11 October 2024 IRS concludes for first time that zero gross income and zero assets did not cause REIT to fail gross income tests or 75% asset test
In PLR 202440007, the IRS concluded for the first time that a lack of assets and income in the first tax year of a real estate investment trust (REIT) did not cause the REIT to fail the 95% and 75% REIT gross income tests or the 75% REIT asset test. Accordingly, the IRS declined to issue the requested ruling to treat the taxpayer as if it had not made a REIT election for its first tax year. A partnership (Parent) formed Taxpayer as a corporation in Year 1, intending to contribute the proceeds of an equity offering to Taxpayer in the same year to enable Taxpayer to acquire interests in certain limited liability companies that own multi-family properties. Due to a delay in receiving regulatory and investor approvals, however, Parent could not do so until the next year (Year 2). As a result, Taxpayer had no gross income or assets in Year 1 and only acquired the limited liability company interests in Year 2. Taxpayer engaged Firm 1 to prepare its tax return for Year 1. According to the PLR, Firm 1 was aware of no clear IRS guidance requiring a REIT to have gross income or assets to satisfy the REIT qualification tests. Accordingly, Firm 1 prepared, and Taxpayer filed, a Form 1120-REIT showing zero assets and zero income for Year 1. During a subsequent audit of Parent's financial statements, Firm 3 advised Taxpayer that (1) it was unclear whether a REIT could satisfy the REIT qualification tests if it had no gross income or assets, and (2) Taxpayer would be precluded from electing REIT status for five years if it failed to qualify as a REIT in Year 1. Taxpayer represented that Firm 1 and Firm 3 were qualified in REIT matters. To resolve this issue, Taxpayer requested a ruling treating it as if it had not made a REIT election for Year 1 and not treating its intended filing of an amended Form 1120-X for Year 1 as a termination or revocation of its REIT status. IRC Section 856(c)(2) requires a REIT to derive at least 95% of its gross income from specified sources of passive income. IRC Section 856(c)(3) requires a REIT to derive at least 75% of its gross income from certain real estate source income. An entity is not a REIT for a tax year unless it meets certain requirements regarding the sources of its gross income for the tax year. In determining whether a REIT's gross income satisfies the 95% or 75% REIT gross income tests, the term "gross income" has the same meaning as under IRC Section 61 for purposes of both the numerator and denominator used for computing the specified percentages (Treas. Reg. Section 1.856-2(c)). IRC Section 856(c)(4)(A) requires that at least 75% of the value of a REIT's total assets at the close of each quarter of its tax year consist of real estate assets, cash and cash items (including receivables), and government securities. An entity will not be considered a REIT for any tax year unless it files a REIT election with its return for that year or has made a REIT election for a previous tax year and the election has not been terminated or revoked under IRC Section 856(g) (IRC Section 856(c)(1)). An entity's REIT election will terminate if it fails to meet the REIT qualification requirements in IRC Sections 856 through 859 (IRC Section 856(g)(1)). A REIT election may be revoked for any tax year after the first tax year for which the election is effective, and the termination or revocation is effective for the tax year in which it occurs and for all succeeding tax years (IRC Section 856(g)(2)). If an entity's REIT election has been terminated or revoked, neither that entity nor any successor will generally be eligible to make a REIT election for five tax years (IRC Section 856(g)(3)). Reasoning that 95% of $0 equals $0 and 75% of $0 equals $0, the IRS concluded that Taxpayer derived at least $0 of gross income in Year 1 from qualifying sources under each of the REIT gross income tests. Citing the 1960 legislative history of the REIT provisions, which states that "[o]ne of the principal purposes of … imposing restrictions on types of income of a qualifying [REIT] is to be sure the bulk of its income is from passive income sources and not from the active conduct of a trade or business" (H.R. Rep. No. 86-2020 (1960)), the IRS explained that Congress was primarily concerned with the sources of a REIT's income. The IRS emphasized that (1) Treas. Reg. Section 1.856-2(c) interprets the REIT gross income tests "as being concerned with the sources of a REIT's gross income and not with whether the REIT has gross income in the first instance" (emphasis added), and (2) Treas. Reg. Section 1.856-2(c)(1) does not prevent REIT qualification as a result of having zero gross income. Accordingly, the IRS concluded that Taxpayer did not fail the REIT gross income tests in Year 1. Regarding the 75% REIT asset test, the IRS reasoned that the legislative history's statement that the asset test "is designed to give assurance that the bulk of the [REIT's] investments are in real estate" (H.R. Rep. No. 86-2020 (1960)) demonstrates that "Congress was concerned with the nature of a REIT's assets and not whether the REIT had assets in the first instance" (emphasis added). Thus, the IRS viewed its conclusion that the REIT did not fail the asset test even though it had no assets as consistent with the legislative history. Because 75% of $0 equals $0, at least $0 of Taxpayer's assets were represented by the qualifying items listed in the 75% asset test. Accordingly, the IRS concluded that Taxpayer did not fail the 75% asset test in Year 1. Because the IRS concluded that the lack of assets and income in Year 1 did not cause Taxpayer to fail the REIT gross income tests or the 75% REIT asset test, the IRS denied Taxpayer's request to be treated as if it had not made a REIT election for Year 1, and concluded it was unnecessary to address Taxpayer's related request regarding filing an amended non-REIT tax return for Year 1. PLR 202440007 is the first IRS ruling to address a REIT's ability to satisfy the 95% and 75% gross income tests when it has zero gross income and the 75% REIT asset test when it has zero assets. There has long been uncertainty among taxpayers and tax advisors regarding whether a REIT could satisfy these requirements absent any income or assets. Given the five-year prohibition on reelecting REIT status after the termination or revocation of a REIT election, the consequences to a REIT of recognizing zero gross income or having zero assets for a tax year were potentially significant. Some taxpayers have addressed this issue by having a newly-formed REIT acquire at least some amount of qualifying assets, which include cash and cash items, and making sure that the REIT recognize at least a small amount of qualifying income, which includes qualifying temporary investment income. Occasionally, however, a REIT may not be able to invest in an income-producing asset before a tax year-end or may not have realized that it recognized zero gross income or had zero assets until after the close of a tax year (or calendar quarter for the 75% asset test). While only the taxpayer that receives a private letter ruling can rely upon it, the IRS's conclusion in PLR 202440007 should provide some helpful guidance to REITs and their advisors on applying the REIT gross income tests and/or 75% asset test where a REIT has zero gross income and/or zero assets. However, given the lack of binding authority, it may still be prudent for REITs to seek to keep their gross income and assets above zero.
Document ID: 2024-1877 | ||||||