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Citing its discretionary authority in IRC Section 856(c)(5)(J), the IRS ruled in PLRs 202005017 and 202005018, that amounts included in income by a real estate investment trust (REIT) in accordance with IRC Section 451 from the receipt of transferable tax credits is qualifying income under the 95% and 75% income tests of IRC Section 856(c)(2) and (3). The tax credits were tied to the REIT's development of a real estate project in an economically distressed area that needed environmental cleanup and is expected to produce qualifying income for purposes of the 95% and 75% income tests.

Facts

A state tax credit program allows taxpayers to claim a credit (Tax Credits) against their state tax liability for a percentage of the eligible cost of rehabilitating a hazardous waste site in an economically distressed area. The Tax Credits also can be transferred, sold, or assigned to a corporation or nonprofit organization.

Taxpayer in each of PLRs 202005017 and 202005018 is a REIT that owns partnership interests in Company. Company is building a mixed-use real estate development (Project) on its property, which is eligible for the Tax Credits. Company will sell the Tax Credits to other eligible persons because Taxpayer, as a partner in Company, does not expect its state tax liability to be significant. Taxpayer represents that "it will recognize its proportionate share of income from the Tax Credits when required under IRC Section 451," and "the Tax Credits will be sold … by the unextended due date of the federal income tax return for the tax year in which the Tax Credits are included in income … ."

Taxpayer also represents that income from the Tax Credits will partially pay for the costs of remediating the property and completing the Project. In addition, Taxpayer represents that, upon completion, substantially all of Taxpayer's income from the Project will be qualifying income under IRC Section 856(c)(2) and (c)(3), and the 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) authorizes the IRS to determine, to the extent necessary to carry out the REIT provisions' purposes, whether items of income or gain that are not 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.

Under IRC Section 451(a), taxpayers must recognize gross income in the tax year received unless their accounting method requires them to account for the income differently.

Unless IRC Section 451(b)(1)(A) requires earlier recognition, an accrual-method taxpayer must recognize income under IRC Section 451(b) and Treas. Reg. Section 1.451-1(a) when "all the events have occurred that fix the right to receive such income and [the amount] can be determined with reasonable accuracy." The first prong of the "all events" test is satisfied "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.

Citing its discretionary authority in IRC Section 856(c)(5)(J), the IRS ruled that taxpayer's income from the Tax Credits, as recognized in accordance with IRC Section 451, is qualifying income under IRC Section 856(c)(2) and (c)(3).

While income from the Tax Credits is not listed as a qualifying source of income under IRC Section 856(c)(2) or (c)(3), the IRS noted, its ruling does not conflict with Congress's objectives in enacting the 95% and 75% income tests. In support of its conclusion, the IRS highlighted Taxpayer's representations that: (i) the Project will be a qualified real estate asset under IRC Section 856; (ii) substantially all the Project's income will be qualifying income for purposes of the 95% and 75% income tests; and (iii) Taxpayer will include its share of the Tax Credits in income when required under IRC Section 451. As the state uses the Tax Credits as an incentive to redevelop real property, the IRS continued, the Tax Credits are connected to a permissible activity for REITs.

Implications

PLRs 202005017 and 202005018 are the second and third private letter rulings in which the IRS has exercised its discretionary authority under IRC Section 856(c)(5)(J) to rule that income attributable to the receipt of "transferable" state tax credits 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. These rulings, as well as the first ruling (PLR 201948006 (Tax Alert 2019-2160)), involve state tax credits that can be used to reduce state tax liability (but are not refundable) or sold to a third party, as contrasted with fully refundable state tax credits. Transferable state tax credits appear to present more issues regarding the timing of income recognition for purposes of IRC Section 451, a matter that is alluded to in the rulings, but not addressed in detail. The IRS gave no opinion on the tax consequences of any dispositions of the Tax Credits, including whether a sale of the Tax Credits is a prohibited transaction subject to the 100% tax under IRC Section 857(b)(6).

The IRS also has previously ruled, under its discretionary authority in IRC Section 856(c)(5)(J), that certain incentive-type income received in the form of cash or fully refundable state tax credits by a REIT related to the development of real property that will be held for the production of qualifying rental income will be treated as qualifying income under the REIT income tests. See 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 state 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, when 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 for the development of real property that will be held for the production of qualifying rental income. The income test conclusion in PLRs 202005017 and 202005018, 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 seeking their own rulings.

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