A REIT's share of a lump-sum city payment to keep apartments affordable counts as qualifying REIT income

Plain-English summary

A real estate investment trust (REIT) has to earn most of its income from passive real estate sources, and a company that fails those income tests can lose its REIT status. This taxpayer, a REIT, held an apartment complex (through a chain of partnerships) where the units had long been rented below market to low and moderate income tenants. When those affordability rules were about to expire, the city paid the partnership a lump sum in exchange for permanently keeping a block of units affordable. The REIT asked whether its share of that payment counts toward the REIT income tests, since a one-time cash payment is not one of the income types the statute lists by name. The IRS ruled yes: using its authority under section 856(c)(5)(J)(ii), it treated the payment as qualifying income because the amount was calculated to replace the rent the partnership gave up by keeping the units below market, making it a substitute for rent that would itself have qualified. The ruling matters because it lets a REIT accept affordability subsidies without endangering the income tests that preserve its favorable tax treatment.

Ruling snapshot

• Question: Does a REIT's proportionate share of a lump-sum payment received (through a partnership) for permanently restricting apartment units to below market rents count as qualifying income under the REIT gross-income tests of section 856(c)(2) and (c)(3)?
• Outcome: Approved (ruled qualifying income under section 856(c)(5)(J)(ii))
• Key authorities: IRC §§ 856(c)(2), (c)(3), (c)(5)(J), (d); § 61; Treas. Reg. §§ 1.856-3(g), 1.856-4(a)(1); Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201904005 Third Party Communication: None
Release Date: 1/25/2019 Date of Communication: Not Applicable
Index Number: 856.00-00
Person To Contact:
---------------------- ------------------------, ID No. ------------------
------------------------------------- ----------------------------------------------------
--------------------------------------- Telephone Number:
------------------------------------------ ----------------------
---------------------------------- Refer Reply To:
CC:FIP:B02
PLR-115090-18
Date:
October 30, 2018

Legend:

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

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

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

Partnership = --------------------------------------------

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

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

Agency = ---------------------------------------------------------------

-
------------------------

Participation Agreement = -------------------------------------------

Subsidy Agreement = ---------------------------------------------------------------

                                                  ---------------------------------------------------------------

                                                  ----------------

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

Date 2 = --------------------------
PLR-115090-18 2

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

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

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

Taxable Year = -------

State 1 = --------------

State 2 = --------------

State 3 = -------

State 4 = --------------

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

B = ----------

C = -----

D = ----

E = -----

F = ----

G = -----

H = ----

I = -----

J = ----------------

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

    This letter is in reply to a letter dated May 1, 2018, in which Taxpayer requests a

ruling in connection with its status as a real estate investment trust (“REIT”) under
section 856 of the Internal Revenue Code. Specifically, Taxpayer has requested a
ruling that pursuant to the authority of section 856(c)(5)(J), a cash payment received in
PLR-115090-18 3

exchange for restricting certain apartment units to below market rental rates will be
considered as qualifying income for purposes of section 856(c)(2) and (c)(3).

Facts:

    Taxpayer is a State 1 corporation that elected to be treated as a REIT beginning

with its taxable year ended Date 1. Taxpayer’s annual accounting period is the
calendar year, and its method of accounting is the accrual method.

    Taxpayer owns a A% general partner interest directly in Operating Partnership, a

State 2 limited partnership, and a B% interest indirectly through a wholly-owned
subsidiary. Operating Partnership, through the C% ownership of several disregarded
entities, owns C% of LLC, a State 3 limited liability company which is also disregarded
for federal income tax purposes. LLC owns a D% partnership interest in Partnership, a
State 4 limited partnership, as general partner. Partnership owns Property, a collection
of more than E apartment homes in an apartment complex in City.

   The original redevelopment of Property was financed through a series of bonds

issued by Agency on Date 2 and Date 3. In connection with the bond issuances, the
Agency and Partnership entered into certain regulatory agreements and a Participation
Agreement that required Partnership to make available F% of the apartment units,
equivalent to G units, to occupants of low or moderate income until Date 4. Upon that
date, Partnership was no longer required to provide below market rate housing or
affordability protections, but if Property continued to be operated on a rental basis,
Agency had the right to rent up to G units from Partnership at market rents, thereby
causing the units to remain at below market rents by providing a subsidy to Partnership
in the amount of the difference between the below market rent and the market rent for
each unit.

    To ensure the long-term availability of affordable housing in the area and to

prevent the displacement of low and moderate income residents residing at Property
upon the expiration of the Participation Agreement, City and Partnership entered into
Subsidy Agreement, dated Date 4, providing that Partnership would maintain the current
affordability levels of all G units with respect to the tenants currently residing in those
units and also create permanent restrictions on H of those units so that they remain
affordable to any future tenants earning up to I% of City’s average median income. As
part of the Subsidy Agreement, City made a payment of $J (“Payment”), to Partnership.
The Subsidy Agreement references the right of the City under the Participation
Agreement to cause the units to remain at below market rental rates by providing a
subsidy to Partnership in the amount of the difference between the below market rental
rate and the market rate rent for each selected unit. The amount of the Payment was
agreed upon through a process of negotiation between City and Partnership that
involved projections by both parties of future market level rents and a process of
discounting such future rental stream to net present value. A private appraisal firm
PLR-115090-18 4

retained by City reported that the value of permanently preserving the H units for
households earning up to I% of area median income is $J.

   To assure Partnership’s compliance with the terms of the Subsidy Agreement,

Partnership provided City with a promissory note for $J. No principal payment or
interest is due under the promissory note and there is no maturity date. The promissory
note only becomes payable if there is default under the Subsidy Agreement that is not
cured.

  Partnership received Payment on Date 5. Taxpayer intends to include its share

of Payment in gross income in Taxable Year.

Law and Analysis:

   Section 61(a) provides that except as otherwise provided by law, gross income

means all income from whatever source derived. Under Section 61, Congress intends
to tax all gains or undeniable accessions to wealth, clearly realized, over which
taxpayers have complete dominion. Commissioner v. Glenshaw Glass Co., 348 U.S.
426, 431 (1955).

   Section 856(c)(2) provides that 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 property in which the corporation is a dealer); 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; and gain from certain sales or other dispositions of real estate
assets.

   Section 856(c)(3) provides that 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 (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 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.

   Section 856(d)(1) provides that rents from real property includes (subject to

exclusions provided in section 856(d)(2)): (A) rents from interests in real property; (B)
charges for services customarily furnished or rendered in connection with the rental of
PLR-115090-18 5

real property, whether or not such charges are separately stated; and (C) rent
attributable to personal property leased under, or in connection with, a lease of real
property, but only if the rent attributable to the personal property for the taxable year
does not exceed 15 percent of the total rent for the taxable year attributable to both the
real and personal property leased under, or in connection with, such lease.

   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 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) whether any
item of income or gain that otherwise constitutes gross income not qualifying under
section 856(c)(2) or (c)(3) may be considered as gross income that qualifies under
section 856(c)(2) or (c)(3).

   Section 1.856-3(g) 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 to
be entitled to the income of the partnership attributable to that 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.

   Section 1.856-4(a)(1) provides that the term “rents from real property” means,

generally, the gross amounts received for the use of, or the right to use, real property of
the real estate investment trust.

   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.”

    Under the Subsidy Agreement, the Payment is being provided by City to

Partnership in exchange for preserving the affordability of certain units. Based on the
language of the Subsidy Agreement, the extensive appraisal report provided, and the
representations of Taxpayer regarding the negotiations between City and Partnership,
the amount of the Payment was calculated specifically with the intent to compensate
Partnership for the difference between the below market rental rate and the market
rental rate for specific units throughout the remaining life of Property. The cash
Payment, however, is not specifically enumerated as qualifying income in section
856(c)(2) or (c)(3). Provided in a lump-sum, the Payment approximates the net present
value of the rent foregone by keeping certain units at below market rental rates. The
Payment can therefore be considered as being in the nature of, or substitute for, actual
PLR-115090-18 6

rent. If received by Partnership in the form of monthly payments from tenants paying
market rent, Taxpayer’s share of the payments would be qualifying income to Taxpayer
under section 856(c)(2) and (c)(3). Therefore, treating Taxpayer’s share of the lump-
sum Payment as qualifying income for purposes of section 856(c)(2) and (c)(3) does not
interfere with or impede the objectives of Congress in enacting section 856(c)(2) and
(c)(3).

Conclusions:

   Based on the facts and representations set forth above, we rule pursuant to the

authority of section 856(c)(5)(J)(ii) that Taxpayer’s proportionate share of income from
Payment in Taxable Year will be considered as qualifying income under section
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 or any other entity otherwise qualifies as a REIT under
subchapter M of the Code.

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