Development grant counted as qualifying REIT income

Plain-English summary

A real estate investment trust indirectly owned joint ventures redeveloping a regional shopping center on city-owned land. A state economic development program reimbursed the property owners for eligible construction, land acquisition, and bridge-financing costs through a city agency. The grant income was not one of the income categories ordinarily listed for the REIT gross-income tests. The IRS nevertheless treated the REIT's allocable share as qualifying income under section 856(c)(5)(J)(ii) because the grant supported development of represented real property and did not interfere with Congress's purpose of limiting REITs largely to passive income. The ruling did not determine whether the taxpayer otherwise qualified as a REIT or address income from selling an interest in the grant.

Ruling snapshot

• Question: Did the state development grant count as qualifying income for the REIT's 95-percent and 75-percent gross-income tests?
• Outcome: Approved, the grant payments were qualifying income for both tests.
• Key authorities: IRC §§ 61 and 856(c)(2), (c)(3), and (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: 201929015                                               Third Party Communication: None
Release Date: 7/19/2019                                         Date of Communication: Not Applicable
Index Number: 856.00-00
                                                                Person To Contact:
-----------------------------------------                       ----------------, ID No. -----------
----------------------------------------------------------      Telephone Number:
------------------------------------------------                --------------------
--------------------------------------                          Refer Reply To:
                                                                CC:FIP:2
                                                                PLR-132802-18
                                                                Date:
                                                                April 12, 2019




Legend

Taxpayer                                     =        --------------------------------------------------------------
--------------------------------------------------------------------------------
Operating Partnership                        =        --------------------------------
JV Partner                                   =        ---------------------------------
Company A                                    =        -----------------------------
Company B                                    =        --------------------------
Company C                                    =        --------------------------
Company D                                    =        --------------------------------------------------
Company E                                    =        ----------------------
Date                                         =        ---------------------------
Year                                         =        -------
State A                                      =        -------------------
State B                                      =        -------------------
City                                         =        -----------------------
Property                                     =        ---------------------------------------------------------------
                                                      -----------------
Program                                      =        ---------------------------------------------------------------
                                                      -----------
Office                                       =        ----------------------------------------------

PLR-132802-18                                 2

Agency                             =      ------------------------------------------------ --------------
                                          ------------------
a                                  =      ------
b                                  =      -------------
c                                  =      --------------
d                                  =      ----------------
e                                  =      --------



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

       This letter responds to your letter dated October 29, 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 State A business trust that has elected to be treated as a real
estate investment trust (“REIT”) under sections 856 through 859. Taxpayer uses an
accrual method of accounting and the calendar year as its taxable year. Taxpayer owns
and operates retail space in the eastern half of the United States. Taxpayer holds
interests in its portfolio of properties through its operating partnership, Operating
Partnership. Taxpayer is the sole general partner of Operating Partnership, and as of
Date, held an a% controlling interest in Operating Partnership. Taxpayer’s
management, leasing and real estate development services are provided through two of
its subsidiaries, Company A and Company B. Company B, Taxpayer’s taxable REIT
subsidiary, generally develops and manages properties, including properties owned by
partnerships in which Taxpayer has an interest and properties that are owned by third
parties in which Taxpayer does not have an interest.

        In Year, Taxpayer, along with JV Partner, a State B corporation that has elected
to be treated as a REIT under sections 856 through 859, formed joint ventures to
develop certain regional shopping centers, including Property. Taxpayer and JV
Partner, through other owned entities that are either disregarded or treated as tax
partnerships, indirectly own e interests in the following joint ventures that will develop
Property: Company C, Company D, and Company E (collectively referred to as the
“Owners”). The Owners own the individual properties that comprise Property, which is
constructed on land leased from City and currently under redevelopment. The
redevelopment of Property will be funded by a grant through Program (the “Grant”).

PLR-132802-18                                 3

       A Program grant is administered by State A, acting through Office, for the
acquisition and construction of economic development projects, with intended regional
or multi-jurisdictional impact, that are expected to substantially increase or maintain
current levels of employment, tax revenues, or other measures of economic activity.
Generally, in order to receive a Program grant, the applicant is required to apply for the
grant, which must be approved by the legislature and selected by the governor of State
A. The recipient of the grant is then required to enter into an agreement with Agency
and Office.

       Property has been approved for a Program grant. As the owner of the underlying
land on which Property was built, City is the recipient (i.e., the grantee) of the Grant.
Agency, acting on behalf of City as the grantee, will formalize a contract with State A,
acting through Office, that will set the responsibilities and obligations of the parties
involved with the Grant. Agency will then approve the Grant payments to the various
sub-grantees. The Owners, as sub-grantees, will enter into a subcontract with Agency
to be approved by Office for the development of Property.

       Pursuant to Program, Agency, as grantee, will apply for periodic project
payments to cover a portion of paid eligible and reimbursable project expenses,
including construction costs, land acquisition costs, and interest costs paid as a result of
the use of interim or bridge financing for the project during construction. The amounts
received from the Grant will then be used to subsidize the Owners, as sub-grantees and
developers, for the costs directly associated with the development of Property.

        Agency was approved for the release of $b in payments from the Grant for
funding the redevelopment of Property, of which $c has been paid to other predecessor
entities that predated the Owners, leaving $d outstanding to be paid to the Owners as
costs directly associated with the development of Property are incurred.

       Taxpayer represents that Property, 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 Property will be qualifying income for purposes of sections
856(c)(2) and (c)(3). Taxpayer also represents that substantially all of the Grant
payments will be for construction of real property (within the meaning of section 1.856-
10 of the Income Tax Regulations) at Property. Taxpayer further represents that
Taxpayer intends to report its allocable share of the Grant payments as gross income
under section 61 and will take its share of the Grant payments into account for the
taxable year in which such income is recognizable.

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

PLR-132802-18                                 4

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 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 Property, 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 Property will be qualifying
income for purposes of sections 856(c)(2) and (c)(3). Taxpayer will earn the Grant
payments for developing real property in State A in accordance with Program. Treating

PLR-132802-18                                5

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 payments 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 representative.

      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)