Mark Twain once said, “Buy land, they don’t do any more.” It is perhaps this sentiment (along with investment returns) that has led to the popularity of real estate investment trusts. However, taxpayers should be aware of the various requirements and restrictions associated with real estate investment trusts, such as income and asset thresholds. Based on a recent private letter ruling, the Internal Revenue Service (“IRS”) noted that certain income (Section 481 adjustments) related to a real estate investment trust would not constitute a gross income and, therefore, would violate the income limits of Section 856.(c)(2) and (3) of the Internal Revenue Code.
Real estate investment trusts, generally
Generally, real estate investment trusts (“REITs”) are corporations that own, finance and/or operate income-producing real estate. REITs provide investment opportunities for shareholders to derive income from real estate without personally buying and/or operating properties. However, to qualify as a REIT, a company must meet several requirements. Section 856(a) of the Internal Revenue Code defines a REIT as a corporation, trust, or association:
(1) Which is managed by one or more directors or administrators;
(2) whose beneficial ownership is evidenced by transferable shares or transferable beneficial interest certificates;
(3) Which (but for the provisions of this part) would be taxable as a domestic company;
(4) that is neither (A) a financial institution (see Section 582(c)(2)), nor (B) an insurance company (see Sub-Chapter L);
(5) beneficially owned by 100 or more persons;
(6) Subject to the provisions of subsection (k), which is not closely held (see subsection (h)); and
(seven) Which meets the requirements of subsection (c).[1]
Section 856(c) describes the limits applicable to qualifying REITs. REITs must file with their returns an election to be a REIT (or at least have made that election in a previous tax year).[2] In addition, REITs must meet certain income and asset thresholds. Section 856(c)(2) and (3) describe the income limits as follows:
(2) at least 95% (90% for taxation years beginning before January 1, 1980) of its gross income (excluding gross income from prohibited transactions) is derived from:
(A) dividends;
(B) interest;
(VS) real estate rents;
(D) gain from the sale or other disposition of stocks, securities and real property (including interest on real property and interest on mortgages on real property) that are not property described in Section 1221(a)(1);
(E) property tax abatements and refunds;
(F) income and gains from seized property (as defined in sub-paragraph (e));
(G) amounts (other than amounts the determination of which depends in whole or in part on a person’s income or profits) received or accrued as consideration for entering into agreements (i) to make loans secured by mortgages on immovable property or on interests in immovable property or (ii) to buy or rent immovable property (including interest on immovable property and interest on mortgages on immovable property);
(H) gain from the sale or other disposition of real property that is not a prohibited transaction solely by virtue of Section 857(b)(6); and
(I) mining royalty income earned in the first taxation year commencing after the date of enactment of this paragraph on real estate owned by a timber real estate investment trust and held, or formerly held, in the course of trade or of the timber production business by such real estate real estate investment trust;
(3) at least 75% of its gross income (excluding gross income from prohibited transactions) is derived from:
(A) real estate rents;
(B) interest on bonds secured by mortgages on real estate or on interests in real estate;
(VS) gain from the sale or other disposition of real property (including interest on real property and interest on mortgages on real property) that is not property described in section 1221(a) (1);
(D) dividends or other distributions on, and gains (other than gains from prohibited transactions) from the sale or other disposition of transferable shares (or transferable beneficial interest certificates) in other trusts investment properties that meet the requirements of this Part;
(E) property tax abatements and refunds;
(F) income and gains from seized property (as defined in sub-paragraph (e));
(G) amounts (other than amounts the determination of which depends in whole or in part on a person’s income or profits) received or accrued as consideration for entering into agreements (i) to make loans secured by mortgages on immovable property or on interests in immovable property or (ii) to buy or rent immovable property (including interest on immovable property and interest on mortgages on immovable property);
(H) gain from the sale or other disposition of real property (other than a non-qualifying REIT debt obligation offered to the public) that is not a prohibited transaction solely by virtue of section 857( b)(6); and
(I) qualifying temporary investment income[.][3]
Further, with respect to income threshold determinations, Section 856 provides the Secretary with the authority to exclude certain types of income from Sections (c)(2) and (3). Specifically, Section 856(c)(5)(J)(i) provides, in part, that:
(J) Power of Secretary to Exclude Other Items of Income.—To the extent necessary to achieve the purposes of this Part, the Secretary is authorized to determine, solely for the purposes of this Part, whether any item of income or gain who-
(I) does not otherwise qualify under subsection (2) or (3) may be deemed not to constitute gross income for the purposes of subsection (2) or (3) . . . .[4]
Private letter decision 202235006
On September 2, 2022, the IRS issued a Private Ruling Letter (“PLR”) regarding a taxpayer’s request for a ruling, in part, under Sections 856(c)(2), (3) and (5)(J )(i).[5] The main facts presented are as follows:
The taxpayer was organized as a government limited liability company in year 1 when the taxpayer elected to be taxed as a real estate investment trust (REIT) under [S]ections 856 to 860. The taxpayer’s overall method of accounting is an accrual method, and its taxation year is the calendar year. The taxpayer has been a partner in OP, a partnership for federal income tax purposes, for all periods beginning in Year 1. The taxpayer’s income is derived almost exclusively from his investment in OP[6]. . . .
After acquiring a majority interest in OP (including indirectly through the acquisition of Taxpayer) in Year 2, Taxpayer conducted a review of Taxpayer’s books and records. The taxpayer concluded that OP improperly depreciated or amortized certain cell and broadcast towers. . . brought into service between the tax years ended Date 1 and Date 2 [] using cost recovery methods applicable to personal property. As a result of this review, OP submitted Forms 3115, Request for Change in Accounting Policy, . . . to change its methods of accounting for depreciation for the [a]ssets to methods applicable to land improvements in asset class 00.3 of Rev. proc. 87-56, 1987-2 CB 674, beginning with the tax year of the change ending on date 3. . . . The [m]method [c]changes have had positive effects [S]adjustments under section 481(a) [] that the Taxpayer will take into account on the [S]section 481(a) adjustment period. Appropriate [S]The section 481(a) adjustment period will generally be the year of the changeover and the following three taxation years, unless an acceleration applies later in certain specified circumstances.[7]
Based on the limited facts presented, the IRS has concluded, in part, as follows:
Based on all facts and circumstances, excluding the taxpayer’s share of OP Section 481(a) adjustments, determined pursuant to [S]Section 1.856-3(g), of the taxpayer’s gross income for purposes of [S]Sections 856(c)(2) and (3), do not interfere with the policy purposes of Congress in enacting income tests under those provisions. Accordingly, based on the information submitted and representations made, we determine that pursuant to [S]Section 856(c)(5)(J)(i), the taxpayer’s share of the OP Section 481(a) The adjustments, so determined, will not constitute gross income for purposes of [S]section 856(c)(2) and (3).[8]
Conclusion
Notably, the Internal Revenue Service has stated that Section 481(a) adjustments would not be considered for purposes of Section 856(c)(2) and (3). This decision is important for several reasons. First, it reaffirms the underlying concern that a REIT’s gross income should be comprised primarily of passive income. Second, he notes that a section 481(a) adjustment is not qualifying income under sections 856(c)(2) and (3). Finally, it highlights the authority of the Secretary to disregard certain income for purposes of Section 856(c)(2) and (3). This fact can be crucial for some taxpayers who are on the edge of the Section 856(c) income limits. Taxpayers in these situations may be well served by submitting a ruling request in the form of a private letter.
[1] See IRC § 856(a).
[2] See IRC § 856(c)(1).
[3] IRC § 856(c)(2), (3).
[4] IRC § 856(c)(5)(J)(i).
[5] Private IRS Ltr. Rule. 202235006 (September 2, 2022).
[6] OP is an independent owner of properties consisting of multi-tenant communications towers, distributed antenna system arrays, and other communications-related real estate such as land parcels and rooftop sites. OP’s core business is the rental of space on and at these sites to a diverse group of tenants in different industries. Identifier.
[7] Identifier. In addition, the Taxpayer made certain other representations which are not reproduced here.
[8] Identifier.
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