State Tax Credits Do Not Imperil REITs

IRS guidance – this one related to contaminated property – underscores why a tax credit is not a factor in making a REIT tax election.

In a private letter ruling released by the Internal Revenue Service last year, a corporate taxpayer asked the agency for an opinion related to state tax credits and real estate investment trusts. The IRS guidance (LTR 200916014) is particularly germane in light of the recent BP Deepwater disaster because the REIT project involved will be built on land that was once contaminated by an oil spill.

The IRS guidance addresses the case of a corporate taxpayer — called AlphaCo for purposes of this column — that elected to be taxed as a REIT. AlphaCo’s principal asset is an interest, held through a number of tiered partnerships, in a mixed-use real estate development known as “The Project.” The Project will be constructed on land previously contaminated by an oil spill. Based on a state statute, the site will be eligible for state tax credits.

The total amount of state tax credits available to an “approved development” is equal to the sum of a percentage of up to three types of expenditures. Further, these state tax credits are “refundable” to the extent that they exceed the state tax liabilities of the owners.

On its annual tax return, AlphaCo claimed a state tax credit and refund of the same amount. However, the company is concerned that the value of its claim for refund, if considered to be an “asset,” could exceed 25% of the value of its total assets, thereby causing the company to fail to qualify as a REIT. The IRS, in its private letter ruling, assuaged AlphaCo’s concerns.

Real Estate Assets

According to the Internal Revenue Code’s Section 856(c)(4)(A), at the close of each quarter of its taxable year, at least 75% of the value of a REIT’s total assets must be represented by “real estate assets,” “cash and cash items” (including receivables), and government securities. Section 856(c)(5)(B) defines “real estate assets” as (1) real property, (2) interests in real property (either fee ownership or co-ownership of land or improvements and leaseholds on land or improvements), (3) interests in mortgages on real property, and (4) shares in other REITs.

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Based on the tax rules, specifically Regulation Section 1.856-2(d)(3), when determining the status of a REIT, “total assets” means the gross assets of the REIT determined in accordance with generally accepted accounting principles (GAAP). The private letter ruling notes that the legislative history underlying the asset test simply indicates that the test is designed to “give assurance” that the “bulk” of the trust’s investments are represented by real estate. Such legislative history also indicates that Congress intended to provide REITs with tax treatment similar to that accorded regulated investment companies.

In the instant case, AlphaCo intends that the development and operation of The Project, through its interests in a limited liability company, will allow it to qualify as a REIT. The state tax credits at issue are intended to promote the remediation and development of contaminated real estate and, the ruling concludes, the furtherance of this public policy does not interfere with, or impede, the policy objectives of Congress in enacting the REIT qualification tests under Section 856(c).

Accordingly, the ruling concludes that AlphaCo’s claim for refund of state taxes will not be considered in determining whether [the taxpayer] satisfies the asset test. Therefore, AlphaCo’s REIT status will in no way be imperiled by its entitlement to state tax credits.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.

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