents will constitute qualifying income for purposes of the REIT income tests. However, PLR 201948006 differs somewhat from prior rulings because the income recognized by the taxpayer in PLR 201948006 arose from the receipt of "transferable" tax credits (that were nonrefundable), as contrasted with the receipt of cash payments or refundable tax credits addressed in the prior rulings, which may present more issues in regards to the timing of the recognition of such income under IRC Section 451. It should be noted that the IRS offered no opinion with respect to the tax consequences of any dispositions of the Tax Credits, including whether a sale of the Tax Credits constitutes a prohibited transaction subject to the 100% tax under IRC Section 857(b)(6).

Prior rulings include PLRs 201929014 and 201929015 (Tax Alert 2019-1383), addressing the receipt of a grant payment relating to the development of a shopping center; PLR 201910002 (Tax Alert 2019-0822), addressing the receipt of an incentive payment relating to 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 addition, see PLRs 201816001, 201816002, 201816003, 201428002, and 200403023, in which the IRS ruled that certain incentive payments or refundable tax credits received by a REIT constituted a refund of real property taxes under IRC Section 856(c)(2)(E) and (c)(3)(E), and thus were qualifying income for purposes of the 95% and 75% income tests, where the amounts were "tied to" the payment of real property taxes.

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 income test conclusion in PLR 201948006, 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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