August 25, 2023
IRS rules payments to REIT for subsurface storage of carbon dioxide are qualifying income
In a ruling obtained by professionals at EY, the IRS ruled in PLR 202334007 that payments made to a real estate investment trust (REIT) by an unrelated third party for the use of space on and below the surface of the REIT's timberlands for the underground storage of carbon dioxide (CO2) are qualifying income for purposes of IRC Sections 856(c)(2) and 856(c)(3).
Taxpayer, a REIT that owns or controls timberlands in the United States, entered into an agreement (the Agreement) with an unrelated party (Storage User), granting Storage User the right to use a specified area of Taxpayer's timberlands (the Premises) in connection with underground storage of CO2. Storage User intends to capture CO2 from emitters near the Premises and transport the CO2 via pipeline to a carbon injection facility to be constructed on the surface of the Premises. The carbon injection facility will maintain the gaseous CO2 as a supercritical fluid and inject it underground into the subsurface area of the Premises.
The Agreement grants Storage User (1) the right to survey, construct, own and operate the carbon storage facility; (2) the right to inject, sequester and permanently store CO2 in the subsurface area of the Premises; (3) the right to construct and maintain pipeline facilities; and (4) rights of ingress and egress necessary to access and operate the carbon injection facility and pipelines. Under the agreement, Taxpayer reserves the right to use the Premises for its own purposes and, subject to Storage User's right of first offer, to grant other third parties rights to use subsurface space at depths not included in the Premises.
The Agreement is for an initial one-year term with the option for multiple one-year extensions (the Exploratory Term), during which Storage User has the right to enter onto the surface of the Premises to conduct exploratory activities in exchange for an upfront payment and fixed annual payments. Taxpayer will treat these payments as rents from real property and did not seek a ruling on their treatment. If Storage User determines that the Premises is suitable for storing CO2, Storage User will begin constructing the carbon storage facility.
Once the carbon injection facility is placed in service, Storage User may elect to enter into a multi-year second phase of the agreement (the Operational Term), during which Storage User will commit to injecting and storing CO2 obtained from emitters within a specified geographic area in the subsurface area of the Premises. During the Operational Term, the Storage User will make monthly payments for the use of the Premises based on the volume of subsurface space used each year, subject to a minimum payment. These payments will be adjusted annually for inflation and may increase after any law change providing additional federal, state or local government benefits for the capture and storage of CO2. Storage User will also be responsible for paying all taxes or government charges imposed on Taxpayer in connection with the injection or storage of CO2 in the subsurface space. In addition, Storage User will make a fixed one-time payment for its rights to use the surface of the Premises during the Operational Term. Taxpayer represented that no portion of these payments (collectively, the Operational Term Payments) will be based on the income or profits of any person.
After termination of the Agreement, Storage User will have the right to permanently store previously injected CO2 in the subsurface space, bear exclusive risk of loss with respect to such CO2, and hold all right, title, interest and ownership of the CO2.
IRC Section 856(c)(2) requires a REIT to derive at least 95% of its gross income from specified sources of passive income, including rents from real property. IRC Section 856(c)(3) requires a REIT to derive at least 75% of its gross income from specified sources of real estate source income, including (1) gain from the sale or disposition of real property and (2) rents from real property.
Under IRC Section 856(d)(1), the term "rents from real property" includes, among other things, rents from interests in real property. Treas. Reg. Section 1.856-4(a) defines the term "rents from real property" generally as the gross amounts received for the use of, or the right to use, the REIT's real property. IRC Section 856(d)(2)(A) excludes from "rents from real property" any amount received that is based, in whole or in part, on a tenant's income or profits from the property.
Treas. Reg. Section 1.856-10(b) defines the term "real property" as land or improvements to land. Treas. Reg. Section 1.856-10(c) defines "land" to include water and air space superjacent to land and natural products and deposits that are unsevered from the land.
If a REIT lease agreement obligates a lessee to pay the state and local real property taxes imposed on the REIT's property, Revenue Ruling 73-426 deems that amount to be for the use of, or right to use, the property; therefore, it constitutes additional rental income to the REIT and qualifies as rents from real property under IRC Section 856(d).
Revenue Ruling 68-291 generally treats consideration received in exchange for granting a permanent easement as proceeds from the sale of an interest in real property, which should be applied as a reduction of the cost or other basis of the portion of land subject to the easement, with any excess treated as gain.
The IRS concluded that:
Thus, the Operational Term Payments are qualifying income for purposes of the 75% and 95% gross income tests under IRC Sections 856(c)(2) and 856(c)(3).
In reaching this conclusion, the IRS stated that each Operational Term Payment is (1) a payment for the use of the Premises during the term of the agreement, (2) a payment for a permanent interest in the Premises, or a (3) combination of both. Because the surface and subsurface of the Premises are land and, therefore, real property for purposes of Treas. Reg. Section 1.856-10(b), the IRS reasoned thatany Operational Term Payment for the use of the Premises during the term of the Agreement meets the general definition of rents from real property, and any Operational Term Payment for a permanent interest in the Premises is "akin" to a payment for a permanent easement and therefore a payment for an interest in real property.
In addition, the IRS noted that the Operational Term Payments include fixed amounts, amounts determined by reference to volumes of CO2, and amounts determined by reference to government charges and benefits, but no amounts determined by reference to the income or profits of any person. Thus, all of the Operational Term Payments represent qualifying income for purposes of the 75% and 95% gross income tests under IRC Sections 856(c)(2) and 856(c)(3).
PLR 202334007 is the first IRS ruling to address the treatment of amounts earned by a REIT in connection with a carbon sequestration agreement that grants an unrelated party the right to inject and permanently store CO2 in the subsurface pore space of a REIT's land. PLR 202334007 is of particular interest given the recent increased focus on clean energy and the enactment of the Inflation Reduction Act.
While the IRS has previously concluded that income attributable to a REIT's receipt of certain carbon offset credits in connection with the REIT's ownership of timberlands is qualifying income for purposes of the 75% and 95% gross income tests under IRC Sections 856(c)(2) and 856(c)(3), those rulings were issued under the IRS's discretionary authority under IRC Section 856(c)(5)(J). See Tax Alert 2020-0076 for a discussion of PLRs 201949004, 201949005 and 201949007. See also PLRs 201751011, 201720008, 201228020, 201123005 and 201123003.
In contrast, in PLR 202334007, the IRS did not rely on IRC Section 856(c)(5)(J) in concluding that the Operational Term Payments are qualifying income. Rather, the IRS concluded that the Operational Term Payments are properly treated as items of qualifying income that are listed under IRC Sections 856(c)(2) and 856(c)(3) — rents from real property, gain from the sale or other disposition of an interest in real property, or a combination of both.
Published by NTD’s Tax Technical Knowledge Services group; Andrea Ben-Yosef, legal editor