A REIT's sale of its apartment portfolios in a liquidation is not a taxable "prohibited transaction"

Plain-English summary

A real estate investment trust (REIT) faces a punishing 100 percent tax under § 857(b)(6) on profits from "prohibited transactions," meaning sales of property the REIT holds primarily for sale to customers in the ordinary course of business (dealer-type activity) rather than as a long-term investment. Here a REIT that owns two multifamily apartment portfolios in one city concluded that the local market was heading into a long decline and decided its investors were best served by selling everything and fully liquidating. It asked the IRS to confirm that these liquidation sales would not be treated as prohibited transactions. The IRS agreed. It relied on the REIT's representations that it had always intended to hold the apartments long-term for rental income and appreciation, had never previously sold any real property, acquired the properties before any liquidation was contemplated, would adopt a liquidation plan only after exploring alternatives, and would run substantially all marketing through a taxable REIT subsidiary or an independent contractor. On those facts, the properties were not held primarily for sale to customers, so the sales escape the 100 percent tax. The IRS did not rule on whether the taxpayer actually qualifies as a REIT.

Ruling snapshot

• Question: Will a REIT's sales of its apartment properties under a plan of complete liquidation be treated as "prohibited transactions" subject to the 100 percent tax under § 857(b)(6)?
• Outcome: Approved (the liquidation sales are not prohibited transactions)
• Key authorities: IRC § 857(b)(6); § 1221(a)(1); § 856(c)(5)(B), (d)(3); Cottle v. Commissioner, 89 T.C. 467 (1987)

Full text (IRS public release)

Internal Revenue Service                                        Department of the Treasury
                                                                Washington, DC 20224

Number: 201844003                                               Third Party Communication: None
Release Date: 11/2/2018                                         Date of Communication: Not Applicable
Index Number: 857.02-03
                                                                Person To Contact:
--------------------                                            --------------------, ID No. ------------------
--------------------------                                      Telephone Number:
------------------------------------                            ----------------------
-----------------------------------                             Refer Reply To:
----------------------------------                              CC:FIP:B02
                                                                PLR-103886-18
                                                                Date:
                                                                August 01, 2018




Legend:

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

JV                                     =   -----------------------------------------

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

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

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

Portfolio A                            =   --------------------------- --------------------------

Portfolio B                            =   --------------------------------------

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

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

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

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

Date 5                                 =   ---------------------------

a                                      =   -----

b                                      =   --
PLR-103886-18                                 2

c                           =      ----

d                           =      --

e                           =      --

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

      This letter responds to your letter dated February 2, 2018, and supplemental
correspondence, in which Taxpayer requests a ruling that the sales of Taxpayer's
assets pursuant to a plan of liquidation will not be considered prohibited transactions for
purposes of section 857(b)(6) of the Internal Revenue Code (the "Code").

                                           Facts

      Taxpayer elected to be treated as a real estate investment trust ("REIT")
beginning with its taxable year ended Date 1. JV, a partnership for federal income tax
purposes, holds a percent of the issued common stock of Taxpayer. JV formed
Taxpayer as a State A limited liability company on Date 2 for the purpose of purchasing
and managing multifamily real estate complexes located in the United States.

        Pursuant to a joint venture agreement effective Date 3 (the "Agreement"), direct
or indirect partners in JV transferred interests in Portfolio A to Taxpayer. Portfolio A
consists of multifamily residential real property located in City. Pursuant to the
Agreement, Taxpayer targeted an initial public offering ("IPO") within b years of Date 3.
In the absence of an IPO, the Agreement provides that Taxpayer shall be liquidated
after c years. Prior to its acquisition of interests of Portfolio A, Taxpayer owned no real
property and held no material assets.

       Effective Date 4, Taxpayer purchased an indirect interest in Portfolio B. Portfolio
B also consists of multifamily residential real property located in City. Portfolio A and
Portfolio B are collectively referred to as the "Properties." For the taxable years ended
Date 1 and Date 5, the majority of the income Taxpayer received from the Properties
was passthrough rental income that Taxpayer represents is qualifying gross income for
purposes of section 856(c)(2) and (3).

       Taxpayer represents that, at all times, it has intended to hold the Properties for a
period of at least c years, and to realize rental income and capital appreciation
therefrom. However, Taxpayer believes that current market conditions represent the
beginning of a long decline in the value of real property in City. Accordingly, Taxpayer
now believes its investors will be best served through a disposition of its assets and
Taxpayer's full liquidation. Taxpayer has not previously disposed of any real estate
assets.
PLR-103886-18                                3

Taxpayer anticipates that the time to fully liquidate the Properties will take between d
and e months. However, Taxpayer has been negotiating with potential purchasers, and
this time period could be accelerated if a letter of intent and/or a purchase agreement is
signed and due diligence can be completed quickly. Taxpayer represents that
substantially all marketing expenditures with respect to sales of the Properties will be
made through a taxable REIT subsidiary of Taxpayer or an independent contractor (as
defined in section 856(d)(3)) from whom Taxpayer does not derive or receive any
income.

       Before Taxpayer pursues a plan of complete liquidation, Taxpayer intends to take
several steps following receipt of this ruling. First, Taxpayer's board of directors will
perform an updated assessment of the state of Taxpayer's business including a review
of the current state of Taxpayer's strategic plan and an updated review of strategic
alternatives. Second, Taxpayer's board will initiate a portfolio liquidation following the
updated review. Third, Taxpayer's board will formally adopt a plan of liquidation. The
adoption of the plan will be publicly disclosed, and the sale of Taxpayer's assets will be
performed subject to any shareholder or other necessary approvals of the liquidation
plan.

                                   Law and Analysis

        Section 857(b)(6)(A) imposes a 100 percent tax on a REIT's net income from
prohibited transactions. Section 857(b)(6)(B)(iii) defines the term "prohibited
transaction" as the sale or other disposition of property described in section 1221(a)(1)
that is not foreclosure property. Section 1221(a)(1) property, in turn, consists of
property held by the taxpayer primarily for sale to customers in the ordinary course of
his trade or business. Section 857(b)(6)(B)(ii) provides that losses attributable to
prohibited transactions are not taken into account in determining the amount of net
income derived from prohibited transactions.

       Section 857(b)(6)(C) excludes certain sales from the definition of a prohibited
transaction. Under section 857(b)(6)(C), the term "prohibited transaction" does not
include the sale of property which is a real estate asset (as defined in section
856(c)(5)(B)) if –

      (i) the REIT has held the property for not less than 2 years;

      (ii) the aggregate expenditures made by the REIT, or any partner of the REIT,
      during the 2-year period preceding the date of sale which are includible in the
      basis of the property do not exceed 30 percent of the net selling price of the
      property;

      (iii) (I) during the taxable year the REIT does not make more than 7 sales of
      property (other than sales of foreclosure property or sales to which section 1033
PLR-103886-18                                 4

       applies), or (II) the aggregate adjusted bases (as determined for purposes of
       computing earnings and profits) of property (other than sales of foreclosure
       property or sales to which section 1033 applies) sold during the taxable year
       does not exceed 10 percent of the aggregate bases (as so determined) of all the
       assets of the REIT as of the beginning of the taxable year, or (III) the fair market
       value of property (other than sales of foreclosure property or sales to which
       section 1033 applies) sold during the taxable year does not exceed 10 percent of
       the fair market value of all the assets of the REIT as of the beginning of the
       taxable year, or (IV) the REIT satisfies the requirements of subclause (II) applied
       by substituting "20 percent" for "10 percent" and the 3-year average adjusted
       bases percentage for the taxable year (as defined in section 857(b)(6)(G)) does
       not exceed 10 percent, or (V) the REIT satisfies the requirements of subclause
       (III) applied by substituting "20 percent" for "10 percent" and the 3-year average
       fair market value percentage for the taxable year (as defined in section
       857(b)(6)(H) does not exceed 10 percent;

       (iv) in the case of property, which consists of land or improvements, not acquired
       through foreclosure (or deed in lieu of foreclosure), or lease termination, the
       REIT has held the property for not less than 2 years for production of rental
       income; or

       (v) if the requirement of clause (iii)(I) is not satisfied, substantially all of the
       marketing and development expenditures with respect to the property were made
       through an independent contractor (as defined in section 856(d)(3)) from whom
       the REIT itself does not derive or receive any income or a taxable REIT
       subsidiary.

       The legislative history underlying section 857(b)(6), which was added to the
Code by the Tax Reform Act of 1976, indicates that the purpose of that section was to
"prevent a REIT from retaining any profit from ordinary retailing activities such as sales
to customers of condominium units or subdivided lots in a development project." S.
Rep. No. 84-938, at 470 (1976), 1976-3 (Vol. 4) C.B. 508.

       To determine whether a taxpayer holds property "primarily for sale to customers
in the ordinary course of its trade or business," the Tax Court has held that several
factors must be considered, none of which is dispositive. Among those factors are: (1)
the nature and purpose of the acquisition of the property and the duration of the
ownership; (2) the extent and nature of the taxpayer's efforts to sell the property; (3) the
number, extent, continuity, and substantiality of the sales; (4) the extent of subdividing,
developing, and advertising to increase sales; and (5) the time and effort the taxpayer
habitually devoted to the sales. Generally, it is the purpose for which property is held at
the time of the sale that is determinative, although earlier events may be considered to
decide the taxpayer's purpose at the time of the sale. See Cottle v. Commissioner, 89
T.C. 467, 487 (1987).
PLR-103886-18                                        5


        Taxpayer has made the following representations that address its purposes with
respect to the Properties. Taxpayer represents that its intention has always been to
hold the Properties over the long-term to generate rental income and appreciated value.
Taxpayer's disposition of the Properties will be due to a plan of liquidation, and
Taxpayer will adopt the plan only after exploring alternatives that would allow Taxpayer
to continue holding the Properties. Since its formation in Year 1, Taxpayer has not sold
any real property. Taxpayer acquired the Properties prior to any consideration of a plan
of liquidation. Moreover, Taxpayer represents that substantially all marketing
expenditures with respect to sales of the Properties will be made through a taxable
REIT subsidiary of Taxpayer or an independent contractor (as defined in section
856(d)(3)) from whom Taxpayer does not derive or receive any income.

                                              Conclusion

      Based on the facts presented and representations made, we conclude that sales
of Taxpayer's Properties pursuant to a plan of liquidation under the above
circumstances will not constitute prohibited transactions within the meaning of section
857(b)(6).1

        This ruling's application is limited to the facts, representations, Code sections,
and regulations cited herein. Except as specifically ruled upon above, no opinion is
expressed concerning any federal income tax consequence 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. 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 penalty of perjury
statements 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.


1
  Section 4 of Rev. Proc. 2018-3 sets forth those areas in which rulings or determination letters will not
ordinarily be issued by the Service. "Not ordinarily" means that unique and compelling reasons must be
demonstrated to justify the issuance of a ruling or determination letter. See Rev. Proc. 2018-3, sec. 2.01.
Section 4.02(5) of Rev. Proc. 2018-3 provides that one of the areas in which rulings or determination
letters will not ordinarily be issued is any matter dealing with the question of whether property is held
primarily for sale to customers in the ordinary course of a trade or business. In this case, Taxpayer has
demonstrated unique and compelling reasons to justify issuance of the ruling.
PLR-103886-18                                  6

         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
                                       Branch Chief (Branch 2)
                                       Office of Associate Chief Counsel
                                       (Financial Institutions & Products)