REIT may exclude default deposit and legal-fee settlement from income tests

Plain-English summary

A real estate investment trust agreed to sell residential properties, but the buyer failed to close. After litigation and an appeal, the REIT received the buyer's earnest-money deposit as liquidated damages and a negotiated reimbursement for part of its legal fees. Neither payment was otherwise listed as qualifying income for the REIT gross-income tests. The IRS allowed both amounts to be excluded from the 75% and 95% tests because they arose from an attempted property sale that would have produced qualifying income and exclusion furthered the purpose of the REIT rules. The ruling does not determine whether the taxpayer otherwise qualifies as a REIT.

Ruling snapshot

• Question: May the REIT exclude a buyer-default deposit and related legal-fee settlement from its gross income when applying the REIT income tests?
• Outcome: Approved
• Key authorities: IRC §§ 856(c)(2), 856(c)(3), and 856(c)(5)(J)(i)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202522001 Third Party Communication: None
Release Date: 5/30/2025 Date of Communication: Not Applicable
Index Number: 856.01-00
Person To Contact:
--------------- --------------------, ID No. -----------------

------------------------------------------------------------ Telephone Number:
--------------- --------------------
--------------------- Refer Reply To:
------------------------------- CC:FIP:B02
-------------------------- PLR-115566-24
Date:
March 03, 2025

LEGEND:

Taxpayer = ------------------------------------------------------------------------
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Buyer = ------------------------------------------------------------------------
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State = ----------------

Taxable Year = ----------------------------------------

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

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

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

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

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

a = ------------------------------------------------------------------------
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b = -----------------

c = ------------------------------------------------------------------------
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d = -----------------

PLR-115566-24 2

e = -------------

f = ---------------

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

This is in reply to a letter dated August 29, 2024, and supplemental
correspondence submitted on behalf of Taxpayer by its authorized representatives.
Taxpayer requests a ruling under section 856 of the Internal Revenue Code (“Code”)
regarding the treatment of the Deposit and Legal Fee Settlement (defined below) for
purposes of section 856(c)(2) and (3) (the “Gross Income Tests”). Specifically, Taxpayer
requests a ruling that any gross income arising from the Deposit and Legal Fee
Settlement not be includable in Taxpayer’s gross income for purposes of determining
whether Taxpayer has satisfied the Gross Income Tests.

Facts

Taxpayer is a State corporation that has elected to be treated as a real estate
investment trust (“REIT”) beginning with Taxable Year. Taxpayer’s assets include a
multi-family residential properties (the “Properties”), which are held through disregarded
entities or a partnership (the “Affiliates”). Taxpayer represents that substantially all
income derived from the Properties is qualifying income for the purposes of the Gross
Income Tests.

Effective Date 1, Taxpayer and the Affiliates entered into an agreement to sell
the Properties to Buyer for a sale price, as amended, of $b (the “Agreement”). Taxpayer
has represented that the gain from selling the Properties under the Agreement would
have been qualifying income under the Gross Income Tests. The Agreement required
Buyer to place $c in escrow as an earnest money deposit (the “Deposit”), which was
described by the terms of the Agreement as a credit toward the total purchase price and
was to be released from escrow to Taxpayer once all conditions of closing were
satisfied. The Agreement also specified that if closing were not to occur due to Buyer’s
default, Taxpayer’s legal remedies would be limited to the retention of the Deposit as
liquidated damages. Under these circumstances, the Agreement noted that the Deposit
was intended to represent a reasonable measure of Taxpayer’s damages resulting from
a termination of the Agreement due to a Buyer default.

Buyer failed to appear at the closing on Date 2. Taxpayer treated this as a Buyer
default and demanded that the Deposit be released from escrow. Buyer objected and
several years of litigation followed. The trial court determined that Buyer had breached

PLR-115566-24 3

the Agreement by failing to appear at the closing but held that the liquidated damages
provision was unenforceable. The trial court did, however, award Taxpayer and the
Affiliates $d in legal fees in response to a post-trial motion filed by Taxpayer.

Both parties appealed the trial court’s decision. On Date 3, the appellate court
affirmed that Buyer breached the Agreement, affirmed the award and amount of legal
fees, but also enforced the liquidated damages clause of the Agreement. Following the
appellate decision, Taxpayer, the Affiliates, and Buyer reached a settlement (the
“Settlement”) comprised of the Deposit plus a negotiated sum of $e (an amount less
than $d) in lieu of the legal fee amount awarded by the courts (the “Legal Fee
Settlement”), for a total of $f. The Deposit and Legal Fee Settlement were received by
the Taxpayer on Date 4 and Date 5, respectively.

Law

Section 856(c)(2) provides that at least 95 percent of a REIT’s gross income
must be derived from certain passive sources which include the gain from the sale or
other disposition of stock, securities, and real property (including interests in real
property and interests in mortgages on real property) which is not property described in
section 1221(a)(1).

Section 856(c)(3) provides that at least 75 percent of a REIT’s gross income
must be derived from certain real estate sources, including the gain from the sale or
other disposition of stock, securities, and real property (including interests in real
property) which is not property described in section 1221(a)(1).

Section 856(c)(5)(J) provides that, to the extent necessary to carry out the
purposes of part II of subchapter M of Chapter 1 of the Code (the “REIT Provisions”),
the Secretary is authorized to determine whether any item of income or gain which — (i)
does not otherwise qualify under section 856(c)(2) or (3) may be considered as not
constituting gross income for the purposes of section 856(c)(2) or (3), or (ii) otherwise
constitutes gross income not qualifying under sections 856(c)(2) or (3), may be
considered as gross income which qualifies under section 856(c)(2) or (3).

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 derived from passive sources. For example, H.R. Rep. No. 2020, 86 th
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.”

PLR-115566-24 4

Analysis

In this case, income attributable to the Deposit and Legal Fee Settlement
constitutes gross income that is not listed as qualifying income under section 856(c)(2)
or (c)(3).

With respect to the portion of the Settlement attributable to the retained Deposit,
the Agreement between Buyer and Taxpayer specified that the Deposit was for
Taxpayer’s damages resulting from Buyer’s breach of contract. The damages were
derived from the attempted sale of the Properties, the gain from which would have been
considered qualifying gross income under the Gross Income Tests had the sale of the
Properties occurred. Taxpayer’s receipt of the Deposit under these circumstances
should not cause any portion of the Deposit to be treated as nonqualifying income.
Excluding the Deposit from Taxpayer’s gross income for purposes of the Gross Income
Tests does not interfere with the Congressional policy objectives in enacting the Gross
Income Tests under those provisions and would carry out the purposes of the REIT
Provisions.

With respect to the Legal Fee Settlement, as noted above, the sale of the
Properties (i.e., the origin of the dispute between Taxpayer and Buyer) would have
produced qualifying income to Taxpayer if consummated. Given that the Legal Fee
Settlement represents a partial reimbursement to Taxpayer of its court-determined legal
fees incurred as a result of this real estate dispute, receipt of the Legal Fee Settlement
should not result in nonqualifying income to Taxpayer. Excluding the Legal Fee
Settlement from Taxpayer’s gross income for purposes of the Gross Income Tests does
not interfere with the Congressional policy objectives in enacting the Gross Income
Tests under those provisions and would carry out the purposes of the REIT Provisions.

Conclusion

Based on the facts and representations submitted, we rule that, pursuant to
section 856(c)(5)(J)(i), Taxpayer may exclude the Deposit and Legal Fee Settlement
from gross income for purposes of the Gross Income Tests.

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 or implied concerning any federal income tax consequences relating to the
facts herein under any other provision of the Code. Specifically, we do not rule whether
Taxpayer otherwise qualifies as a REIT under subchapter M of Chapter 1 of the Code.

This ruling is directed only to the taxpayer requesting it. Taxpayer should attach a
copy of this ruling to each tax return to which it applies. Section 6110(k)(3) of the Code
provides that this ruling may not be used or cited as precedent. In accordance with the

PLR-115566-24 5

provisions of a Power of Attorney on file with this office, a copy of this letter is being
sent to your authorized representatives.

                                            Sincerely,

                                            _______________________
                                            Bernard J. Audet, Jr.
                                            Chief, Branch 2
                                            Office of Associate Chief Counsel
                                            (Financial Institutions & Products)

cc: ----------------------------------
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