In PLR 202522001, the IRS ruled that a real estate investment trust (REIT) could exclude from gross income (1) a damages payment and (2) the reimbursement of legal fees received in connection with a dispute over a real estate transaction for purposes of IRC Section 856(c)(2) and (c)(3) (REIT gross income tests).

Facts

Taxpayer is a REIT with assets that include certain multi-family residential properties (Properties), which are held through disregarded entities or a partnership (Affiliates). Taxpayer and Affiliates agreed to sell Properties to Buyer pursuant to a purchase agreement (Agreement). Taxpayer represented that the gain from selling the Properties would have been qualifying income under the REIT gross income tests.

The Agreement required Buyer to place a deposit (Deposit) in escrow and specified that if the closing did not to occur due to Buyer's default, Taxpayer's legal remedies would be limited to retaining the Deposit as liquidated damages. Buyer failed to appear at the closing; Taxpayer treated this as a Buyer default under the Agreement and demanded that the Deposit be released from escrow to the Taxpayer.

Buyer objected and several years of litigation followed. The trial court found that Buyer breached the Agreement, held that the liquidated damages provision was unenforceable, but awarded Taxpayer and Affiliates legal fees. Both parties appealed the trial court's decision.

The appellate court affirmed (1) that Buyer breached the Agreement and (2) the award of legal fees to Taxpayer. The appellate court also enforced the liquidated damages clause of the Agreement.

Taxpayer, Affiliates and Buyer subsequently reached a settlement comprised of the Deposit plus an amount in lieu of the legal fee amount awarded by the courts (Legal Fee Settlement), which was paid to Taxpayer.

Law and analysis

IRC Section 856(c)(2) requires a REIT to derive at least 95% of its gross income from certain types of income, including rents from real property and gain from the sale of stock, securities, or real property that is not held primarily for sale to customers in the ordinary course of a trade or business (dealer property under IRC Section 1221(a)(1)). IRC Section 856(c)(3) requires a REIT to derive at least 75% of its gross income from certain types of income, including rents from real property and gain from the sale of real property that is not dealer property under IRC Section 1221(a)(1).

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 REIT gross 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.

The IRS observed that the Deposit was to serve as damages for Buyer's breach of contract, and Taxpayer's damages here stemmed from an attempted sale of the Properties. Gain from the sale of the Properties would have been qualifying income for purposes of the REIT gross income tests. Accordingly, the IRS concluded that excluding the Deposit from Taxpayer's gross income for purposes of the REIT gross income tests is consistent with the purposes of the REIT provisions of the tax code.

The IRS further explained that the Legal Fee Settlement represented a reimbursement to Taxpayer of legal costs incurred in establishing its right to damages following Buyer's failure to close on its purchase of the Properties. As Taxpayer's gain from such a sale would have been qualifying income for purposes of the REIT gross income tests, the IRS determined that Taxpayer's gross income from receipt of the Legal Fee Settlement should not result in nonqualifying income to Taxpayer. Accordingly, the IRS concluded that excluding the Legal Fee Settlement from Taxpayer's gross income for purposes of the REIT gross income tests is consistent with the purposes of the REIT provisions of the tax code.

Implications

PLR 202522001 is consistent with prior PLRs in in which the IRS has ruled that a REIT's income from the pursuit and settlement of a real estate-related dispute may be disregarded for purposes of the REIT gross income tests.

The IRS previously ruled pursuant to its authority under IRC Section 856(c)(5)(J) that where a REIT was a plaintiff or claimant in a lawsuit related to a real estate investment, the amounts received for settling and pursuing such claims were excluded from gross income for purposes of the REIT gross income tests (see PLRs 201145008 and 201122016). The IRS concluded in these earlier rulings that excluding the amounts received in settlement of the REIT's claims did not interfere with Congressional policy objectives in enacting the gross income tests.

Prior to the enactment of IRC Section 856(c)(5)(J), the IRS ruled that similar amounts could be excluded from a REIT's gross income for purposes of the gross income tests. See PLR 9636014 (concluding that a payment received by a REIT in settlement of a legal dispute over lease terms would not be taken into account in determining whether the REIT satisfied the gross income tests); PLR 200039027 (excluding settlement payments made to a REIT in connection with a dispute over a mall development from gross income for purposes of the Income Tests); PLR 200127024 (excluding a merger termination fee paid to a REIT in connection with the REIT's pursuit of legal remedies resulting in settlement of an alleged breach of a merger agreement from gross income for purposes of the Income Tests). In contrast, in PLR 9308013, the IRS concluded that a REIT's recovery of fair rental damages in a lawsuit against a sublessee was in substitution for rent and should therefore be considered qualifying rents from real property for purposes of the REIT gross income tests.