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Letter Ruling: REIT With Zero Assets & Gross Income Qualifies as REIT

A recent IRS ruling addressed the computation of the gross income and asset tests for certain REITs.

A recent IRS letter ruling (LTR 202440007) responded to a ruling request and determined that the real estate investment trust (REIT) addressed in the ruling satisfied the asset and gross income tests with zero assets and zero gross income in its first year. For the first time, the IRS has addressed the computation of the gross income and asset tests when a REIT has zero gross income and zero assets. The REIT community will welcome this ruling, as it provides guidance on an area that has been uncertain for many years.

A private letter ruling may be used only for the taxpayer who receives the ruling, but its stated authorities and rationale may be considered by other taxpayers. The IRS ruled that the gross income and asset tests are multiplication tests and not division tests. The IRS based this conclusion on the legislative history, which was concerned with the nature of the gross amounts and not the amounts themselves. The IRS stated that this was confirmed by the regulations that provide for the percentages to be applied to the gross income or asset with $0 being a gross income or asset.

For each taxable year, a REIT must satisfy both the 95% and 75% tests. Failure to satisfy these tests results in a REIT’s ineligibility to elect REIT status for five years.

Letter Ruling LTR 202440007 – Three Formulas Offered as Guidance

The following formulas satisfy the quarterly asset and yearly income tests:

  1. Seventy-five percent multiplied by zero assets equals zero.
  2. Seventy-five percent multiplied by zero gross income equals zero.
  3. Ninety-five percent multiplied by zero gross income equals zero.

Assets – Quarterly 75% Test

Section 856(c)(4) states that at the close of each quarter of the taxable year, at least 75% of the value of total assets is represented by real estate assets, cash and cash items (including receivables), and government securities.

Section 856(c)(5)(B) defines real estate assets as real property (including interests in real property and interests in mortgages on real property) or on interests in real property, shares (or transferable certificates of beneficial interest), and debt instruments issued by publicly offered REITs. Such terms also include any property (not otherwise a real estate asset) attributable to the temporary investment of new capital, but only if such property is stock or a debt instrument and only for the one-year period beginning on the date the real estate trust receives such capital.

Income – Annual 95% Test

Section 856(c)(2) states that at least 95% of a REIT’s gross income must be derived from certain specifically enumerated sources. Examples of “good income” for the 95% test include:

  1. Dividends
  2. Interest
  3. Rents from real property
  4. Gain from the sale or other disposition of stock, securities, and real property, including interests in real property and interest in mortgages on real property, which is not dealer property
  5. Abatements and refunds of taxes on real property
  6. Income and gain from foreclosure property
  7. Amounts received or accrued as consideration for entering into agreements to make loans secured by mortgages on real property or on interests in real property
  8. Gain from the sale or other disposition of a real estate asset which is not a prohibited transaction under §857(b)(6)
  9. Mineral royalty income earned in 2009 from real property owned by a timber REIT and held in connection with the trade or business of producing timber by such REIT

Income – Annual 75% Test

Section 856(c)(3) states that at least 75% of a REIT’s gross income must be derived from certain specifically enumerated sources. At least 75% of the REIT’s gross income during the year must be sourced from transactions that produce passive income and are closely connected with real estate activities. Examples of “good income” for the 75% test include:

  1. Rents from real property
  2. Interest on obligations secured by mortgages on real property or on interests in real property
  3. 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 dealer property
  4. Dividends or other distributions and gain (other than gain from prohibited transactions) from the sale or other disposition of shares of other REITs
  5. Abatements and refunds of taxes on real property
  6. Income and gain from foreclosure property
  7. Amounts received or accrued as consideration for entering into agreements to make loans secured by mortgages on real property or on interests in real property
  8. Gain from the sale or other disposition of a real estate asset
  9. Qualified temporary investment income

Insight From Forvis Mazars

The reliance on legislative history and the interpretation of the gross income and asset tests requiring multiplication rather than division suggests that this ruling’s conclusion will not be revisited soon. A more conservative approach is for the REIT to buy an asset that either is a good REIT real estate asset or is treated as one under the temporary investment of new capital exception.

If you have any questions or need assistance, please reach out to a professional at Forvis Mazars.

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