In the last several months, the IRS has released five private letter rulings (PLR), some of which were obtained by professionals at EY, addressing whether certain items of income recognized by a real estate investment trust (REIT) invested in timberlands constitute qualifying income for purposes of the REIT gross income tests under IRC Sections 856(c)(2) and 856(c)(3) (Income Tests). The IRS concluded that carbon emission offset credits, reforestation grant payments, settlement payments for damages and carbon sequestration payments are qualifying income for the Income Tests.

Facts

Offsets

In PLRs 202536023, 202536024, 202536025 and 202549006, the Taxpayer is a REIT that owns commercial forestland (Site). A greenhouse gas (GHG) registry and emissions tracking system (Registry) approved by a state agency (Agency) is used by members to register verified project-based GHG emissions reductions and removals as serialized carbon offset credits (Offsets) and to record the issuance, retirement and cancellation of Offsets. Taxpayer submitted to Registry a listing for a carbon sequestration project on a portion of the Site that would enhance the Site's long-term capacity to absorb and store atmospheric carbon in trees (Project). The Project also involves calculating the estimated quantity of additional carbon that can be sequestered at the Site through improved forest management practices. Taxpayer agreed to certain obligations and land-use restrictions for the Project that could be recorded as easements or restrictive covenants under local law (e.g., the Project must include a set percentage of native species).

Agency issues Offsets to Taxpayer based on the quantity of carbon dioxide removed from the environment due to the Project's land-use restrictions. Offsets are intended to compensate Taxpayer for the loss of revenue from timber sales and the decrease in value and income caused by complying with the land-use restrictions.

When Agency issues Offsets, it holds back a risk-adjusted portion of the Offsets (Reserved Offsets) that it places in a buffer account. If an unintentional reversal of Offsets occurs (e.g., due to a forest fire), Reserved Offsets are retired in an amount equal to the total metric tons of carbon dioxide that were reversed. If an intentional reversal of Offsets occurs (e.g., due to Taxpayer's negligence), Taxpayer must purchase Offsets in the market and relinquish them to Agency to replace the reversed Offsets.

In PLRs 202536023, 202536024 and 202536025, Taxpayer represented that it does not intend to hold Offsets for speculative purposes and will transfer Offsets to a taxable REIT subsidiary (TRS) that will sell the Offsets to unrelated purchasers. In PLR 202549006, Taxpayer similarly represented that it does not intend to hold the carbon offset credits for speculative purposes, but represented that it would directly sell the credits and treat any gain from the sales as nonqualifying income for purposes of the Income Tests.

Grant payments

In PLRs 202536023 and 202536024, Taxpayer receives reforestation grant payments (Grant Payments) that reimburse Taxpayer for all or a portion of its costs incurred in reforesting and restoring portions of the Site that were damaged by wildfires. Taxpayer represented that when the reforested portions of the Site mature, substantially all the income generated from those assets will constitute qualifying income for purposes of the Income Tests. Taxpayer also represented that two portions of the Site damaged by a single wildfire and covered by separate reforestation grants do not overlap.

Settlement payments

In PLR 202536024, one of the wildfires that damaged a portion of the Site was caused by a tree that fell across a power line that was owned, operated and maintained by an electric utility. Taxpayer's attorneys submitted a demand letter to the power company, alleging that its negligence resulted in damages and forest rehabilitation costs. Taxpayer expects to receive a settlement payment from the power company for (1) damages to the Site caused by the fire (Damages Settlement Payment) and (2) attorneys' fees and mediation and/or court costs (Additional Settlement Payment). Taxpayer will calculate its claim for the Damages Settlement Payment based on the amount of money needed to replace damaged or destroyed property with similar property of the same quality, and Taxpayer will not seek a Damages Settlement Payment over that amount minus the amount of Grant Payments received under a reforestation grant related to the same fire.

Carbon sequestration payments

In PLR 202551041, Taxpayer, a REIT, owns or controls timberlands through its interest in a partnership (Operating Partnership). Operating Partnership entered into an agreement (Agreement) with an unrelated party (Storage User) who develops and implements technologies to capture carbon dioxide emissions from industrial processes, converts the carbon dioxide into a supercritical fluid, transports the carbon dioxide via pipeline to a facility owned and operated by the Storage User, and injects the supercritical carbon dioxide into underground formations.

The Agreement grants the Storage User the right to (1) survey, construct, own and operate a carbon storage facility; (2) inject and store carbon dioxide in subsurface reservoirs (Storage Area) at specified depths beneath a specific area of the Operating Partnership's timberlands (Subsurface Storage Rights); and (3) use certain surface space of the timberlands (Surface, and together with the Storage Area, Premises) as needed to access, develop and utilize the Storage Area. Under the Agreement, Taxpayer reserves the right to manage the timberlands as a working forest and all rights to timber and other natural resources associated with the Premises.

The Agreement specifies an Initial Term and an Injection Term. The Initial Term continues until the Storage User commences injecting carbon dioxide into the Storage Area or, if earlier, a certain number of years after the Agreement's effective date. During the Initial Term, the Storage User has the right to access the Surface to conduct exploratory activities in exchange for annual payments (Annual Payments). Taxpayer will treat the Annual Payments as rents from real property and did not seek a ruling on their treatment.

If the Storage User injects carbon dioxide into the Storage Area, the Initial Term will end and the Injection Term will begin. During the Injection Term, the Storage User will no longer make Annual Payments and will instead make monthly payments for the Subsurface Storage Rights based on the volume of the carbon dioxide injected into the Storage Area during the month, subject to a minimum payment (Injection Payments). Storage User will also be responsible for paying all taxes or government charges imposed on the Operating Partnership in connection with the Storage User's property located on the Premises and the injection and storage of carbon dioxide in the Storage Area (Government Charges).

Each time the Storage User expands its activities onto a new area of the Surface (during the Initial Term and/or the Injection Term), the Storage User must make a payment in connection with occupying that Surface area (Surface Payment). There are two types of Surface Payments: (1) General Surface Payments are calculated based on the amount of the Surface occupied and utilized by the Storage User in connection with storage wells and associated equipment, and (2) Specific Surface Payments are calculated based on the length and type of pipelines, flowlines and roads constructed, installed, and/or upgraded on the Surface by the Storage User.

Taxpayer represented that no portion of the Surface Payments, Injection Payments or Government Charges (referred to collectively as Storage User Payments) will be based on the income or profits of any person, and no Storage User Payment is for services or personal property.

Paying the Surface Payments will not relieve the Storage User of its obligations (1) to indemnify Operating Partnership against all other damages caused by the Storage User's operations or activities and (2) to restore the Premises as provided in the Agreement. Upon termination of the Agreement, the Storage User must perform site remediation to restore the Surface to its pre-Agreement condition, including removing all structures and pipelines (unless Operating Partnership purchases the pipelines or allows Storage User to abandon the pipelines in place).

After termination of the Agreement, Storage User will (1) have the right to permanently store previously injected carbon dioxide in the Storage Area; (2) bear exclusive risk of loss with respect to the carbon dioxide ; (3) hold all right, title, interest and ownership of the carbon dioxide ; and (4) indemnify Operating Partnership for any claims, damages or losses resulting from a release, spill or emission of carbon dioxide .

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 from certain types of income, including rents from real property and certain gains from the sale of real property. 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 certain gains from the sale of real property.

Treas. Reg. Section 1.856-10(b) defines the term "real property" as "land or improvements to land." Treas. Reg. Section 1.856-10(c) defines "land" to include "water and air space superjacent to land and natural products and deposits that are unsevered from the land."

If a REIT lease agreement obligates a lessee to pay the state and local real property taxes imposed on the REIT's property, Revenue Ruling 73-426 deems that amount to be for the use of, or right to use, the property; therefore, it constitutes additional rental income to the REIT and qualifies as rents from real property under IRC Section 856(d).

Revenue Ruling 68-291 generally treats consideration received in exchange for granting a permanent easement as proceeds from the sale of an interest in real property, which should be applied as a reduction of the cost or other basis of the portion of land subject to the easement, with any excess treated as gain.

In Vest v. Commissioner, 481 F.2d 238 (5th Cir. 1973), the court held that certain payments for the grant of various surface rights related to a mineral lease were in the nature of rent. The taxpayers received surface payments under an agreement with a company for certain surface activities, such as well locations, flowlines and roads, which were necessary to exploring the subsurface mineral rights also acquired under the agreement. The agreement also required the company to pay the taxpayers for all actual damage to the surface of the property. The court concluded that because the taxpayers could not be compensated for damages twice, the surface payments were in the nature of rental 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 Income Tests may nevertheless be (1) disregarded for purposes of the Income Tests or (2) treated as qualifying income for purposes of the Income Tests.

Offsets

In considering the treatment of Taxpayer's income from the issuance of Offsets in PLRs 202536023, 202536024, 202536025 and 202549006, the IRS emphasized that Congress intended to restrict the beneficial tax treatment afforded to REITs to "what is clearly passive income from real estate investments, as contrasted to income from the active operation of businesses involving real estate." The IRS reasoned that the Offsets are similar to receiving payment for granting an easement for a term of years with respect to real property. This is because Taxpayer will earn the Offsets by agreeing to restrictions that require Taxpayer to abstain from certain uses of its land and to perform certain actions on its land. Under these circumstances, the IRS concluded that treating Taxpayer's income from Offsets as qualifying income is consistent with the purposes of the REIT provisions.

Accordingly, the IRS ruled under IRC Section 856(c)(5)(J)(ii) that Taxpayer's income from Offsets will be considered qualifying income for purposes of the Income Tests. The IRS also ruled that income from 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.

Grant payments

In PLRs 202536023 and 202536024, the IRS reasoned that treating Taxpayer's income from the Grant Payments received by Taxpayer as reimbursements for all or a portion of its actual costs incurred in reforesting and restoring portions of the Site that were damaged by wildfires as qualifying income is consistent with the purposes of the REIT provisions. Accordingly, the IRS ruled under IRC Section 856(c)(5)(J)(ii) that Taxpayer's income from the Grant Payments will be considered qualifying income for purposes of the Income Tests.

Settlement payments

In PLR 202536024, the IRS reasoned that the Damages Settlement Payment constitutes compensation for damage to Taxpayer's real property and that nothing in the legislative history or any statutory interpretation of the REIT provisions indicates that Congress intended to discourage REITs from pursuing legal remedies. Accordingly, the IRS concluded that treating the Damages Settlement Payment as qualifying income is consistent with the purposes of the REIT provisions and ruled under IRC Section 856(c)(5)(J)(ii) that the Damages Settlement Payment will be considered qualifying income for purposes of the Income Tests.

The IRS also concluded that the Additional Settlement Payment should not result in nonqualifying income because it represents a reimbursement of Taxpayer's legal fees incurred to obtain the Damages Settlement Payment. Accordingly, the IRS ruled under IRC Section 856(c)(5)(J)(i) that the Additional Settlement Payment will be excluded from gross income for purposes of the Income Tests.

Carbon sequestration payments

In PLR 202551041, the IRS concluded that Taxpayer's gross income attributable to any Storage User Payment for a permanent interest in the Premises is gain from the sale or other disposition of an interest in real property for purposes of IRC Sections 856(c)(2)(D) and (c)(3)(C). It also determined Taxpayer's gross income attributable to any Storage User Payment that is not for a permanent interest in the Premises is rents from real property under IRC Sections 856(c)(2)(C) and 856(c)(3)(A). Thus, the Storage User Payments are qualifying income for purposes of the Income Tests.

The IRS reasoned that each Storage User Payment is (1) a payment for the use of the Premises during the term of the Agreement, (2) a payment for a permanent interest in the Premises, or (3) a combination of both. Because the Surface and Storage Area are land and, therefore, real property for purposes of Treas. Reg. Section 1.856-10(b), the IRS reasoned that any Storage User Payment for the use of the Premises during the term of the Agreement meets the general definition of rents from real property, and any Storage User Payment for a permanent interest in the Premises is similar to a payment for a permanent easement and, therefore, a payment for an interest in real property.

The IRS also observed that, similar to the surface payments described in Vest v. Commissioner, the Specific Surface Payments do not relieve the Storage User of its obligation to restore the Premises. Therefore, the Specific Surface Payments could be considered to be in exchange for the use of the Premises and not a duplication of the obligation to remediate damage to the Surface.

Implications

PLRs 202536023, 202536024, 202536025 and 202549006 are the most recent PLRs 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 Income Tests. See PLRs 202401011 and 202402002 (Tax Alert 2024-0201); PLRs 201949004, 201949005 and 201949007 (Tax Alert 2020-0076); and PLRs 201720008, 201123005 and 201123003 (as modified by PLR 201751011). See also AM 2024-004, which is nonprecedential IRS guidance concluding that state carbon offset credits received by a carbon offset project operator are an accession to wealth and must be included in the operator's gross income upon receipt (Tax Alert 2025-0256).

In addition, PLRs 202536023 and 202536024 are the first PLRs in which the IRS has exercised its discretionary authority under IRC Section 856(c)(5)(J) to conclude that income from reforestation grant payments will be considered qualifying income for purposes of the REIT income tests. The IRS has previously issued rulings, however, on similar types of grant or incentive payments. See PLR 202409002 (REIT's income attributable to the receipt or accrual of brownfield redevelopment tax credits considered qualifying REIT income) (Tax Alert 2024-0524). For a discussion of similar rulings under IRC Section 856(c)(5)(J), see Tax Alerts 2023-0265 and 2024-0402.

PLR 202536024 is also consistent with the IRS's previous rulings on the treatment of settlement payments and other payments intended to make a REIT whole after damages to its real property. See PLR 202346008 (REIT's income attributable to an insurance payment for damaged real property considered qualifying REIT income) (Tax Alert 2023-1931); PLR 202237004 (business interruption insurance proceeds that replaced lost revenue from marina damage considered qualifying REIT income) (Tax Alert 2022-1413); PLR 201418037 (settlement payment amount relating to unpaid rent considered qualifying income, and amount relating to REIT's legal fees excluded from gross income, for purposes of the Income Tests).

PLR 202334007 is the second IRS ruling to address the treatment of amounts earned by a REIT in connection with a carbon sequestration agreement that grants an unrelated party the right to inject and permanently store carbon dioxide in the subsurface pore space of a REIT's land. See PLR 202334007 (Tax Alert 2023-1449). Similar to PLR 202334007 and in contrast to the rulings regarding offset credits, grant payments and settlement payments, the IRS did not rely on IRC Section 856(c)(5)(J) in concluding that the Storage User Payments are qualifying income. Rather, the IRS concluded that the Storage User Payments are properly treated as items of qualifying income that are listed under IRC Sections 856(c)(2) and 856(c)(3) — rents from real property, gain from the sale or other disposition of an interest in real property, or a combination of both.