Mark Twain once said, “Buy land, they’re not making it anymore.” Perhaps it is this sentiment (along with returns on investments) that has led to the popularity of real estate investment trusts. However, taxpayers should be mindful of the various requirements and restrictions related to 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 gross income and, therefore run afoul of the income limitations of Section 856(c)(2) and (3) of the Internal Revenue Code.
Real Estate Investment Trusts, Generally
Generally, real estate investment trusts (“REITs”) are companies that own, finance, and/or operate income-producing real estate. REITs offer investment opportunities to shareholders to earn income from real estate without personally purchasing 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 trustees or directors;
(2) The beneficial ownership of which is evidenced by transferable shares, or by transferable certificates of beneficial interest;
(3) Which (but for the provisions of this part) would be taxable as a domestic corporation;
(4) Which is neither (A) a financial institution (see Section 582(c)(2)), nor (B) an insurance company (see Subchapter L);
(5) The beneficial ownership of which is held by 100 or more persons;
(6) Subject to the provisions of subsection (k), which is not closely held (see subsection (h)); and
(7) Which meets the requirements of subsection (c).[1]
Section 856(c) outlines the limitations for qualifying REITs. REITs must file with their returns an election to be REIT (or at least have made that election in a prior taxable year).[2] Additionally, REITs must satisfy certain income and asset thresholds. Section 856(c)(2) and (3) outline the income limitations as follows:
(2) at least 95 percent (90 percent for taxable years beginning before January 1, 1980) of its gross income (excluding gross income from prohibited transactions) is derived from—
(A) dividends;
(B) interest;
(C) rents from real property;
(D) 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);
(E) abatements and refunds of taxes on real property;
(F) income and gain derived from foreclosure property (as defined in subsection (e));
(G) amounts (other than amounts the determination of which depends in whole or in part on the income or profits of any person) received or accrued as consideration for entering into agreements (i) to make loans secured by mortgages on real property or on interests in real property or (ii) to purchase or lease real property (including interests in real property and interests in mortgages on real property);
(H) gain from the sale or other disposition of a real estate asset which is not a prohibited transaction solely by reason of section 857(b)(6); and
(I) mineral royalty income earned in the first taxable year beginning after the date of the enactment of this subparagraph from real property owned by a timber real estate investment trust and held, or once held, in connection with the trade or business of producing timber by such real estate investment trust;
(3) at least 75 percent of its gross income (excluding gross income from prohibited transactions) is derived from—
(A) rents from real property;
(B) interest on obligations secured by mortgages on real property or on interests in real property;
(C) gain from the sale or other disposition of real property (including interests in real property and interests in mortgages on real property) which is not property described in section 1221(a)(1);
(D) dividends or other distributions on, and gain (other than gain from prohibited transactions) from the sale or other disposition of, transferable shares (or transferable certificates of beneficial interest) in other real estate investment trusts which meet the requirements of this part;
(E) abatements and refunds of taxes on real property;
(F) income and gain derived from foreclosure property (as defined in subsection (e));
(G) amounts (other than amounts the determination of which depends in whole or in part on the income or profits of any person) received or accrued as consideration for entering into agreements (i) to make loans secured by mortgages on real property or on interests in real property or (ii) to purchase or lease real property (including interests in real property and interests in mortgages on real property);
(H) gain from the sale or other disposition of a real estate asset (other than a nonqualified publicly offered REIT debt instrument) which is not a prohibited transaction solely by reason of section 857(b)(6); and
(I) qualified temporary investment income[.][3]
Further, with respect to the income threshold determinations, Section 856 provides authority to the Secretary to exclude certain types of income from Section (c)(2) and (3). Specifically, Section 856(c)(5)(J)(i) provides, in part, as follows:
(J) Secretarial authority to exclude other items of income.—To the extent necessary to carry out the purposes of this part, the Secretary is authorized to determine, solely for purposes of this part, whether any item of income or gain which—
(i) does not otherwise qualify under paragraph (2) or (3) may be considered as not constituting gross income for purposes of paragraphs (2) or (3) . . . .[4]
Private Letter Ruling 202235006
On September 2, 2022, the IRS issued a Private Letter Ruling (“PLR”) related to 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:
Taxpayer was organized as a State limited liability company in Year 1 when Taxpayer elected to be taxed as a real estate investment trust (REIT) under [S]ections 856 through 860. Taxpayer’s overall method of accounting is an accrual method, and its taxable year is the calendar year. Taxpayer has been a partner in OP, a partnership for federal income tax purposes, during all periods from and after Year 1. Taxpayer’s revenue arises almost exclusively from its investment in OP[6]. . . .
After a majority of the interests in OP were acquired (including indirectly through the acquisition of Taxpayer) in Year 2, Taxpayer conducted a review of Taxpayer’s books and records. Taxpayer concluded that OP had been improperly depreciating or amortizing certain cellular and broadcast towers . . . placed in 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, Application for Change in Accounting Method, . . . to change its methods of accounting for depreciation and amortization for the [a]ssets to methods applicable to land improvements under Asset Class 00.3 of Rev. Proc. 87-56, 1987-2 C.B. 674, beginning with the taxable year of change ended Date 3. . . . The [m]ethod [c]hanges resulted in positive [S]ection 481(a) adjustments [] that Taxpayer will take into account over the appropriate [S]ection 481(a) adjustment period. The appropriate [S]ection 481(a) adjustment period will generally be the year of change and the next three taxable years unless an acceleration later applies under certain specified circumstances.[7]
Based on the limited facts presented, the IRS held, in part, as follows:
Based on all the facts and circumstances, excluding Taxpayer’s share of the OP Section 481(a) Adjustments, determined in accordance with [S]ection 1.856-3(g), from Taxpayer’s gross income for purposes of [S]ections 856(c)(2) and (3), does not interfere with Congressional policy objectives in enacting the income tests under those provisions. Accordingly, based on the information submitted and representations made, we rule that pursuant to [S]ection 856(c)(5)(J)(i), Taxpayer’s share of the OP Section 481(a) Adjustments, so determined, will not constitute gross income for purposes of [S]ection 856(c)(2) and (3).[8]
Conclusion
Notably, the Internal Revenue Service stated that the Section 481(a) adjustments would not be taken into account for purposes of Section 856(c)(2) and (3). This ruling is important for a few reasons. First, it reemphasizes the underlying concern that a REIT’s gross income should be primarily composed of passive income. Second, it notes that a Section 481(a) adjustment is not qualifying income under Section 856(c)(2) and (3). Finally, it highlights the Secretary’s authority to effectively disregard certain income for purposes of Section 856(c)(2) and (3). That fact may be crucial to certain taxpayers who are teetering on the edge of Section 856(c)’s income limitations. Taxpayers in those situations may be well served by submitting a request for a private letter ruling.
Expert Tax Attorneys
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[1] See I.R.C. § 856(a).
[2] See I.R.C. § 856(c)(1).
[3] I.R.C. § 856(c)(2), (3).
[4] I.R.C. § 856(c)(5)(J)(i).
[5] I.R.S. Priv. Ltr. Rul. 202235006 (September 2, 2022).
[6] OP is an independent owner of properties consisting of multi-tenanted communications towers, distributed antenna system networks, and other communications-related real estate such as land parcels and rooftop sites. OP’s primary business I the leasing of space on and at these sites to a diverse group of tenants in different industries. Id.
[7] Id. Additionally, the Taxpayer made certain other representations that are not reproduced here.
[8] Id.
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