12 January 2026 IRS rules that income from purchased and offsetting interest rate caps is excluded from gross income for REIT income test
In PLRs 202533008, 202533009 and 202601013, some of which were obtained by EY professionals, the IRS ruled that income from purchased and offsetting interest rate caps and swaps does not constitute gross income for purposes of the real estate investment trust (REIT) gross income tests under IRC Sections 856(c)(2) and (c)(3) (Income Tests). The Taxpayers in PLRs 202533008 and 202533009 (Parent REIT and SubREIT, respectively) have elected to be taxed as REITs. Parent REIT owns an interest in a partnership (OP), which has a disregarded subsidiary (Subsidiary). Through disregarded entities, Subsidiary owns common stock of SubREIT and interests in disregarded entities that own real estate (Propcos). After the contribution described below, SubREIT also owned Propcos. Certain Propcos and owners of Propcos (Borrowers) borrowed funds from third parties (Lenders) to finance OP's real estate assets (Loans). Each Loan has a floating interest rate and is secured by the Borrower's real estate assets or interests in a Propco. As a condition of each Loan, the Lender required the Borrower to enter into an interest rate cap agreement (Purchased Cap) under which the counterparty pays the Borrower to the extent the floating rate payable by the Borrower under the Loan exceeds the Purchased Cap's fixed strike rate. Typically, each Purchased Cap's term is equal to the corresponding Loan's remaining term, and its notional amount equals the Loan's outstanding principal amount. Parent REIT prefers that OP manage interest rate risk on the Loans and its other floating-rate debt on an aggregate basis. Therefore, Subsidiary entered into interest rate swap agreements (Swaps) under which (1) Subsidiary is required to pay its counterparties based on set fixed rates that are generally lower than the Purchased Caps' strike rates and (2) the counterparties are required to pay Subsidiary based on set floating rates. Subsidiary contributed certain Borrowers to SubREIT. Subsidiary novated to SubREIT the portion of the Swaps that manage interest rate risk on Loans owed by Borrowers that were contributed to SubREIT. As part of each Taxpayer's interest rate risk management plan, Subsidiary and SubREIT entered into interest rate cap agreements (Offsetting Caps) in exchange for cash (Cap Premium) to counteract the Purchased Caps. Under each Offsetting Cap, Subsidiary or SubREIT (as applicable) pays its counterparty to the extent a set floating rate exceeds a fixed strike rate that matches the corresponding Purchased Cap's strike rate. This payment offsets all or a portion of the payment the applicable Borrower receives under its Purchased Cap. Thus, entering into an Offsetting Cap is intended to have the economic effect of terminating all or a portion of the corresponding Purchased Cap. Taxpayers represented that counteracting hedges are commonly used by market participants to achieve the economic effect of terminating original hedges. Each Taxpayer made the following representations regarding the Purchased Caps, Swaps and Offsetting Caps (as applicable to each Taxpayer):
The Taxpayer in PLR 202601013 has elected to be taxed as a REIT. Substantially all of Taxpayer's assets are long-term debt instruments that pay a fixed rate of interest and are secured by mortgages on real property (Mortgage Assets). Taxpayer finances acquisitions of Mortgage Assets through sale-repurchase transaction debt secured by the Mortgage Assets (REPOs). The REPOs bear interest at a variable rate, exposing Taxpayer to the risk of incurring interest expense on the REPOs in excess of interest payable on the Mortgage Assets. To hedge against this interest rate risk, Taxpayer enters into interest rate swaps (Swap Hedges) that require (1) Taxpayer to pay its counterparties based on set fixed rates and (2) the counterparties to pay Taxpayer based on set floating rates. Taxpayer also enters into options that allow it to enter into swaps with specified terms within a certain period of time (Swaptions). When Taxpayer desires to terminate a Swap Hedge or Swaption (together, Hedges), it enters into a counteracting notional principal contract or swaption (Counteracting Hedge) to achieve the same economic result as terminating the hedge without incurring breakage costs.
IRC Section 856(c)(2) requires a REIT to derive at least 95% of its gross income from specified sources of passive income, and IRC Section 856(c)(3) requires a REIT to derive at least 75% of its gross income from specified sources of real estate-related income. 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 Income Tests 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 under IRC Section 1221(a)(7). Under IRC Section 1221(b)(2)(A), a "hedging transaction" includes a transaction entered into by a taxpayer in the normal course of its trade or business primarily to manage risk of interest rate changes with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, by the taxpayer. Under Treas. Reg. Section 1.1221-2(d)(3), if a transaction is entered into primarily to offset all or any part of the risk management effected by one or more hedging transactions, the transaction is a hedging transaction. 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 Income Tests or (2) treated as qualifying income for purposes of the Income Tests. The IRS explained that the requirements of IRC Section 856(c)(5)(G) are met when a hedging transaction entered into by a REIT (1) satisfies the identification requirement under IRC Section 1221(a)(7), (2) meets the definition of a "hedging transaction" under IRC Section 1221(b)(2)(A), and (3) in the case of an interest rate hedge, is a hedge of indebtedness incurred or to be incurred to acquire or carry real estate. Accordingly, based on the facts and the Taxpayers' representations in each of the three rulings, the IRS concluded that Taxpayers' gross income from the Purchased Caps, the Swap Hedges or the Swaptions, as applicable, qualifies for the exclusion from gross income for purposes of the Income Tests under IRC Section 856(c)(5)(G). Noting that the legislative history of IRC Section 856(c)(5)(G) shows that Congress intended the REIT hedging rules to conform generally to the hedging rules under IRC Section 1221, the IRS stated in PLRs 202533008 and 202533009 that if the identification requirements under IRC Section 1221(a)(7) are satisfied, the Offsetting Caps qualify as hedging transactions under Treas. Reg. Section 1221-2(d)(3) because they are entered into primarily to offset all or a part of the risk management effected by the Purchased Caps. The IRS reasoned that excluding Taxpayers' income from the Cap Premium from gross income for purposes of the Income Tests does not interfere with Congressional policy objectives in enacting the Income Tests because the Offsetting Caps will fully or partially offset the corresponding Purchased Caps but will not hedge notional amounts in excess of the Purchased Caps. Accordingly, the IRS concluded that Taxpayers' gross income from the Cap Premium will be excluded from gross income for purposes of the Income Tests pursuant to the IRS's discretionary authority under IRC Section 856(c)(5)(J)(i). The IRS applied identical reasoning in PLR 202601013 to conclude that Taxpayer's gross income from the Counteracting Hedges (i.e., the notional principal contracts and swaptions entered into to counteract the Hedges) will be excluded from gross income for purposes of the Income Tests pursuant to the IRS's discretionary authority under IRC Section 856(c)(5)(J)(i). PLRs 202533008, 202533009 and 202601013 are the fourth, fifth and sixth rulings to address the treatment of a REIT's income from counteracting hedging transactions. See PLRs 201527012, 201527013 and 201406009 (ruling that income from original interest rate risk hedges would not constitute gross income for purposes of the Income Tests under IRC Section 856(c)(5)(G) and income from counteracting hedges would not constitute gross income for purposes of the Income Tests under IRC Section 856(c)(5)(J)(i)). These prior PLRs predate the enactment of IRC Section 856(c)(5)(G)(iii), which now provides a gross income exclusion for income from certain, but not all, counteracting hedges. The Offsetting Caps addressed in PLRs 202533008 and 2020533009 and the Counteracting Hedges addressed in PLR 202601013 are similar to the counteracting hedges to which IRC Section 856(c)(5)(G)(iii) applies, but do not fit squarely within that provision, leading the IRS to again use its discretionary authority to issue the recent PLRs. The taxpayer in PLR 202601013 represented that it would not be "over-hedged," i.e., the notional amounts of the Hedges would not exceed the principal amount of the Mortgage Assets, and the notional amounts of the Counteracting Hedges would not exceed the notional principal amounts of the Hedges. In contrast, in PLRs 202533008 and 202533009, both the taxpayers' Swaps and Purchased Caps managed taxpayers' interest rate risk on its Loans, while the Offsetting Caps offset Purchased Caps. In these PLRs, the taxpayers represented that going forward, they generally intended for the Offsetting Caps to fully counteract the Purchased Caps, and the notional amounts of the Offsetting Caps would not exceed that of the Purchased Caps, but the rulings clearly contemplate that the taxpayers would continue to have both Swaps and Purchased Caps in place with respect to the Loans. In these rulings, the taxpayers did not make a representation regarding "over-hedging." While not directly addressed by the rulings, it might be inferred that the IRS viewed the economic effect of an Offsetting Cap (i.e., economically terminating all or a portion of the corresponding Purchased Cap) as effectively preventing the taxpayers from being in an over-hedged position. As the IRS relied on its discretionary authority under IRC Section 856(c)(5)(J) in PLRs202533008, 202533009 and 202601013 regarding the taxpayers' income from counteracting hedging transactions, REITs with similar situations will want to consider seeking their own rulings.
Document ID: 2026-1069 | ||||||
