Development tax credits treated as qualifying REIT income

Plain-English summary

A real estate investment trust indirectly invested in a partnership developing rental real estate in a designated economic-development area. State law awarded transferable tax credits based on the project's capital investment, and the partnership planned to sell them because it had no state tax liability. The REIT represented that the credits would offset development costs, the completed project would be a qualified real estate asset, and substantially all project income would otherwise qualify under the REIT income tests. The IRS ruled that amounts included in income from the credits would count as qualifying income for both the 95-percent and 75-percent gross-income tests. It did not rule on the tax treatment of selling the credits or on the taxpayer's overall REIT qualification.

Ruling snapshot

• Question: Would income from transferable state development tax credits qualify under the REIT gross-income tests?
• Outcome: Approved.
• Key authorities: IRC §§ 451 and 856(c)(2), (c)(3), and (c)(5)(J)(ii); Treas. Reg. §§ 1.451-1(a) and 1.856-3(g).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201948006 Third Party Communication: None
Release Date: 11/29/2019 Date of Communication: Not Applicable
Index Number: 856.00-00
Person To Contact:
-------------------------------- ---------------, ID No. -----------
--------------------------------------- Telephone Number:
----------------- --------------------
--------------------------------------- Refer Reply To:
----------------------------------- CC:FIP:B02
PLR-108284-15
Date:
August 27, 2019

Legend:
Taxpayer = ----------------------------------------

Operating Partnership = -----------------------------
Holding = -------------------------------------------------------
Company A = -----------------------------------------------
Company B = ------------------------------------
State A = ------------
State B = ------------
State C = ----------------
Project = ---------------------------------------------
Act = --------------------------------------------
Authority = ------------------------------------------------------------------------

Area = ------------------------------------------------------------------------

Qualified Venture = -----------------------------------------------------------------------

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

u = ---
v = ---
w = ---

PLR-108284-15 2

x = ---
y = ---
z = ------------

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

   This is in response to your letter dated March 2, 2015, and subsequent

correspondence, requesting a ruling that the Tax Credits (described below) will be
treated as qualifying income for purposes of section 856(c)(2) and (c)(3) of the Internal
Revenue Code (“Code”) pursuant to section 856(c)(5)(J)(ii).

                                             FACTS

    Taxpayer, a State A corporation, is engaged in the business of owning and

operating rental real estate. Taxpayer elected to be taxed as a real estate investment
trust (“REIT”) under sections 856 through 859. Taxpayer uses the calendar year and an
accrual method as its overall method of accounting.

   Taxpayer has over a v% general partnership interest in Operating Partnership,

and Taxpayer is the sole general partner in Operating Partnership. Operating
Partnership, a State B limited partnership, is engaged in the ownership, operation,
leasing, acquisition and management of rental property.

   Operating Partnership is the sole member of Company A. Company A is a State

C limited liability company that is treated as a disregarded entity for U.S. tax purposes.
Company A is a w% member of Holding. The remaining x% membership interests of
Holding are held by Company B, an unrelated third-party. Holding is treated as a
partnership for all tax purposes.

   Holding was organized for the purpose of financing, developing, constructing,

owning, operating, managing, leasing and maintaining Project, a Qualified Venture.
Project is the first phase of a possible three-phase larger project at the same location.

   Under State C law, Act authorizes the issuance of state tax credits when a

developer makes a capital investment1 in a Qualified Venture within an Area (the “Tax
Credits”). The purpose of the program creating the Tax Credits is to encourage
economic development of Areas through capital investment and the creation of
employment opportunities. The Tax Credits issued for a Qualified Venture are based

1
Act defines “capital investment” as expenses incurred for the development of real property including site
preparation and construction, repair, renovation, improvement, equipping, or furnishing of a building,
structure, facility or improvement to real property.

PLR-108284-15 3

exclusively on the developer’s capital investment in the Qualified Venture, but are
limited to no more than y% of the capital investment. The Tax Credits are
nonrefundable credits that may be used against specified State C taxes. The Tax
Credits may be transferred (by sale or assignment) if the developer that receives the
Tax Credits under Act applies for and receives a Tax Credit transfer certificate from
Authority.

   Holding submitted an application for a grant of Tax Credits relating to Project to

Authority. Authority approved the issuance of Tax Credits in an amount up to a
maximum of $z to be received over a period of u years. Taxpayer represents that it will
include the income from the Tax Credits when required under section 451. Because
Taxpayer has no State C tax liability, Holding has opted to sell its Tax Credits.
Taxpayer further represents that the Tax Credits are sold or disposed of by the
unextended due date of the federal tax return for the taxable year in which the Tax
Credits are included in income in accordance with section 451.

    Taxpayer further represents that the income from the Tax Credits will be used to

offset the actual cost of developing Project and upon completion of Project, substantially
all of Taxpayer’s income from Project will be qualifying income for purposes of sections
856(c)(2) and (c)(3). Taxpayer further represents that upon completion, Project will be a
qualified real estate asset under section 856(c)(5)(B).

                                       LAW

   Section 856(c)(2) provides that at least 95 percent of a REIT’s gross income

must be derived from 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), abatement 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 at least 75 percent of a REIT’s gross income

must be derived from rents from real property, interest on obligations secured by 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, certain commitment fees, gain from certain sales or other
disposition 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, whether any item of income or gain which –
(i) 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) otherwise

PLR-108284-15 4

constitutes gross income not qualifying under section 856(c)(2) or (c)(3) may be
considered as gross income which qualifies under section 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 of the assets
of the partnership and is deemed to be entitled to the income of the partnership
attributable to such 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. The character of the various assets in the hands of the partnership and
items of gross income of the partnership shall retain the same character in the hands of
the partners as in the hands of the partnership for all purposes of section 856.

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

all income from whatever source derived.

   Section 451(a) provides that the amount of any item of gross income shall be

included in the gross income for the taxable year in which received by the taxpayer,
unless, under the method of accounting used in computing taxable income, such
amount is to be properly accounted for as of a different period.

    Under an accrual method of accounting, unless section 451(b)(1)(A) requires

earlier inclusion, an item of gross income is includible when all the events have
occurred which fix the right to receive such income and the amount thereof can be
determined with reasonable accuracy. See section 451(b) and section 1.451-1(a). All
the events that fix the right to receive income generally occur upon the earliest of the
following: (1) the required performance takes place, (2) payment is due, or (3) payment
is made. See Schlude v. Commissioner, 372 U.S. 128 (1963); Rev. Rul. 2003-10,
2003-1 C.B. 288.

   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 822-823 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.”

                                    ANALYSIS

    Income attributable to the receipt of the Tax Credits constitutes gross income that

is not listed as qualifying income under section 856(c)(2) or (c)(3). Taxpayer represents
that Project will be a qualified real estate asset for purposes of section 856 and that
substantially all of the income Taxpayer derives from Project will be qualifying income
for purposes of sections 856(c)(2) and (c)(3). Furthermore, Taxpayer represents that it

PLR-108284-15 5

will include the Tax Credits in income when required under section 451. The Act
provides the Tax Credits as a government incentive to redevelop property that may not
otherwise be a profitable venture for the REIT and, therefore, the Tax Credits are
received in connection with the development of real property, an activity that is
permissible for REITs. Treating income from the receipt of the Tax Credits 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 amounts included in income with respect
to the Tax Credits in accordance with section 451 shall be treated as qualifying income
for purposes of section 856(c)(2) and (c)(3).

                                   CONCLUSION

   Based on the facts and representations submitted by Taxpayer, we conclude that

amounts included in income with respect to the Tax Credits in accordance with section
451 will be qualifying income for purposes of section 856(c)(2) and (c)(3) pursuant to
section 856(c)(5)(J)(ii).

   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. Specifically, no opinion is expressed whether taxpayer
otherwise qualifies as a REIT under part II of subchapter M of Chapter 1 of the Code.
Nor is any opinion expressed with respect to the tax consequences of any dispositions
of the Tax Credits, including whether a sale of the Tax Credits constitutes a prohibited
transaction as described in section 857(b)(6)(B)(iii).

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