In a private ruling, IRS has concluded that the right to receive brownfield credits, to the extent it is an asset under generally accepted accounting principles (GAAP), is a receivable for purposes of the real estate investment trust (REIT) asset qualification test. IRS also ruled that income attributable to the brownfield credits is qualifying income for REIT purposes.
Observation. This appears to be the first time IRS has ruled on how income from brownfield credits should be classified for REIT purposes.
Background on brownfields credits. According to the U.S. Environmental Protection Agency, a brownfield is a property, the expansion, redevelopment, or reuse of which may be complicated by the presence or potential presence of a hazardous substance, pollutant, or contaminant. Various states have extended tax incentives, including tax credits, to property owners that remediate brownfields.
Background on REIT qualification tests. To qualify as a REIT, a corporation must satisfy tests (the Income Tests) aimed at ensuring that income is primarily derived from passive real estate investments. An entity must derive at least 95% of its gross income from sources listed in Code Sec. 856(c)(2) (including rents from real property), and at least 75% must be from sources listed in Code Sec. 856(c)(3) (including rents from real property). In addition, under Code Sec. 856(c)(4)(A), at the close of each quarter of its tax year, at least 75% of the value of a REIT’s total assets must be represented by real estate assets (including interests in real property under Code Sec. 856(c)(5)(B)), cash, and cash items (including receivables), and Government securities (the Asset Test).
Reg. § 1.856-2(d)(1) defines the term “receivables” for purposes of the Asset Test under Code Sec. 856(c)(4)(A) to mean only those receivables that arise in the ordinary course of a REIT’s operation, excluding receivables purchased from another person.
Reg. § 1.856-2(d)(3) provides that in determining the investment status of a REIT, the term “total assets” means the gross assets of the REIT determined in accordance with GAAP.
Reg. § 1.856-10(b) defines real property for purposes of the above rules to mean land and improvements to land. Improvements to land includes structural components, as defined in Reg. § 1.856-10(d)(3). (Reg. § 1.856-10(d)(1))
Under Code Sec. 856(c)(5)(J), IRS is authorized to determine whether any item of income or gain which otherwise constitutes gross income not qualifying under Code Sec. 856(c)(2) or Code Sec. 856(c)(3) may, for purposes of the Income Tests: a) nonetheless be considered qualifying income or b) be considered as not constituting gross income.
Facts. Taxpayer, a corporation electing to be treated as a REIT, incurred significant expenses in connection with the remediation of adverse environmental conditions at Site and with the rehabilitation and development of Site. Site is leased under a long-term lease from its third party owner. Taxpayer represents that the expenditures have been for the remediation, rehabilitation, or development of real property within the meaning of Reg § 1.856-10.
As a result of remediation, rehabilitation, and development expenditures of Taxpayer (and Subsidiary), Taxpayer is eligible for State brownfield redevelopment tax credits (“brownfield credits”). The amount of the brownfield credits is a percentage of the costs of (1) site preparation, (2) certain tangible property (including buildings and structural components placed in service at the Site), and (3) on-site groundwater remediation.
Taxpayer expects the brownfield credits to exceed its State income tax liability. Under State law, the excess is treated as an overpayment of tax and Taxpayer will elect to receive a refund of the overpayment.
Taxpayer represents that the right to receive the brownfield credits is properly treated as a receivable on its balance sheet under GAAP. The brownfield credits are allowable and refundable only with respect to Taxpayer’s State income tax liability and are not abatements or refunds of taxes on real property under State law.
Taxpayer, acting through Subsidiary, intends to sublease space at the site to unrelated third parties in order to generate income that will qualify as rents from real property for purposes of Code Sec. 856(c)(2) and Code Sec. 856(c)(3). Taxpayer represents that it expects substantially all of the income derived from Site (other than income arising from the receipt or accrual of the brownfield credits) to be qualifying income for purposes of Code Sec. 856(c)(2) and Code Sec. 856(c)(3).
Favorable ruling. IRS concluded that Taxpayer’s right to receive the brownfield credits, to the extent the right is an asset under GAAP, is a receivable for purposes of Code Sec. 856(c)(4). IRS reasoned that Taxpayer’s right to receive the brownfield credits arises from the development of real property on land in connection with the leasing business of Taxpayer and Subsidiary, and thus the right is a receivable that arises in the ordinary course of Taxpayer’s operations within the meaning of Reg. § 1.856-2(d)(1).
IRS also concluded that Taxpayer’s income attributable to the receipt or accrual of the brownfield credits should be treated as qualifying income for purposes of Code Sec. 856(c)(2) and Code Sec. 856(c)(3). True, income attributable to the brownfield credits is not derived from any source listed in those provisions. Nevertheless, under Code Sec. 856(c)(5)(J), IRS has the authority to determine that the income attributable to the receipt or accrual of the brownfield credits be treated as qualifying gross income under those provisions.
Based on the facts and circumstances, including Taxpayer’s representations that it intends to sublease the Site to generate real property rents and that it expects substantially all of the Site’s income to be qualifying income for purposes of Code Sec. 856(c)(2) and Code Sec. 856(c)(3), IRS said that treating the income attributable to the brownfield credits as qualifying income doesn’t interfere with or impede the objectives of Congress in enacting those provisions, namely, to assure that a REIT’s gross income should largely be composed of passive income.
References: For the REIT income tests, see FTC 2d/FIN ¶ E-6521; United States Tax Reporter ¶ 8564.03.