Zero income and assets did not defeat REIT qualification tests

Plain-English summary

A corporation filed a REIT return for its first tax year even though delays prevented it from receiving investment proceeds, acquiring real estate interests, or earning income until the next year. It later asked the IRS to treat it as if it had not made the first-year REIT election because advisers questioned whether a REIT with zero income and zero assets could satisfy the qualification tests. The IRS ruled that 95 percent and 75 percent of zero gross income are zero, and 75 percent of zero assets is also zero. The absence of income and assets therefore did not cause failure of the gross-income or asset tests. The IRS denied the request to disregard the REIT election and did not need to address the planned amended return.

Ruling snapshot

• Question: Did having no gross income or assets in the first year cause the taxpayer to fail the REIT gross-income and asset tests?
• Outcome: No, and the request to disregard the first-year REIT election was denied
• Key authorities: IRC §§ 61, 856(c)(1)-(4), 856(g); Treas. Reg. § 1.856-2(c)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202440007 Third Party Communication: None
Release Date: 10/4/2024 Date of Communication: Not Applicable
Index Number: 856.00-00
Person To Contact:
--------------------------------------------------- --------------------------, ID No. ----------------
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------------------------------------- Telephone Number:
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Refer Reply To:
CC:FIP:2
PLR-124112-23
Date:
June 25, 2024

Legend

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

Parent = ------------------------------------------------------

Seller = ------------------------------------

Firm 1 = ---------------------------------------

Firm 2 = ----------------------------

Firm 3 = ---------------------------

Year 1 = -------

Year 2 = -------

Year 3 = -------

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

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

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

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

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

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Date 6 = -----------------------

Date 7 = ------------------

Date 8 = -----------------------

Date 9 = --------------------------

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

Country = -----------------

x = -----

y = -----

z = ------

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

   This letter responds to a private letter ruling request dated December 11, 2023.

Taxpayer requests a ruling that Taxpayer will be treated as if Taxpayer had not made
an election to be a real estate investment trust (REIT) on its Form 1120-REIT, U.S.
Income Tax Return for Real Estate Investment Trusts, filed for Year 1. Taxpayer further
requests that, pending an affirmative ruling, its intended filing of Form 1120-X, Amended
U.S. Corporation Income Tax Return for Year 1 not be treated as a termination or
revocation of its REIT status for purposes of section 856(g) of the Internal Revenue
Code (Code).

                                       FACTS

   Taxpayer was formed on Date 1 as a State corporation. Currently, Taxpayer

indirectly owns, through entities treated as partnerships for U.S. federal income tax
purposes, multi-family properties. Parent, a Country special limited partnership that is a
partnership for U.S. federal income tax purposes, owns x percent of the common
interests in Taxpayer. Each of y individual shareholders owns a nonvoting preferred
interest in Taxpayer.

   In Year 1, Parent sought to issue equity in exchange for cash to allow Taxpayer

to acquire a portion of the multi-family properties owned by Seller. Parent intended to
complete that offering so that Taxpayer could acquire an interest in those properties
before Date 2. Parent completed its equity offering on Date 2 but was not able to obtain

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the required approvals from investors and regulatory agencies to transfer the cash
proceeds from that equity offering to Taxpayer by the end of Year 1. Parent was able to
contribute those cash proceeds to Taxpayer on Date 3. Taxpayer thus had no gross
income from any source, and no assets, at any point prior to Year 2, the year following
Year 1. On Date 3, Taxpayer acquired from Seller approximately z percent of the
membership interests in certain limited liability companies that owned multi-family
properties and that were previously treated as disregarded entities of Seller.

     On Date 4, Taxpayer engaged Firm 1 to provide a Form 1120-REIT for

Taxpayer’s Year 1 taxable year. Taxpayer represents that Firm 1 was qualified in REIT
related matters. When Taxpayer initially began discussions in Year 1 with Firm 1
regarding the engagement, Taxpayer intended to acquire assets from Seller in Year 1
and to be treated as a REIT by filing a Form 1120-REIT for Year 1. Taxpayer informed
Firm 1 that, due to unforeseen circumstances, Taxpayer did not acquire assets until
Date 3, and did not begin to earn gross income until its Year 2 taxable year. Firm 1 was
aware of no clear Internal Revenue Service guidance indicating that a REIT was
required to have gross income or assets to satisfy the tests required for REIT
qualification. Accordingly, Firm 1 did not communicate any issue with Taxpayer’s ability
to satisfy the tests required for REIT qualification. Firm 1 prepared a Form 1120-REIT
for Taxpayer for Year 1 showing zero dollars’ worth of assets and zero dollars of total
income, which was approved and filed by Taxpayer on Date 5. Taxpayer relied on Firm
1, its tax return preparer, when it filed that Form 1120-REIT.

    On Date 6, Parent engaged Firm 2 to provide audit services of Parent’s financial

statements. Firm 2 engaged Firm 3 to provide audit services with respect to the U.S.
REIT qualification and taxation of Taxpayer. Taxpayer represents that Firm 3 was
qualified in REIT related matters. As part of its audit procedures, Firm 3 requested any
formation documents and any prior-year returns. On Date 7, Firm 3 received
Taxpayer’s Form 1120-REIT for Year 1. After reviewing Taxpayer’s Form 1120-REIT
for Year 1, Firm 3 advised Taxpayer that there may be uncertainty with respect to
Taxpayer’s REIT qualification. Firm 3 advised Taxpayer that it was unclear whether a
REIT could satisfy the tests required for REIT qualification if the REIT did not have
gross income or assets. Firm 3 further advised Taxpayer that if Taxpayer were treated
as not qualifying as a REIT for Year 1, section 856(g)(3) would preclude Taxpayer from
electing REIT status until its taxable year ending Date 9. To resolve these issues,
Taxpayer filed this ruling request. Taxpayer timely filed a Form 1120-REIT for Year 2
on Date 8.

    Pending an affirmative ruling, Taxpayer intends to file a Form 1120-X, a non-

REIT amended return for Year 1. Taxpayer represents that the Form 1120-X will not
alter in its amended return any tax treatment or position on its original Year 1 return,
other than the REIT election.

PLR-124112-23 4

                              LAW AND ANALYSIS

   Section 856(c)(1) of the Code provides that a corporation, trust or association

shall not be considered a REIT for any taxable year unless it files with its return for the
taxable year an election to be a REIT or has made such election for a previous taxable
year, and such election has not been terminated or revoked under section 856(g).

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

must be derived from certain specifically enumerated sources.

  Section 856(c)(3) provides that at least 75 percent of a REIT’s gross income

must be derived from certain specifically enumerated sources (together with section
856(c)(2), the “Gross Income Tests”).

   Section 856(c)(4)(A) provides that, at the close of each quarter of its taxable

year, at least 75 percent of the value of a REIT’s total assets must be represented by
certain specifically enumerated items (the “Asset Test”).

    Section 1.856-2(c) of the Income Tax Regulations provides that a corporation,

trust, or association is not a REIT for a taxable year unless it meets certain
requirements with respect to the sources of its gross income for the taxable year.

   Section 1.856-2(c)(1) provides that in determining whether the gross income of a

REIT satisfies the percentage requirements of section 856(c)(2) and (3), for purposes of
both the numerator and denominator in the computation of the specified percentages,
the term “gross income” has the same meaning as that term has under section 61 and
the regulations thereunder.

  Section 61(a) of the Code provides that, except as otherwise provided, gross

income includes all income from whatever source derived.

    Section 856(g)(1) provides that an election under section 856(c)(1) made by a

corporation shall terminate if the corporation is not a REIT to which the provisions of
part II of subchapter M of chapter 1 of the Code apply for the taxable year with respect
to which the election is made, or for any succeeding taxable year. Such termination
shall be effective for the taxable year for which the corporation is not a REIT to which
the provisions of part II of subchapter M of chapter 1 of the Code apply, and for all
succeeding taxable years.

   Section 856(g)(2) provides that an election under section 856(c)(1) made by a

corporation may be revoked by it for any taxable year after the first taxable year for
which the election is effective. Such revocation shall be effective for the taxable year in
which made and for all succeeding taxable years.

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   Section 856(g)(3) provides, in general, that if a corporation has made a REIT

election and such election has been terminated or revoked, such corporation or any
successor corporation, shall not be eligible to make an election under section 856(c)(1)
for any taxable year prior to the fifth taxable year which begins after the first taxable
year for which such termination or revocation is effective.

    Legislative history indicates that Congress enacted part II of subchapter M of the

Code to provide for a type of conduit treatment for income of certain “organizations
specializing in investments in real estate and real estate mortgages.” H.R. Rep. No.
2020, 86th Cong., 2d Sess. 4 (1960), 1960-2 C.B. 819, 820. The legislative history
further indicates that the central concern behind the Gross Income Tests is that a
REIT’s gross income should largely be composed of passive income. For example,
H.R. Rep. No. 86-2020, 2d Sess. 4 (1960), 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.” The
legislative history similarly indicates that the Asset Test “is designed to give assurance
that the bulk of the [REIT’s] investments are in real estate . . . .” See H.R. Rep. No. 86-
2020, 2d Sess. 4 (1960), 1960-2 C.B. 819, at 822.

    The Gross Income Tests provide that at least a percentage of the REIT’s gross

income is derived from enumerated sources. Taxpayer’s gross income in Year 1 was
$0. The percentage is 95% under section 856(c)(2), and 95% of $0 equals $0. The
percentage is 75% under section 856(c)(3), and 75% of $0 equals $0. Thus, in Year 1,
at least $0 of Taxpayer’s gross income was derived from the enumerated sources under
the Gross Income Tests. Section 1.856-2(c) interprets the Gross Income Tests as
being concerned with the sources of a REIT’s gross income and not with whether the
REIT has gross income in the first instance. Section 1.856-2(c)(1) does not prevent
qualification as a REIT on account of having $0 of gross income. Similarly, the above
legislative history demonstrates that Congress was primarily concerned with the source
of a REIT’s income. Accordingly, Taxpayer did not fail the Gross Income Tests in Year
1.

    The Asset Test provides that at least 75% of the value of the REIT’s total assets

is represented by enumerated items. The value of Taxpayer’s total assets in Year 1
was $0, and 75% of $0 equals $0. Thus, in Year 1, at least $0 of Taxpayer’s assets
was represented by the enumerated items under the Asset Test. To state that the
Asset Test is not failed in the absence of any assets is consistent with the above
legislative history, which demonstrates that in enacting the Asset Test, Congress was
concerned with the nature of a REIT’s assets and not whether the REIT had assets in
the first instance. Accordingly, Taxpayer did not fail the Asset Test in Year 1.

PLR-124112-23 6

                                  CONCLUSION

     Based upon the facts and representations submitted, we conclude that

Taxpayer’s lack of assets and income in Year 1 did not cause Taxpayer to fail the Gross
Income Tests or Asset Test in Year 1. Accordingly, Taxpayer’s request to be treated as
if it had not made an election to be a REIT for Year 1 is denied, and it is unnecessary to
address Taxpayer’s further request regarding the effect of the intended filing of Form
1120-X for Year 1.

                                     CAVEATS

   This ruling’s application is limited to the facts, representations, Code sections,

and regulations cited herein. Except as specifically provided otherwise, no opinion is
expressed on the federal income tax consequences of the transactions described
above. In particular, and except as expressly provided, no opinion is expressed or
implied regarding whether Taxpayer otherwise 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 terms of a power of attorney on file in this office, a copy of

this letter is being sent to your authorized representatives.

                                   Sincerely,


                                   ___________________________
                                   K. Scott Brown
                                   Senior Technician Reviewer, Branch 2
                                   Office of Associate Chief Counsel
                                   (Financial Institutions & Products)

PLR-124112-23 7

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