Construction-account interest qualified for the REIT income test

Plain-English summary

A real estate investment trust was developing an affordable residential rental building with bond financing from a state agency. Some bond proceeds had to remain in a trustee-held account until needed for construction, and the account's earnings reduced the debt service on the bonds. Although that interest did not ordinarily qualify for the 75 percent REIT income test, the IRS found it was inextricably linked to developing real property that would produce qualifying rent. Using its authority under section 856(c)(5)(J), the IRS treated the interest earned during the specified development years as qualifying income for the 75 percent test.

Ruling snapshot

• Question: Would interest earned on temporarily held bond proceeds count as qualifying income under the 75 percent REIT income test?
• Outcome: approved for the specified development years
• Key authorities: IRC §§ 856(c)(2), 856(c)(3), 856(c)(5)(J)

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201732012                                              Third Party Communication: None
Release Date: 8/11/2017                                        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-112777-16
                                                               Date:
                                                               May 11, 2017


Legend:

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

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

Property                   =         --------------------------------------------------------------------------------
                     -----------------------------------------------------------------------------------------------
                     -
                                    -----------------------------------------

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

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

State Agency               =        ---------------------------------------------------------

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

Year 1                     =        -------

Year 2                     =        -------

Year 3                     =        -------

Year 4                     =        -------

Amount 1                   =        ----------------

Amount 2                   =        ----------
PLR-112777-16                                    2

Amount 3                  =   ----------------

a                         =   ----

b                         =   ----


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

        This is in reply to a letter dated April 14, 2016, submitted on behalf of Taxpayer
by its authorized representative. Taxpayer requests a ruling under section 856(c)(5)(J)
with respect to the qualification under section 856(c)(3) of certain interest income
received by Taxpayer.

                                                 FACTS

      Taxpayer is a domestic limited liability company that elected to be treated as a
corporation for Federal income tax purposes as of Date 1. Taxpayer elected on its Year
2 Federal Income tax return to be treated as a real estate investment trust (“REIT”)
under section 856(c) as of Date 1 (“First REIT Taxable Year”). Taxpayer is the sole
owner of LLC, a domestic limited liability company that is disregarded as separate from
Taxpayer for Federal income tax purposes.

         LLC is the owner of Property located in City. On Property, LLC is constructing a
large residential rental building (the “Building”) with at least a percent of the units
designated as affordable, or low income, housing. Taxpayer represents that, once
completed, the Building will be real property within the meaning of section 856 and the
rental income from units in the Building will be qualifying income under sections
856(c)(2) and (3). Taxpayer also represents that, based on the cost of constructing the
Building and the market economics of real estate development in City, Taxpayer must
utilize financing options offered by State Agency. To finance the construction of the
Building, State Agency is offering bonds to the public from Year 1 through Year 4. State
Agency will issue both tax-exempt bonds and taxable bonds. Each of the bonds issued
by State Agency will have a term of b years.

       LLC will receive the proceeds of the bonds issued by State Agency pursuant to a
loan agreement between LLC and State Agency. State Agency’s loan to LLC is
secured by the land and improvements on Property. As part of State Agency’s
resolution authorizing the issuance of the bonds, State Agency can direct that a portion
of the bond proceeds it receives from the public be held by a trustee in a special
account (the “Account”) and invested at State Agency’s direction, until the funds are
needed by LLC to finance construction of the Building. LLC must pay State Agency
interest on all of the bond proceeds; however, the earnings on the bond proceeds held
in the Account will be applied to reduce the debt service on the bonds.
PLR-112777-16                                 3


         State Agency has the sole ability to control how the money in the Account is
invested, and treats the money in the Account as its own for purposes of State
regulations that restrict the types of investments made by government agencies. For
accounting purposes, LLC treats income from the Account as a reduction in interest
expense on its loan from State Agency. Although neither LLC nor Taxpayer holds legal
title to the Account and the EIN on file for the Account is not that of LLC or Taxpayer,
LLC received a Form 1099 for Year 2 issued by State Agency for Amount 1 of interest
earned from the Account. Of this amount, approximately Amount 2 represents interest
earned after Date 1 and thus constitutes gross income to Taxpayer for its First REIT
Taxable Year. LLC paid a total of Amount 3 to State Agency as interest on the bonds
between Date 1 and the end of Year 2. Amount 3 is significantly more than Amount 2,
the amount of interest earned on the Account after Date 1. Since Date 1, Taxpayer has
also had a relatively minimal amount of qualifying income for purposes of the income
test in section 856(c)(3) of the Code. Taxpayer does not expect to have a significant
portion of the Building complete and producing rental income that qualifies under
section 856(c)(3) prior to the end of Year 4.

       Taxpayer requests a ruling that the income received by Taxpayer as interest
earned from the Account in its First REIT Taxable Year, Year 3, and Year 4 constitutes
qualifying income for purposes of the income test in section 856(c)(3) of the Code.

                                  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 sources that include dividends; interest;
rents from real property; gain from the sale or other disposition of stock, securities, and
real property (other than section 1221(a)(1) property); abatements 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) 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 interests in real property, gain
from the sale or other disposition of real property (other than section 1221(a)(1)
property), dividends from REIT stock and gain from the sale of REIT stock, abatements
and refunds of taxes on real property, income and gain derived from foreclosure
property, commitment fees to make loans secured by mortgages on real property or to
purchase or lease real property, gain from certain sales or other dispositions of real
estate assets, and qualified temporary investment income.
PLR-112777-16                                4

        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, whether any item of income or gain which
(i) 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) otherwise constitutes gross income not qualifying under sections 856(c)(2) or (c)(3)
may be considered as gross income which 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.”

       Although the interest earned from the Account, as gross income that is derived
from interest, is qualifying income for purposes of section 856(c)(2), it is not qualifying
income for purposes of section 856(c)(3). Pursuant to section 856(c)(5)(J), the
Secretary has the authority to determine whether income that does not otherwise qualify
under section 856(c)(2) or (c)(3) may be considered as either not constituting gross
income under sections 856(c)(2) or (c)(3) or as qualifying gross income under those
provisions.

       Taxpayer represents that the Building being constructed on Property will be real
property within the meaning of section 856 when completed. Additionally, Taxpayer
represents that after completion of construction the rental income from the Building will
be qualifying income for purposes of sections 856(c)(2) and (3). Furthermore, Taxpayer
represents that the economics of the type of large-scale residential construction project
being undertaken by Taxpayer in City generally requires the use of State Agency bond
financing.

       The terms of the financing transaction with State Agency require that the bond
proceeds be placed in the Account, which is held by a trustee. The proceeds of the
Account must be used by Taxpayer to construct the Building, and interest income
earned on the Account must be used by Taxpayer to pay debt service on the bonds
issued by State Agency. The interest income that Taxpayer receives from the Account
is therefore inextricably linked to the development of the Building, which is real property
that will generate qualifying rental income. Under these circumstances, treating the
interest income from the Account as qualifying income in its First REIT Taxable Year,
Year 3, and Year 4 does not interfere with or impede the objectives of Congress in
enacting section 856(c)(3).

                                      CONCLUSION
PLR-112777-16                                   5


       Based on the facts and representations submitted, we rule that, pursuant to
section 856(c)(5)(J)(ii), interest income received by Taxpayer from the Account in its
First REIT Taxable Year, Year 3, and Year 4 will be treated as qualifying income for
purposes of section 856(c)(3).

        Except as specifically ruled upon above, no opinion is expressed concerning any
federal income tax consequences relating to the facts herein under any other provision
of the Code. Specifically, we do not rule whether Taxpayer qualifies as a REIT under
Part II of subchapter M of Chapter 1 of the Code.

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

                                   Sincerely,


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