State development grant income qualified for the REIT income tests

Plain-English summary

A REIT's subsidiaries planned a mixed-use real estate development and qualified for a state grant that would reimburse some construction costs. Annual grant payments would depend on eligible state tax revenues generated by the project, and the REIT expected the grant to exceed a small redacted percentage of its gross revenue. The grant was not one of the income categories that ordinarily qualify under the REIT gross income tests. The IRS used its authority under section 856(c)(5)(J) to treat the grant income as qualifying because the grant was earned by developing real property and that treatment did not interfere with Congress's purpose for the REIT income restrictions.

Ruling snapshot

• Question: Will income earned from the state development grant qualify for the REIT gross income tests?
• Outcome: approved, the grant income is qualifying income for both REIT gross income tests
• Key authorities: IRC §§ 856(c)(2), 856(c)(3), 856(c)(5)(J), 1221(a)(1)

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201716043                                              Third Party Communication: None
Release Date: 4/21/2017                                        Date of Communication: Not Applicable
Index Number: 856.00-00
                                                               Person To Contact:
------------------------                                       ---------------------, ID No. ------------------
-------------------------------                                Telephone Number:
---------------------------------                              ----------------------
---------------------------------------                        Refer Reply To:
 -------------------------------                               CC:FIP:B01
                                                               PLR-133554-14
                                                               Date:
                                                               January 09, 2017


Legend:

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

Subsidiary 1               =        ---------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------------

Subsidiary 2               =         --------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------------------

City                       =        -------------------------------

State                      =        -----------------

State Act                  =         --------------------------------------------------------------------------------
----------
---------------------------------------------------------------------------------

State Authority            =        ---------------------------------------------------------------

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

State Official B           =         --------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---
                                    -------------
PLR-133554-14                                             2

Project Area               =         --------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------------
                                    -------------------------------------------------------------------------------
                                    -------------------------------------------

A                          =        ------------

B                          =        ----

C                          =        ----------------

D                          =        ------------------

E                          =        ----------------

F                          =        ----

G                          =        --

H                          =        --


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

      This letter responds to your letter dated September 9, 2014 and supplemental
correspondence requesting a ruling on behalf of Taxpayer that, pursuant to Internal
Revenue Code Section 856(c)(5)(J), income from the Grant (as defined below) is
considered qualifying income for purposes of Taxpayer’s gross income tests under
Sections 856(c)(2) and (c)(3).

Facts:

      Taxpayer is a limited liability company that has elected to be taxed as a
corporation for U.S. federal tax purposes and has elected to be treated as a “real estate
investment trust” (“REIT”) under Section 856. Taxpayer wholly owns Subsidiary 1 and
Subsidiary 2 (the “Subsidiaries”), which are limited liability companies disregarded as
separate from their owner for U.S. federal tax purposes. Taxpayer uses an accrual
method of accounting and a calendar tax year.

        The Subsidiaries were organized to own a real estate development project (the
“Project”) in City. The Project will include the development and construction of a transit-
oriented mixed-use development property of approximately A square feet incorporating
retail, office, and light industrial uses. Taxpayer represents that the Project constitutes
real property within the meaning of Section 856. The Project will be constructed on land
PLR-133554-14                                 3

that is eligible for an economic redevelopment and growth incentive grant (the “Grant”)
through State that was established under State Act.

       State Act provides state incentive reimbursement grants to developers to
address project financing gaps by reimbursing certain construction costs using a portion
of new state incremental taxes derived from a project’s development (the “State Grant
Program”). The State Grant Program was established to help municipalities targeted for
growth to improve their business districts through comprehensive redevelopment. The
State Grant Program may provide grants for a variety of types of redevelopment
projects including commercial, retail, and residential projects.

       Under State Act, a developer is required to first apply for a state incentive grant
and provide adequate support requested by State including the estimated cost of the
project, estimated revenue increment base and projection of eligible revenues for the
project, and a description of how the project addresses various economic and social
factors that further State’s interest in the proposed redevelopment.

        Once State approves a developer’s application for an incentive grant, State and
the developer enter into an incentive grant agreement. The incentive grant agreement
describes the terms and conditions of the arrangement between the developer and
State, including the maximum percentage of the actual eligible project costs that is
eligible for reimbursement, the maximum aggregate dollar amount of the incentive grant
to be awarded to the developer, the maximum annual percentage of eligible tax
revenues that may be used for reimbursement of eligible project costs, and the
particular tax or taxes referenced to determine the amount of the grant.

        Project Area is owned by the Subsidiaries and was determined to be a qualifying
economic redevelopment and growth incentive area for purposes of the Grant Program.
The Subsidiaries filed an application with State Authority and State Official A
(collectively, the “State Authorities”) to receive the Grant for the Project, and the State
Authorities approved the Subsidiaries’ application for the Grant in the maximum amount
of B percent of the actual eligible project costs, not to exceed a maximum aggregate
amount of $C. Accordingly, the Subsidiaries are entering into an incentive grant
agreement (the “Agreement”) with the State Authorities. Under the Agreement, the
State Authorities determined that the Project has estimated total project costs of $D and
eligible project costs of $E.

       Pursuant to the Agreement, the aggregate amount of the Grant shall not exceed
F percent of the eligible tax revenues out of which the Grant is payable and the annual
amount of the reimbursement shall not exceed F percent of the eligible tax revenues in
each year. The eligible tax revenues for purposes of the Grant include corporate taxes,
a tax imposed on marine insurance companies, public utility franchise and excise taxes,
taxes derived from distributive shares of partnership and S corporation income, a tax
imposed on the purchase of materials used in certain construction, a hotel and motel
PLR-133554-14                                 4

occupancy fee, and a portion of a certain fee imposed on the sale of real property at the
site of the Project.

        The Subsidiaries and the State Authorities agree that actual costs incurred to
complete the Project may vary from the amounts approved. If the actual costs incurred
exceed the amounts approved, the Grant will not be adjusted upwards, but if the actual
costs incurred are less than the estimated amounts, the Grant will be reduced. The
Agreement further provides that if the Project does not provide the estimated amount of
eligible tax revenues in a given tax year, the Grant shall continue to be limited to F
percent of the actual eligible tax revenues received for that tax year. The Agreement
also states that the Project will be completed within G years of the execution of the
Agreement.

       Upon receipt of the verified and actual eligible project costs from the State
Authorities, State Official B will calculate the maximum Grant to which the Subsidiaries
may be entitled, subject to the limitations described above and in the Agreement. For
such year, and on an annual basis thereafter, State Official B will calculate the
appropriate annual grant payment based on the revenues collected in the prior calendar
year from the eligible tax revenues and subject to the limitations in the Agreement.
State Official B is required to pay the Subsidiaries annual installments for a period of B
years.

       Taxpayer has represented that it expects the amount of the Grant to exceed H
percent of Taxpayer’s gross revenues. Taxpayer expects that substantially all of the
other income (other than income from the Grant) derived from the Project will be
qualifying income for purposes of Sections 856(c)(2) and (c)(3).

Law and Analysis:

       Section 856(c)(2) provides that in order for a corporation to qualify as a REIT, at
least 95 percent of the corporation’s gross income (excluding gross income from
prohibited transactions) must be derived from specified sources, which include
dividends, interest, rents from real property, gain from the sale or other disposition of
stock, securities, and real property not described in Section 1221(a)(1), abatements and
refunds of taxes on real property, income and gain derived from foreclosure property,
certain commitment fees, and gain from certain sales or other dispositions of real estate
assets.

       Section 856(c)(3) provides that in order for a corporation to qualify as a REIT, at
least 75 percent of the corporation's gross income (excluding gross income from
prohibited transactions) must be derived from rents from real property, interest on
obligations secured by mortgages on real property or on interests on real property, gain
from the sale or other disposition of real property not described in Section 1221(a)(1),
certain dividends or distributions on, and gains from the sale or disposition of, shares in
PLR-133554-14                                5

other REITs, abatements and refunds of taxes on real property, income and gain
derived from foreclosure property, certain commitment fees, gain from certain sales or
other dispositions of real estate assets, and qualified temporary investment income.

       Section 856(c)(5)(J) provides 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, (i) whether any item of income or gain that
does not otherwise qualify under Sections 856(c)(2) or (c)(3) may be considered as not
constituting gross income for purposes of Sections 856(c)(2) or (c)(3), or (ii) whether
any item of income or gain that otherwise constitutes gross income not qualifying under
Sections 856(c)(2) or (c)(3) may be considered as gross income that qualifies under
Sections 856(c)(2) or (c)(3).

       The legislative history underlying the tax treatment of REITs indicates that a
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. 2020, 86th
Cong., 2d Sess. 4 (1960) at 6, 1960-2 C.B. 819, at 822-23 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.”

       Income from the Grant constitutes gross income not listed as qualifying income
under Sections 856(c)(2) or (c)(3). Taxpayer represents that the Project, once
completed, will be real property for purposes of Section 856 and that substantially all of
the other income Taxpayer derives from the Project will be qualifying income for
purposes of Sections 856(c)(2) and (c)(3). Taxpayer will earn the Grant for developing
real property in State in accordance with the State Grant Program. Treating income
from the Grant as qualifying income does not interfere with or impede the objectives of
Congress in enacting Sections 856(c)(2) and (c)(3). Accordingly, pursuant to Section
856(c)(5)(J)(ii), it is appropriate for the Secretary to determine that income from the
Grant is treated as qualifying income for purposes of Sections 856(c)(2) and (c)(3).

Conclusion:

      We hereby rule that, pursuant to Section 856(c)(5)(J), income from earning the
Grant will be qualifying income for purposes of Taxpayer’s gross income tests under
Sections 856(c)(2) and (c)(3).

       This ruling’s application is limited to the facts, representations, Code Sections,
and regulations cited herein. 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. In particular, no opinion is expressed with
regard to whether Taxpayer otherwise qualifies as a REIT under subchapter M of the
PLR-133554-14                                6

Code. Additionally, no opinion is expressed regarding income from a sale of an interest
in the Grant.

       This ruling is directed only to the taxpayer that requested it. Section 6110(k)(3)
provides that it may not be used or cited as precedent. In accordance with the
provisions of a Power of Attorney on file, we are sending a copy of this ruling letter to
your authorized representatives.

      The rulings contained in this letter are based upon information and
representations submitted by the taxpayer and accompanied by a penalty of perjury
statement executed by an appropriate party. While this office has not verified any of the
material submitted in support of the request for rulings, it is subject to verification on
examination.


                                                 Sincerely,



                                                 Steven Harrison
                                                 Branch Chief, Branch 1
                                                 Office of Associate Chief Counsel
                                                 (Financial Institutions & Products)