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In six private letter rulings¹ released on May 10, 2024 (the Rulings), the IRS found that a failure by a real estate investment trust (REIT) to properly identify an interest rate cap as a hedging transaction under Treas. Reg. Section 1.1221-2(f)(1) and (2) was due to inadvertent error.

Accordingly, the taxpayers in the rulings may treat the late identification of the interest rate cap as satisfying the hedge identification requirements on the date the transactions were entered, assuming the identification requirements were otherwise met.

Facts

In each Ruling, investment funds (Funds) collectively own 100% of the common stock of the REIT taxpayer, a limited liability company that elected to be taxed as a REIT beginning with its initial tax year. Each REIT wholly owns a subsidiary (Company A) that is disregarded as separate from the REIT for US federal income tax purposes.

In each case, Company A issued a floating interest rate debt instrument (Note) to a third-party lender for the purpose of acquiring or carrying a real estate asset (Property). Each REIT represented that a specified percentage of gross income derived from Property has qualified as rents from real property under IRC Section 856(d) each tax year since the REIT's initial tax year. The terms of each Note required Company A to enter into an interest rate cap (Cap) agreement.

On the Note's issuance date, Company A executed a Cap agreement to manage its exposure to interest rate fluctuations with respect to Company's A floating rate interest payments under the Note. The Cap agreement required Company A's counterparty to pay Company A if market interest rates rose above a target rate. The counterparty began making monthly payments to Company A at the point interest payments from Company A to lender exceeded the Cap's target interest rate.

At the time the Cap agreement was executed, the Funds' accounting firm erroneously believed that the REIT was not required to identify the Cap as a hedging transaction because the Cap was required under the terms of the Note and therefore was not a strategic investment that was separate from the Note. The REIT relied on the accounting firm's expertise and advice on such matters.

Subsequently, as part of due diligence procedures conducted by the Funds' outside tax counsel (Law Firm), Law Firm asked the Funds' about hedging transactions similar to the Cap. In response to Law Firm's inquiry, the Funds told Law Firm that they were not aware of the tax hedge identification requirements and therefore had not identified the Cap as a hedging transaction under IRC Section 1221(a)(7) and Treas. Reg. Section 1.1221-2(f). Law Firm informed the Funds and the REIT that the REIT was required to identify the Cap as a hedging transaction. Because the REIT had not done so, the payments to Company A under the Cap would not be excluded from gross income for purposes of the REIT gross income tests unless failure to identify the Cap as a hedging transaction resulted from inadvertent error. Accordingly, the REIT promptly executed a hedge identification for the Cap that satisfied the hedge identification requirements other than the same-day identification timing requirement. The REIT also established a procedure to ensure that subsequent hedging transactions were timely identified for tax purposes.

Law and analysis

Under IRC Section 856(c)(5)(G)(i), income from a hedging transaction, including gain from the sale or disposition of a hedging transaction, is excluded from gross income for purposes of the REIT gross income tests under IRC Section 856(c)(2) and (3) to the extent the transaction hedges indebtedness incurred or to be incurred by the REIT to acquire or carry real estate assets. IRC Section 856(c)(5)(G)(iv) further requires the hedging transaction to satisfy the identification requirement of IRC Section 1221(a)(7) "(determined after taking into account any curative provisions provided under the regulations referred to therein)."²

Under Treas. Reg. Section 1.1221-2(f)(1), the required identification of a transaction as a tax hedge must be made on the same day that the taxpayer enters into the transaction. Under Treas. Reg. Section 1.1221-2(g), a taxpayer's failure to timely and clearly identify a transaction as a tax hedge on the execution date will generally prohibit the transaction from being treated as a tax hedge unless the failure was inadvertent and other requirements are met.

In each Ruling, the REIT represented that the Cap met the definition of a hedging transaction under Treas. Reg. Section 1.1221-2(b). However, because the REIT failed to timely identify the Cap under IRC Section 1221(a)(7) and Treas. Reg. Section 1.1221-2(f)(1), the issue before the IRS was whether that failure was due to "inadvertent error," which is not defined in the regulations. The IRS reasoned that the term "inadvertent error" should be given its ordinary meaning of an "accidental oversight; a result of carelessness" as defined in Black's Law Dictionary and stated that whether a mistake results from inadvertent error must be based on all the facts and circumstances.

The IRS ruled in each case that REIT's failure to identify the Cap resulted from inadvertent error within the meaning of Treas. Reg. Section 1.1221-2(g)(2)(ii). In support of that conclusion, it noted that the REIT (1) relied on the advice of accounting firm professionals who mistakenly believed that a tax hedge identification was not required for the Caps; (2) promptly made substantial efforts to correct the errors once identified, and (3) established a procedure to correctly and promptly identify future hedges under to the tax hedge identification requirements.

Implications

The IRS has addressed whether a failure to satisfy the tax hedge identification requirements was due to inadvertent error on several occasions over the past 24 years.³ Three private letter rulings published in 2000 established that the term "inadvertent error" is given its ordinary meaning and refers to an accidental oversight or a result of carelessness. Although seemingly applying the same standard, the IRS guidance post-2000 appeared to take the position that establishing "inadvertent error" means the taxpayer had to show both inadvertence and error (that is, the IRS did not seem to view the error aspect as met simply because a hedging transaction was not properly identified). Moreover, at bar panels and similar discussions, IRS personnel appeared to take the position that the inadvertent error rule was very limited.

The Rulings here do not analyze the term "inadvertent error" as two independent requirements and thus appear closer to the rulings issued in 2000. However, there are hints that the IRS may still require a higher showing than simple accidental oversight or carelessness. For example, the IRS notes that the taxpayer, upon discovering the error, promptly executed a hedge identification for the Cap that satisfied the hedge identification requirements other than the same-day identification timing. Although such actions are advisable, they likely do not bear directly on whether the error was inadvertent or whether the taxpayer otherwise meets the requirements under the inadvertent-error exception. The published guidance demonstrates that the IRS has no particular discretion in answering the question of whether an inadvertent error existed; the legal question is addressed by courts based on all of the facts and circumstances of the particular taxpayer.

Applying the inadvertent-error exception in the context of a REIT, it could be argued that a REIT's failure to identify a hedging transaction ought to be presumed to result from inadvertent error. Support for this argument stems from the facts that (1) a REIT's failure to properly identify a hedging transaction causes income from that transaction to be nonqualifying income under the REIT gross income tests under IRC Sections 856(c)(2) and (3); and (2) a REIT does not gain any meaningful tax benefit from an intentional nonidentification.