January 14, 2024
IRS rules income attributable to the issuance of carbon emission offsets constitutes qualifying REIT income
In PLR 202401011 and PLR 202402002, the IRS ruled under IRC Section 856(c)(5)(J)(ii) that a real estate investment trust's income from the issuance of carbon emission offsets (Offsets) by a greenhouse gas registry and emissions tracking system (Registry) will be considered qualifying income under IRC Section 856(c)(2) and (c)(3). The IRS also ruled that income from the issuance of the Offsets will accrue upon the earliest of when the Offsets are earned, received or due, unless IRC Section 451(b)(1)(A) requires earlier inclusion.
In PLR 202401011, Taxpayer, a limited liability company that intends to elect to be taxed as a real estate investment trust (REIT), expects that its wholly owned disregarded entity (Subsidiary) will hold title to a portion of Taxpayer's commercial forestland (Site). Through Subsidiary, Taxpayer intends to participate in a carbon sequestration project designed to enhance the Site's long-term capacity to sequester atmospheric carbon (Project).
Under an agreement between Subsidiary and Taxpayer's technical consultant (Intermediary), Intermediary will develop the Project and calculate the estimated quantity of additional carbon that can be sequestered at the Site through improved forest management practices. Subsidiary will agree to certain land-use restrictions required by the Project (e.g., not to harvest above a certain volume of timber each year or a volume exceeding a specified amount of growth in a year). Subsidiary could record the land-use restrictions as easements under local law. The Registry will issue Offsets to Taxpayer based on the quantity of additional carbon that can be sequestered at the Site due to the Project's land-use restrictions.
The Registry requires Taxpayer to assess and mitigate the risk that Offsets will be reversed and select a risk mitigation mechanism for the Project. Therefore, the Taxpayer intends to participate in the Registry's buffer pool by contributing a certain number of Offsets to the pool. If a reversal of Offsets occurs that exceeds the number of Offsets Taxpayer has contributed to the buffer pool, Taxpayer will be required to contribute additional Offsets to the pool. The number of Offsets required to be contributed is lower for an unintentional reversal (e.g., due to a forest fire) than for an intentional reversal.
Upon registration and issuance of the Offsets by the Registry, Taxpayer will transfer the Offsets (other than those contributed to the buffer pool) to Intermediary, which will market them for sale to third parties. Taxpayer will bear the benefits and burdens of ownership of the Offsets from issuance until sale and does not intend to hold the Offsets for the purpose of speculating on future appreciation.
Taxpayer represents that it will include the fair market value of the Offsets in gross income upon issuance. Income attributable to issuance of the Offsets is intended to compensate Taxpayer for the loss of revenue from otherwise permissible timber sales and the decrease in value and income resulting from Taxpayer's adherence to the land-use restrictions. Taxpayer will treat any gain from the sale of Offsets as nonqualifying income under IRC Section 856(c)(2) and (c)(3).
The facts of PLR 202402002 are substantially similar to those of PLR 202401011, the primary difference being that Subsidiary in PLR 202402002 acquired the Site from a third party (Seller) that had already entered into an agreement with Intermediary for the development of the Site. Thus, Subsidiary assumed all rights, title and interests of the Seller in such agreement and succeeded the Seller with respect to the Project. PLR 202402002 includes a caveat that the ruling relates only to those Offsets earned by Taxpayer, and expresses no opinion regarding any Offsets that were earned by, or issued to, the Seller and received by Taxpayer after purchasing the Site.
Law and analysis
Under IRC Section 61(a), gross income includes income realized in any form, whether in money, property or services. IRC Section 451 and its regulations provide rules for determining the tax year of inclusion for items of gross income.
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; abatements and refunds of taxes on real property; and certain other sources of income.
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; abatements and refunds of taxes on real property; and 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 (1) disregarded for purposes of the 95% or 75% income tests or (2) treated as qualifying income for purposes of the 95% or 75% income tests.
In each ruling, the IRS reasoned that the Offsets are akin to receiving payment for granting an easement for a term of years with respect to real property because Taxpayer will earn the Offsets by agreeing to and complying with restrictions that require Taxpayer to abstain from certain uses of its land and perform certain actions on its land. Under these circumstances, the IRS concluded that treating Taxpayers' income from the issuance of the Offsets as qualifying income does not interfere with or impede Congress's objectives in enacting the REIT income tests. Accordingly, the IRS ruled under IRC Section 856(c)(5)(J)(ii) that Taxpayers' income from the issuance of the Offsets will be considered qualifying income under IRC Section 856(c)(2) and (c)(3).
The IRS also ruled that income from the issuance of Offsets will accrue upon the earliest of when the offsets are earned, received or due, unless IRC Section 451(b)(1)(A) requires earlier inclusion.
PLRs 202401011 and 202402002 are the most recent private letter rulings in which the IRS has exercised its discretionary authority under IRC Section 856(c)(5)(J) to conclude that income attributable to a REIT's receipt of carbon emission offset credits in connection with owning timberlands will be considered qualifying income for purposes of the REIT income tests. See Tax Alert 2020-0076 regarding PLRs 201949004, 201949005 and 201949007. See also PLRs 201720008, 201123005 and 201123003 (as modified by 201751011).
As in PLRs 201949004, 201949005 and 201949007, the IRS offers no opinion in PLRs 202401011 and 202402002 on the tax consequences of disposing of the Offsets, including whether selling the Offsets gives rise to qualifying income for purposes of the REIT income tests and whether a sale constitutes a prohibited transaction under IRC Section 857(b)(6)(B)(iii). The Taxpayers in PLRs 202401011 and 202402002 represent, however, that they will treat any gain from the sale of the Offsets as nonqualifying income.
It is worth noting that the IRS recently addressed (in PLR 202334007) how to treat amounts earned by a REIT in connection with a carbon sequestration agreement granting an unrelated party the right to inject and permanently store carbon dioxide in the subsurface pore space of a REIT's timberlands. In that ruling, the IRS did not rely on IRC Section 856(c)(5)(J) in concluding that resulting payments are qualifying income. Instead, the IRS ruled that those payments are properly treated as items of qualifying income listed under IRC Section 856(c)(2) and (c)(3) as either rents from real property, gain from the sale or other disposition of an interest in real property or a combination of both. See Tax Alert 2023-1449.