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In PLR 202405001, the IRS issued several rulings on the treatment under the REIT income tests of certain payments by local governments to a real estate investment trust (REIT) to incentivize the REIT's development of real property. Specifically, the IRS ruled that:

1. Repayments of principal under an incentive arrangement involving bonds issued by a local government would generate qualifying income for purposes of IRC Section 856(c)(2) and (3)
2. Repayments of interest under the bond arrangement would generate qualifying income but only for purposes of IRC Section 856(c)(2)
3. Reimbursements for construction costs would generate qualifying income for purposes of IRC Section 856(c)(2) and (3) to the extent the reimbursements were payable from property taxes imposed on real property owned by the REIT
4. Reimbursements for construction costs would generate qualifying income only for purposes of IRC Section 856(c)(2) to the extent the reimbursements were payable from other sources

Facts

Taxpayer, a publicly traded corporation that has elected to be taxed as a REIT, is engaged in acquiring, redeveloping and leasing hotels. Taxpayer holds interests in a limited partnership (Operating Partnership). Through disregarded entities, Operating Partnership owns hotels, including Property 1 (which Operating Partnership holds through Property 1 Owner) and Property 2 (which Operating Partnership holds through Property 2 Owner). Operating Partnership also owns all the interests in Taxpayer's taxable REIT subsidiary (Lessee).

Property 1 Owner and Property 2 Owner have leased Property 1 and Property 2, respectively, to Lessee's disregarded entities, which have engaged an eligible independent contractor (within the meaning of IRC Section 856(d)(9)) from which Taxpayer does not derive any income to manage and operate the hotels. Taxpayer represented that substantially all income that it derives from Property 1 and Property 2 (other than income from the "Bonds" and "Reimbursement Amounts," as defined below) is rental income that constitutes qualifying income for purposes of IRC Section 856(c)(2) and (3).

Certain governmental entities have entered into financial arrangements, as explained below, with Taxpayer to incentivize the construction and development of Property 1 and Property 2.

Property 1 — Bonds

The county in which Property 1 is located (County) has issued bonds (Bonds) to Taxpayer to partially fund the construction costs of Property 1. The Bonds bear a fixed interest rate, provide for one or more partial principal payments and provide for payment of the remaining stated principal at maturity. County pays interest and principal on the Bonds solely from an account funded with incremental property taxes imposed on Property 1 and occupancy taxes paid by Property 1's guests (Tax Increment Fund). If the Tax Increment Fund has insufficient cash to make the full scheduled payment on the Bonds, the unpaid amount is deferred until the next payment date. Taxpayer intends to hold the Bonds to maturity and expects to receive all stated principal and interest due under the Bonds.

The IRS issued a prior PLR to Taxpayer upon its receipt of the Bonds, ruling that (i) the transfer of the Bonds to Taxpayer was a nonshareholder contribution of capital under IRC Section 118(a), and (ii) Taxpayer's initial basis in the Bonds was zero under IRC Section 362(c)(1).

Taxpayer represented that (i) the Bonds are securities under IRC Section 856 and the Investment Company Act of 1940, (ii) the Bonds are debt instruments under Treas. Reg. Section 1.1275-1(d), (iii) the Bonds are not market discount bonds, and (iv) receiving payments of stated interest on the Bonds constitutes compensation for the use or forbearance of money.

Property 2 — Reimbursement Amounts

The municipality in which Property 2 is located (Municipality) and a government agency (Agency) entered into an agreement (Incentive Agreement) with Taxpayer. Taxpayer then sold the rights to develop Property 2, including the right to acquire the site of Property 2, to an unrelated party (Developer) and assigned the Incentive Agreement to Developer. Developer subsequently assigned Property 2 and all rights under the Incentive Agreement (including all rights to the Reimbursement Amounts (defined below)) to a disregarded entity of Property 2 Owner. Operating Partnership later acquired all the interests in Property 2 Owner, at which time Property 2 Owner became a disregarded entity of Operating Partnership and Operating Partnership reacquired all rights to the Reimbursement Amounts.

Under the Incentive Agreement, Agency directly reimburses Taxpayer for its eligible construction costs for Property 2 (the Reimbursement Amounts). The Agency funds the Reimbursement Amounts solely from (i) incremental real and personal property taxes that Municipality and certain other local governments and agencies impose on Property 2 and certain other properties, (ii) all real and personal property taxes that a new district imposes on Property 2, and (iii) certain sales, use and lodger's taxes collected by the Municipality and the state in which Municipality is located.

Law and analysis

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 and abatements and refunds of real property taxes.

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 rents from real property and abatements and refunds of real property taxes.

Under Treas. Reg. Section 1.856-3(g), a REIT that is a partner in a partnership is deemed to own its proportionate share of the partnership's assets and is entitled to the income of the partnership attributable to that share for purposes of applying the REIT asset and income tests.

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.

PLR 202405001 contains five rulings. Rulings 1 through 3 pertain to the Bonds issued for Property 1. Rulings 4 and 5 relate to the Reimbursement Amounts paid for Property 2.

Ruling 1: Interest on the Bonds is "interest" under IRC Section 856(c)(2)(B)

The IRS ruled that Taxpayer's allocable share of income from Bond payments that are otherwise treated as interest under the IRC constitutes "interest" under IRC Section 856(c)(2)(B). Under Treas. Reg. Section 1.856-5(a), the term "interest" as used in IRC Section 856(c)(2) and (3) includes only amounts that constitute compensation for the use or forbearance of money. Treas. Reg. Section 1.856-5(a) also states that "interest" does not generally include any amount received or accrued, directly or indirectly, if the determination of that amount depends in whole or in part on the income or profits of any person.

Interest on the Bonds is payable at a stated, fixed rate, and the only exception to payment applies when there is a deficit in the Tax Increment Fund. The County finances the Tax Increment Fund with 100% of its proceeds from specified real property taxes and occupancy taxes. The County does not reduce the funds in the Tax Increment Fund via any method other than payments on the Bonds. Accordingly, the IRS determined that interest payments on the Bonds do not depend on the income or profits of County. The IRS therefore concluded that interest payments on the Bonds would not be treated as "other than interest" for purposes of IRC Section 856(c).

Ruling 2: Non-interest payments on the Bonds are gains from the sale of securities under IRC Section 856(c)(2)(D)

Under IRC Section 1271(a)(1), amounts received upon retirement of a debt instrument are considered amounts received in exchange for the debt instrument. In Timken v. Commissioner, 6. T.C. 483 (1946) and Avery v. Commissioner, 13 T.C. 351 (1949), the Tax Court held that each partial payment on a promissory note constituted a partial retirement of the note and therefore an amount received in exchange for a portion of the note. Under IRC Section 856(c)(2)(D), gain from the "sale or other disposition" of securities is qualifying income for purposes of the 95% income test.

Citing IRC Section 1271(a)(1), Timken, and Avery, the IRS ruled that Taxpayer's allocable share of income from Bond payments that are not treated as interest under the IRC will be treated as gain from the sale or other disposition of securities for purposes of IRC Section 856(c)(2)(D).

The IRS noted that the reference in IRC Section 856(c)(2)(D) to gain recognized on a "sale or other disposition" of stock or securities is broad enough to include an "exchange" as used in IRC Section 1271(a). Because Taxpayer represented that the Bonds are (i) securities under IRC Section 856 and the Investment Company Act of 1940, (ii) debt instruments under Treas. Reg. Section 1.1275-1(d) and (iii) not market discount bonds, the IRS concluded that non-interest payments on the Bonds represent gains from the disposition of a security.

Ruling 3: Non-interest gains on the Bonds will be treated as qualifying income under IRC Section 856(c)(3)

The IRS ruled under IRC Section 856(c)(5)(J) that Taxpayer's allocable share of gain (not including any amounts properly treated as interest for tax purposes) from the Bonds, including gain from receiving partial principal payments, will be treated as qualifying income for purposes of IRC Section 856(c)(3). In so ruling, the IRS stated that Taxpayer's gain on the Bonds is not attributable to investment experience but is in substance deferred recognition of County's financial assistance. Furthermore, Taxpayer represented that substantially all its income from Property 1 (other than income from the Bonds) is rents from real property and qualifying income for purposes of IRC Section 856(c)(2) and (3). Given these circumstances, the IRS concluded that treating Taxpayer's share of non-interest gain from the Bonds as qualifying income is consistent with the purposes of Part II of Subchapter M of the IRC.

Ruling 4: The portion of Reimbursement Amounts attributable to Operating Partnership's property taxes is an abatement or refund of taxes on real property under IRC Section 856(c)(2)(E) and (3)(E)

The IRS ruled that Taxpayer's allocable share of income from the Reimbursement Amounts, to the extent attributable to property taxes imposed on Operating Partnership's real property, is an abatement or refund of taxes on real property under IRC Section 856(c)(2)(E) and (3)(E). The IRS determined that the Reimbursement Amounts should be bifurcated between (i) the portion that is a return of Taxpayer's capital (and therefore not gross income for purposes of IRC Section 856(c)(2) or (3)), based on an allocation of basis from Operating Partnership's acquisition of Property 2 Owner to the right to receive the Reimbursement Amounts and (ii) the remainder (RA Gross Income). The RA Gross Income is further divisible between the amount attributable to real property taxes that Operating Partnership pays on its own property (the Real Property Tax Fraction) and the amount attributable to the remaining taxes that fund the RA Gross Income (the Remaining Fraction). The IRS concluded that the product of the Real Property Tax Fraction and the amount of RA Gross Income is properly treated as income derived from a refund of taxes on real property under IRC Section 856(c)(2)(E) and (3)(E).

Ruling 5: The product of the Remaining Fraction and RA Gross Income will be treated as qualifying income under IRC Section 856(c)(2)

The IRS ruled under IRC Section 856(c)(5)(J) that the product of the Remaining Fraction and the amount of RA Gross Income will be treated as qualifying income for purposes of IRC Section 856(c)(2). The IRS stated that this ruling is consistent with the purposes of Part II of Subchapter M of the IRC based on, among other things, Taxpayer's representation that substantially all its income from Property 2 (other than the income from the Reimbursement Amounts) is rents from real property and qualifying income for purposes of IRC Section 856(c)(2) and (3).

Implications

PLR 202405001 is the latest ruling in which the IRS relied on its authority under IRC Section 856(c)(5)(J) to address incentive-type payments received or accrued by a REIT from a state or local jurisdiction in connection with the development of real property. For discussion of other rulings under IRC Section 856(c)(5)(J), see Tax Alert 2023-0265.

Similar to the rulings in PLRs 201816001, 201816002 and 201816003 (see Tax Alert 2018-0960), the IRS in PLR 202405001 treated a portion of the Reimbursement Amount as a refund of real property taxes under IRC Section 856(c)(2)(E) and (3)(E). In contrast to many previous PLRs, however, the IRS did not use its authority under IRC Section 856(c)(5)(J) to rule that the remainder of the Reimbursement Amount was qualifying income for purposes of IRC Section 856(c)(3); instead, it concluded that the amount would be treated as qualifying solely for the purposes of IRC Section 856(c)(2). This conclusion is similar to that in PLR 202006001, where the IRS held that income attributable to reimbursement payments received by a REIT under an economic development agreement with a city was qualifying income for purposes IRC Section 856(c)(2) but not IRC Section 856(c)(3) (see Tax Alert 2020-0354). Operating Partnership's acquisition of Property 2 Owner from Developer following Developer's construction of some portion of Property 2 is not unlike the facts in PLR 202006001, where the REIT purchased a fully-developed rental property and succeeded to the seller's contractual rights to receive the incentive-type payments from the city.

In contrast, Taxpayer owned Property 1 throughout its construction, and the IRS concluded that the non-interest payments received on the Bonds were qualifying income for purposes of both IRC Section 856(c)(2) and (c)(3). Despite concluding that Taxpayer's allocable share of income from non-interest payments on the Bonds will be treated as gain from the sale or other disposition of securities for purposes of IRC Section 856(c)(2)(D), the IRS exercised its discretionary authority under IRC Section 856(c)(5)(J) to permit the treatment of those payments as nevertheless qualifying under IRC Section 856(c)(3).

The IRS's approach to interest payments on the Bonds may run contrary to its approach in PLR 201732012, where a state agency issued bonds to the public and loaned the proceeds to a REIT for use in developing a building. The agency placed the proceeds in a special account under its sole control and reduced the debt service on the bonds with any interest earned on the funds in the account. Despite not holding legal title to the account at any point, the REIT received a Form 1099 from the agency regarding interest earned on the account. The IRS ruled under IRC Section 856(c)(5)(J) that the interest income would be treated as qualifying income under IRC Section 856(c)(3). Because the proceeds in the account had to be used to construct a building that constituted real property, and the interest on the bond proceeds had to reduce the debt service, the IRS reasoned that the interest income the REIT received was "inextricably linked to the development of the [residential building], which is real property that will generate qualifying rental income."

While it is encouraging that the IRS generally continues to take a favorable view under the REIT income tests regarding "incentives" received by a REIT to develop real property that will produce qualifying rental income, PLR 202405001 may present some fresh uncertainties in this space. Also, the third and fifth rulings in this PLR rely on the IRS's exercise of its discretionary authority under IRC Section 856(c)(5)(J). Given these considerations, REITs with similar situations will want to consider whether to seek their own rulings.