REIT may exclude its indirect share of related management fees from income tests

Plain-English summary

A real estate investment trust held mortgage and foreclosed-property investments through an operating partnership. After a restructuring, the operating partnership would own part of the manager that it paid to manage those investments, causing the REIT to recognize both investment income and an indirect share of the related management fees. The IRS ruled that the REIT may exclude its proportionate indirect share of those fees when applying the 95 percent and 75 percent gross-income tests under IRC § 856(c). The exclusion prevents the same underlying investment activity from effectively being counted twice and is consistent with the REIT rules’ focus on passive income. The ruling did not decide whether the taxpayer otherwise qualified as a REIT or whether its investment income, foreclosure property, or property sales received favorable REIT treatment.

Ruling snapshot

• Question: May the REIT exclude its indirect share of management fees paid on investments that already generate income included in its REIT gross-income tests?
• Outcome: Approved
• Key authorities: IRC § 856(c)(2), (3), and (5)(J); Treas. Reg. §§ 1.856-3(g) and 1.856-4(b)(5)(ii)

Full text (IRS public release)

Internal Revenue Service                                        Department of the Treasury
                                                                Washington, DC 20224

Number: 201620001                                               Third Party Communication: None
Release Date: 5/13/2016                                         Date of Communication: Not Applicable
Index Number: 856.00-00, 856.01-00
                                                                Person To Contact:
------------------------------                                  ------------------------, ID No. ----------------
--------------------------------------------------              Telephone Number:
----------------------                                          --------------------
-----------------------------------------------------           Refer Reply To:
 ---------------------------------                              CC:FIP:B02
                                                                PLR-103094-15
                                                                Date:
                                                                February 09, 2016




Legend


Taxpayer                             =       -----------------------------------------------------------------------
                                             ----------------------------------

Operating Partnership                =       -----------------------------------------------------------------------
                                             --------------------------------------

Company X                            =       ------------------------------------

Company Y                            =       ------------------

Manager                              =       -----------------------------------------

LLC                                  =       -----------------------------

State A                              =       ------------

State B                              =       ------------

Date 1                               =       ------------------

Date 2                               =       --------------------------

Date 3                               =       ------------------------

Date 4                               =       ----------------

Date 5                               =       ---------------------
PLR-103094-15                                   2

a                             =     -------

b                             =     ------

c                             =     --

d                             =     ----

e                             =     ---

f                             =     --



Dear ---------------------:

       This is in response to your letter dated January 13, 2015, and supplemental
submissions, regarding the treatment of the Taxpayer’s allocable share of management
fees for purposes of the gross income tests under section 856(c)(2) and (c)(3) of the
Internal Revenue Code (“Code”).

                                              FACTS

        Taxpayer is a State A corporation. Taxpayer was formed during Date 1, and will
elect to be taxed as a real estate investment trust (“REIT”) beginning with the taxable
year ended Date 2.

      Taxpayer conducts substantially all of its investment activities through Operating
Partnership, a State B limited partnership, which is treated as a partnership for federal
income tax purposes.

         Taxpayer owns the sole general partnership interest in Operating Partnership
through its wholly owned subsidiary Company X, a State B limited liability company.
Company X is disregarded for federal income tax purposes. Taxpayer also directly
owns a limited partnership interest in Operating Partnership. Taxpayer completed an
initial public offering (“IPO”) of its stock on Date 3. As of Date 5, Taxpayer’s collective
ownership percentage in Operating Partnership is a%.

       Operating Partnership is the sole owner of Company Y, a State B limited liability
company, which elected to be treated as a corporation for federal income tax purposes.
Company Y and Taxpayer jointly elected to treat Company Y as a taxable REIT
subsidiary. Company Y owns b% of Manager, a State B limited liability company
treated as a partnership for federal income tax purposes. Manager owns c% of
Taxpayer.
PLR-103094-15                                          3


        Operating Partnership’s primary business is to acquire, invest in, and manage a
portfolio of re-performing and non-performing mortgage loans secured by single-family
residences, and, to a lesser extent, loans secured by multi-family residential and
commercial mixed use retail/residential properties (collectively, the “Mortgages”).
Taxpayer represents that Operating Partnership owns 100% of the investments.
Operating Partnership’s portfolio predominantly consists of re-performing loans. With
respect to the non-performing loans, Operating Partnership will often acquire the
underlying properties securing the Mortgages through foreclosure (such properties
referred to as “real estate owned” or “REOs”) (collectively, the Mortgages and REOs are
the “Investments”). REOs acquired by Operating Partnership will be either rented or
sold to third parties soon after they are acquired.

         On Date 4, Manager entered into a management agreement with Taxpayer and
Operating Partnership (“Management Agreement”). Pursuant to the Management
Agreement, Manager implements Operating Partnership’s business strategy and
manages Operating Partnership’s business and investment activities and day-to-day
operations. Manager also provides Operating Partnership and Taxpayer with
management, corporate governance, administrative and other services related to
finance and accounting, human resources, legal, investment company exemption, risk
management, corporate services, vendor management operations, operations support,
and REIT qualification (collectively, the “Services”), including a management team and
necessary administrative and support personnel to run the daily operations of Operating
Partnership and Taxpayer.1 Taxpayer represents that the Services provided by
Manager will be usual and customary asset management of investments in mortgages
and REOs. Manager does not currently provide Services to any persons (as defined in
section 7701(a)(1)) other than Operating Partnership. The Management Agreement
provides that Manager may provide Services in the future to third parties under the
condition that its Services provided to Taxpayer are not impaired. Neither Taxpayer nor
Manager, however, anticipates that Manager will provide Services to or invest on behalf
of third parties.

      Manager will not be the servicer of the Mortgages or provide any services to the
tenants of any REOs. LLC will service the mortgages and provide any necessary
property management, lease management, and renovation management required for
the REOs. Taxpayer represents that LLC is an independent contractor within the
meaning of section 856(d)(3) with respect to Taxpayer.

      Manager is compensated through fees paid by Operating Partnership. Operating
Partnership pays a base management fee and an incentive fee to Manager (collectively,

1
  Taxpayer anticipates the rental of real property to constitute a small part of its business. If Taxpayer
provides any services to its tenants, Taxpayer will use an independent contractor or taxable REIT
subsidiary as described under section 856(d)(7)(C) to ensure that any impermissible tenant service
income does not exceed the de minimis amount in section 856(d)(7)(B).
PLR-103094-15                               4

the “Management Fees”). The base management fee is d% of Taxpayer’s consolidated
stockholders’ equity per annum. Taxpayer’s consolidated stockholders’ equity is the
sum of the net proceeds from any issuances of equity by Taxpayer or Operating
Partnership since inception, plus Taxpayer’s and Operating Partnership’s retained
earnings less (i) any amount Taxpayer or Operating Partnership has paid to repurchase
its common stock or units since inception, (ii) any unrealized gains and losses and other
non-cash items that have affected consolidated stockholder’s equity, (iii) any amount
related to one-time events caused by changes in GAAP, and (iv) certain non-cash items
not otherwise discussed above. The base management fee will be paid in a
combination of cash and shares of Taxpayer’s common stock.

       The incentive fee will be payable quarterly in an amount equal to e% of the dollar
amount by which the sum of (A) aggregate cash dividends declared out of the REIT
taxable income of Taxpayer and (B) distributions declared out of the taxable income of
Operating Partnership (without duplication) exceeds the product of f% and the book
value per share of Taxpayer’s common stock as of the end of each quarter. The
incentive fee is payable in cash.

       Taxpayer intends to restructure its operations. Company Y will distribute its b%
interest in Manager to Operating Partnership. Thus, Operating Partnership will directly
own the b% interest in Manager. Manager will continue to manage the Investments and
be compensated as provided in the Management Agreement (as described above).
Because Operating Partnership will be a partner in Manager and Taxpayer is a partner
in Operating Partnership, Taxpayer will be allocated a portion of the fees that Manager
receives from Operating Partnership. Therefore, Taxpayer, through its partnership
interest in Operating Partnership, will have gross income that includes Taxpayer’s
proportionate share of both the Investment Income from Operating Partnership’s assets
and Operating Partnership’s b% share of the Management Fees.

                                          LAW

       Section 856(c)(2) of the Code provides that at least 95 percent of a REIT’s gross
income must be derived from dividends, interest, rents from real property, gain from the
sale or other disposition of stock, securities, and real property (other than property in
which the corporation is a dealer), abatement and refunds of taxes on real property,
income and gain derived from foreclosure property, commitment fees, and gain from
certain sales or other dispositions of real estate assets.

       Section 856(c)(3) of the Code provides that at least 75 percent of a REIT’s gross
income must be derived from rents from real property, interest on obligations secured
by real property, gain from the sale or other disposition of real property (other than
property in which the corporation is a dealer), dividends from REIT stock and gain from
the sale of REIT stock, abatements and refunds of taxes on real property, income and
PLR-103094-15                                 5

gain derived from foreclosure property, commitment fees, gain from certain sales or
other disposition of real estate assets, and qualified temporary investment income.

        Section 856(c)(5)(J) of the Code provides, in relevant part, that to the extent
necessary to carry out the purposes of part II of subchapter M of the Code, the
Secretary is authorized to determine, solely for purposes of such part, whether any item
of income or gain which—(i) does not otherwise qualify under section 856(c)(2) or (c)(3)
may be considered as not constituting gross income for purposes of section 856(c)(2) or
(c)(3), or (ii) otherwise constitutes gross income not qualifying under section 856(c)(2)
or (c)(3) may be considered as gross income which qualifies under section 856(c)(2) or
(c)(3).

        Section 1.856-3(g) of the Income Tax Regulations provides that a REIT that is a
partner in a partnership is deemed to own its proportionate share of each of the assets
of the partnership and is deemed to be entitled to the income of the partnership
attributable to such share. For purposes of section 856, the interest of a partner in the
partnership’s assets is determined in accordance with the partner’s capital interest in
the partnership. The character of the various assets in the hands of the partnership and
items of gross income of the partnership retain the same character in the hands of the
partners as in the hands of the partnership for all purposes of section 856.

       Section 1.856-4(b)(5)(ii) of the Income Tax Regulations provides that the
directors or trustees of a REIT are not required to delegate or contract out their fiduciary
duty to manage the REIT itself, as distinguished from rendering or furnishing services to
the tenants of the REIT’s property or managing or operating the property. Thus, the
trustees or directors may do all things necessary, in their fiduciary capacities, to
manage and conduct the affairs of the trust itself. For example, the trustees or directors
may establish rental terms, choose tenants, enter into and renew leases, and deal with
taxes, interest, and insurance, relating to the REIT’s property.

      Section 61(a) of the Code provides that, except as otherwise provided, gross
income includes all income from whatever source derived.

       The legislative history underlying the tax treatment of REITs indicates that the
central concern behind the gross income restrictions is that a REIT’s gross income
should largely be composed of passive income. For example, H.R. Rep. No. 86-2020,
2d Sess. 4, at 6 (1960), 1960-2 C.B. 819, at 822-823 states, “[o]ne of the principal
purposes of your committee in imposing restrictions on types of income of a qualifying
real estate investment trust 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.” The legislative history
also indicates that Congress intended to equate the tax treatment of REITs with the
treatment accorded regulated investment companies. Id.
PLR-103094-15                                6

        The staff of the Joint Committee on Taxation in its General Explanation of the
Tax Legislation Enacted in the 110th Congress describes section 856(c)(5)(J) as
follows: “The provision authorizes the Treasury Department to issue guidance that
would allow other items of income to be excluded for purposes of the computation of
qualifying gross income under either the 75 percent or the 95 percent test, respectively,
or to be included as qualifying income for either of such tests, respectively, in
appropriate cases consistent with the purposes of the REIT provisions.” Footnote 309
of the General Explanation provides that income that is statutorily excluded from a
REIT’s gross income computations is not intended to be within the authority granted to
the Treasury Department to include amounts as qualifying income. Staff of the Joint
Committee on Taxation, 111th Cong., General Explanation of the Tax Legislation
Enacted in the 110th Congress, 1st Sess., at 239 (2009).

                                        ANALYSIS

       In the instant case, Manager will be providing Services to Operating Partnership
that promote Operating Partnership’s investment strategy through the management of
investment activities as well as Operating Partnership’s day-to-day operations.
Manager is managing the Operating Partnership’s investments in mortgages and REOs.
Taxpayer represents that the activities that Manager performs are activities that a REIT
may, under the Code and Regulations, perform in managing the assets of the REIT as
well as the trust itself without adverse tax consequences. All mortgage servicing and all
services provided in connection with the REOs are done by LLC, an independent
contractor.

        In the instant case, in the ordinary course of Operating Partnership’s investment
activities, Operating Partnership will receive interest income and income from the sale
or rental of REO foreclosure property (collectively, “Investment Income”), and Operating
Partnership will pay Management Fees to Manager. At the same time, Operating
Partnership will be allocated b% of the Management Fees it pays to Manager because it
is a b% partner in Manager. Thus, Operating Partnership’s gross income will include
both the Investment Income from its assets and its b% share of the Management Fees.
Furthermore, Taxpayer, as a partner of Operating Partnership and, through its
partnership interest in Operating Partnership, an interest holder in Manager, will include
as income both its proportionate share of the Investment Income from its direct interest
in Operating Partnership and the Management Fee income from its indirect interest in
Manager. Because the Management Fees are derived from the same Investments that
generate the Investment Income, including the Management Fees in Taxpayer’s gross
income would cause the amounts to be counted twice for purposes of the gross income
tests under section 856(c). Accordingly, under the authority of section 856(c)(5)(J)(i), to
the extent that Manager earns Management Fees from managing Operating
Partnership’s wholly owned Investments, we conclude that Taxpayer may exclude from
its gross income (for purposes of section 856(c)(2) and (c)(3)) Taxpayer’s allocable pro
rata share (a%) of Operating Partnership’s allocable pro rata share (b%) of
PLR-103094-15                                  7

Management Fees that Manager receives from Operating Partnership. Under the facts
of the instant case, excluding the Management Fees (as described above) from
Taxpayer’s gross income for purposes of section 856(c)(2) and (c)(3) does not interfere
with Congressional policy objectives in enacting the income tests under those
provisions.

                                       CONCLUSION

       Based on the facts and representations submitted by Taxpayer, we rule that to
the extent that Manager earns Management Fees from managing Operating
Partnership’s wholly owned Investments, Taxpayer may exclude from its gross income
(for purposes of section 856(c)(2) and (c)(3)) Taxpayer’s allocable pro rata share of
Operating Partnership’s allocable pro rata share of Management Fees that Manager
receives from Operating Partnership.

       Except as expressly provided herein, no opinion is expressed or implied
concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter. Specifically, no opinion is expressed or implied as to whether
Taxpayer otherwise qualifies as a REIT under part II of subchapter M of Chapter 1 of
the Code. No opinion is expressed or implied regarding whether Taxpayer’s pro rata
allocable share of the Investment Income is qualifying REIT income under either section
856(c)(2) or (3). Additionally, no opinion is expressed or implied regarding whether the
REOs qualify as foreclosure property or whether the sale of an REO is a prohibited
transaction under section 857(b)(6).

      This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of
the Code provides that it may not be used or cited as precedent.

         In accordance with the Power of Attorney on file with this office, a copy of this
letter is being sent to your authorized representatives.

                                       Sincerely,


                                       Andrea M. Hoffenson
                                       Andrea M. Hoffenson
                                       Chief, Branch 2
                                       Office of Associate Chief Counsel
                                       (Financial Institutions & Products)