A construction grant for a REIT redevelopment project is qualifying income

Plain-English summary

A REIT planned to redevelop a distressed, high-vacancy property into modern retail, residential, and other uses. It applied for a state economic-development grant that would reimburse documented construction and related eligible costs. The grant itself was not one of the income categories expressly listed in the REIT gross-income tests. The IRS nevertheless ruled under section 856(c)(5)(J)(ii) that the REIT's share of the grant income would count as qualifying income for both the 95 percent and 75 percent tests. Treating the construction reimbursement as qualifying income would not interfere with Congress's goal that REIT income remain largely passive, given the representation that the redeveloped property would be a real estate asset and substantially all other income from it would qualify.

Ruling snapshot

• Question: Is income from the state construction grant qualifying income for the REIT's section 856(c)(2) and (c)(3) gross-income tests?
• Outcome: Approved
• Key authorities: IRC §§ 856(c)(2), 856(c)(3), and 856(c)(5)(J)(ii); Treas. Reg. § 1.856-3(g)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201841002 Third Party Communication: None
Release Date: 10/12/2018 Date of Communication: Not Applicable
Index Number: 856.01-00
Person To Contact:
--------------- ---------------, ID No. ------------
---------------------------------------------------- Telephone Number:
------------------------------- --------------------
--------------------------------- Refer Reply To:
------------------------------------------------------- CC:FIP:B02
PLR-109703-18
Date:
July 10, 2018

Legend:

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

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

Subsidiary = -------------------------------------------

Center = ------------------------------------------------

Program = --------------------------------------------------------------
----------

Act = ---------------------------------------------------------------

Budget Office = ---------------------------------------------

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

a = ------

b = -----

c = ------------

d = --

Year 1 = ------

Year 2 = ------

Year 3 = ------

Dear -------------

   This letter responds to your letter dated March 6, 2018, requesting a ruling on

behalf of Taxpayer that, pursuant to section 856(c)(5)(J)(ii) of the Internal Revenue
Code, 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 corporation that has elected to be treated as a real estate

investment trust (“REIT”) under sections 856 through 859. Taxpayer owns a% of the
interests in Operating Partnership. Operating Partnership owns b% of the member
interests in Subsidiary, a limited liability company that is disregarded for federal income
tax purposes. Taxpayer uses an accrual method of accounting and a calendar tax year.

   In Year 1, Subsidiary acquired Center through three separate purchases. The

neighborhood in which Center is located has been revitalized. Center, however, still
suffers from a high vacancy rate with buildings in derelict condition. Taxpayer now
intends to redevelop Center by modernizing the site’s buildings and infrastructure, and
by providing the surrounding neighborhoods with state-of-the-art retail, residential and
other amenities, all of which is intended to produce jobs and other economic benefits to
the area (the “Redevelopment”). Taxpayer represents that Center, after the
Redevelopment, will qualify as a real estate asset for purposes of section 856 and that
substantially all of the other income Taxpayer derives from Center will be qualifying
income for purposes of sections 856(c)(2) and (c)(3).

    In order to fund the Redevelopment, Taxpayer has applied for a $c grant through

Program (the “Grant”). Program is authorized by Act and is for projects that are
primarily economic development projects. The projects must have a regional or multi-
jurisdictional impact and generate substantial increases or maintain current levels of
employment, tax revenue or other measures of economic activity. A developer must go
through an application process in order to be approved and awarded a Program grant.
Once the application process is complete, and the developer has been approved,
Budget Office enters into a Program grant between State and the developer.

   Program operates on a proportional reimbursement basis. As the developer

incurs and pays construction expenses, State will reimburse the developer, provided
State receives sufficient documentation regarding reimbursable expenditures with the
request for reimbursement. The primary intent and use of Program funds should be
towards reimbursement of construction costs. Secondary reimbursable costs that are

allowed include interest paid during construction, permit costs, land acquisition costs,
and other costs related to the abatement of hazardous materials. Ineligible costs
include future physical maintenance and operation costs, administrative costs, legal
fees, financing and accounting costs, and architectural and engineering fees.

    In the event that Taxpayer is awarded the Grant, Taxpayer will use the Grant

proceeds to reimburse certain construction costs incurred by Taxpayer. Assuming
Subsidiary is successful with the Redevelopment, Taxpayer believes the Grant
proceeds will be received in late Year 2 or early Year 3, when the phase of construction
the Grant is meant to fund is completed. Taxpayer represents that the Grant proceeds
will be recognized as income by Operating Partnership for federal income tax purposes,
and Taxpayer expects its share of the gross income from the Grant proceeds to exceed
d% of Taxpayer’s gross income.

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 in 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
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).

    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 asset of the
partnership and will be deemed to be entitled to the income of the partnership
attributable to its share.

   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 Center, after the
Redevelopment, will qualify as a real estate asset for purposes of section 856 and that
substantially all of the other income Taxpayer derives from Center 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 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)(ii), Taxpayer’s income

attributable to receipt of Grant is considered qualifying income for purposes of 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
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 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,

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