IRS expands on what constitutes good REIT income
The Internal Revenue Service (“IRS”) released this week Private Letter Rulings 20112303 and 20112305, in which the IRS acted upon the authority granted to it by Congress in Section 856(c)(5)(J) to hold that income from the sale of carbon emission units is “good” real estate investment trust (“REIT”) income.
In order to qualify and remain qualified as a REIT, an entity must satisfy two income tests, a 75 percent test and a 95 percent test. Each income test requires that the REIT’s gross income be derived from certain specified sources – so-called good REIT income. The legislative history regarding these income tests indicates that Congress wanted to insure that a REIT’s gross income was largely limited to passive income. Examples of good REIT income include rent from real property and gain from the sale or other disposition or real property or interests in real property.
The problem with the categories of good REIT income is that they are limited. As markets evolve and develop, REITs are faced with opportunities that might be profitable, but which they may refrain from entering into out of concern of jeopardizing their REIT status. Congress provided some relief to REITs in 2008 when Section 856 was amended to add Section 856(c)(5)(J). Section 856(c)(5)(J) granted the Secretary of Treasury the authority to treat any income or gain that would not constitute good REIT income for purposes of the 75 percent and 95 percent income tests as good REIT income where doing so would be necessary to carry out the purposes of the REIT rules.
Section 856(c)(5)(J) grants the IRS with the authority and discretion to treat gross income that would otherwise constitute bad REIT income, and may result in the REIT failing the income tests, as good REIT income where the IRS determines such treatment was appropriate. Private Letter Rulings 20012303 and 20112305 indicate that the IRS is willing to provide taxpayers relief by applying this provision. The REITs in these private letter rulings were timber REITs that held significant timberlands. In addition to harvesting timber and selling timberlands, the REITs decided to enter into programs that enabled them to sell carbon emission units generated with respect to specified tracts of timberlands. The IRS determined that the income from the sale of these carbon emission units did not fit within the categories of good REIT income set forth in Section 856(c). Nonetheless, the IRS held that it was appropriate to treat the income from the sale of the units as good REIT income under the authority granted by Section 856(c)(5)(J). The IRS stated that this treatment was appropriate because the income from the sale of the credits was “inextricably linked to the underlying timberland and standing timber thereon, which are qualifying REIT assets.”
It should be noted that a private letter ruling only binds the IRS with respect to the particular taxpayer that obtains the ruling, and other taxpayers cannot rely on the ruling. Nonetheless, these private letter rulings are important in that they establish a willingness of the IRS to issue rulings in this type of situation. Taxpayers that are REITs, or are considering electing to become a REIT, should consider applying for a ruling from the IRS if they are engaging in transactions where they have income from the sale of credits or other activities generated because of their ownership of real estate. Taxpayers can make such an application without risk of being bound by a negative ruling. If the IRS determines that it will not rule in a taxpayer’s favor, the taxpayer will be provided the opportunity to withdraw the ruling request.
Please contact Amanda Wilson or one of the other Capital Market attorneys for more information.