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Citing its discretionary authority in IRC Section 856(c)(5)(J), the IRS ruled in PLR 20200601 that income attributable to reimbursement payments received by a real estate investment trust (REIT) under an economic development agreement (EDA)with a city is qualifying income under the 95% income test of IRC Section 856(c)(2). The REIT had acquired the EDA in connection with the purchase of a fully-developed rental property.

Facts

Taxpayer, a REIT, is a partner in JV, which purchased from Seller: (i) an existing mixed-use residential, retail and office property (Project) and (ii) rights and obligations of Seller under an EDA with City.

City had entered into the EDA with Seller to incentivize Seller to make certain public improvements (e.g., stormwater and road improvements and a public park) to the Project. In general, the EDA obligated City to reimburse Seller for the cost of the public improvements plus simple interest (Reimbursement Payments). The Reimbursement Payments are payable solely from incremental sales tax revenues generated at the Project for a specified number of years.

At the time JV acquired the EDA rights from Seller, the public improvements had already been constructed and applicable improvements had been conveyed to the City as required. JV had no remaining construction obligations or other obligations under the EDA, except for maintenance of the park and creating a certain number of jobs at Project.

Taxpayer represents that, ignoring rights under the EDA, substantially all assets of the Project constituted qualifying real estate assets for purposes of IRC Section 856(c)(4); substantially all of the income generated by the Project is expected to produce qualifying income for purposes of the 95% and 75% income tests of IRC Section 856(c)(2); and (3) JV will use a permissible method of accounting for the income attributable to the Reimbursement Payments that does not improperly frontload or backload JV's recovery of basis in the EDA.

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.

Under IRC Section 856(f), the term "interest" generally does not include an amount received or accrued "if the determination of the amount depends in whole or in part on the income or profits an any person."

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

Based on the facts and representations and citing its discretionary authority in IRC Section 856(c)(5)(J), the IRS ruled that income attributable to the Reimbursement Payments will be treated as qualifying income for purposes of the 95% income test of IRC Section 856(c)(2).

In support of its conclusion, the IRS highlighted Taxpayer's representations that income from the Project will predominately be qualifying income for purposes of the 95% and 75% income tests. The IRS also stated that "treating the income attributable to the Reimbursement Payments as qualifying income solely for purposes of IRC Section 856(c)(2) does not interfere with or impede the objectives of Congress in enacting IRC Section 856(c)(2)," elaborating further that the central concern of the REIT income tests is that a "REIT's gross income should largely be composed of passive income."

Implications

The IRS has previously ruled in several private letter rulings, under its discretionary authority in IRC Section 856(c)(5)(J), that certain incentive-type income received by a REIT from a governmental entity and related to the REIT's development of real property to be held by the REIT for the production of qualifying rental income will be treated as qualifying income for purposes of both the 95% and 75% income tests. See Tax Alert 2020-0340 (addressing PLRs 202005017 and 202005018) for further discussion of these private letter rulings.

PLR 20200601 differs from these prior private letter rulings because the REIT in PLR 20200601 did not develop the real property, but rather purchased a fully-developed rental property from a seller and succeeded to the seller's contractual rights to receive the incentive-type payments from the governmental entity. Another important difference is that, in PLR 20200601, the IRS exercised its authority under IRC Section 856(c)(5)(J) to rule that the income attributable to the Reimbursement Payments was qualifying income solely for purposes of the 95% income test. It appears that the IRS may have taken the view that the income from the Reimbursement Payments was akin to income received under a debt instrument. It also seems evident that the Taxpayer had allocated part of its purchase price in the overall Project to the rights under the EDA, and thus not all of the Reimbursement Payments constituted taxable income. Finally, it is noted that the IRS did not rule on the "amount, character, or timing" of income attributable to the Reimbursement Payments.

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