In Letter Ruling 201137004, the IRS ruled that income a real estate investment trust (REIT) receives from an interest-rate swap agreement that hedges indebtedness of the REIT’s lower-tier partnership is not includible in the REIT’s gross income for purposes of applying the 95% and 75% gross income tests of Secs. 856(c)(2) and (3).
The taxpayer is a corporation that has elected to be taxed as a REIT. The taxpayer owns and leases commercial real estate through its subsidiaries, most of which are partnerships or disregarded entities. The taxpayer wholly owns a subsidiary corporation that has elected to be taxed as a taxable REIT subsidiary of the taxpayer under Sec. 856(l).
The taxpayer and the subsidiary together own a limited liability company (LLC 1). The taxpayer and LLC 1 together own a second LLC (LLC 2). LLC 1 and LLC 2 are both treated as partnerships for federal tax purposes. A third LLC (LLC 3) is wholly owned by LLC 2 and disregarded as an entity separate from LLC 2 for tax purposes.
LLC 3 took out a loan with a fixed-rate portion and a floating-rate portion from an unrelated party. LLC 3 used the loan to acquire real estate assets, which secure the loan. Because LLC 3 is a disregarded entity, LLC 2 is treated as the borrower under the loan and as the owner of the assets securing it.
The taxpayer entered into an interest-rate swap with a third party to manage risk associated with the fixed-rate portion of the loan. Under the terms of the swap, the taxpayer must make quarterly payments to the counterparty based on a floating rate, while the counterparty must make monthly payments to the taxpayer based on a fixed rate. As a result, the taxpayer has earned and will earn income from the swap whenever the floating rate set in the swap agreement is lower than its fixed rate and could have gain upon the sale or disposition of the swap (swap income).
The taxpayer identified the swap as a hedge on the day it entered into it and identified the related transaction and risk within the next 35 days, specifying the expected date of issuance of the debt, the expected maturity, the total expected issue price, and the expected interest provision. It represents that it entered into the swap in the normal course of its trade or business primarily to manage the risk of interest-rate “fluctuations” with respect to the loan. The taxpayer, rather than LLC 2 or LLC 3, was party to the swap because the taxpayer is party to an International Swaps and Derivatives Association agreement and not because the taxpayer wanted to derive federal income tax benefits not available to LLC 2 or LLC 3.
Law and Analysis
To qualify as a REIT, an entity must derive at least 95% of its gross income from sources listed in Sec. 856(c)(2) and at least 75% from sources listed in Sec. 856(c)(3). The IRS noted that the legislative history behind these gross income restrictions indicates that the central purpose is to ensure that a REIT’s gross income is largely composed of passive income. Income from swaps is not specifically listed in Sec. 856(c)(2) or (3).
Under Sec. 856(c)(5)(G)(1), income of a REIT from a hedging transaction (as defined in Sec. 1221(b)(2)(A)(ii) or (iii)) that is clearly identified according to Sec. 1221(a)(7)—including gain from the sale or disposition of such a transaction—does not constitute gross income under Sec. 856(c)(2) or (3) to the extent the transaction hedges indebtedness incurred or to be incurred by the REIT to acquire or carry real estate assets.
Sec. 856(c)(5)(J)(i) authorizes the secretary to determine (to the extent necessary to carry out the purposes of part II of subchapter M and solely for those purposes) whether any item of income or gain that does not otherwise qualify under paragraph (2) or (3) may be considered as not constituting gross income for purposes of Sec. 856(c)(2) or (3).
Regs. Sec. 1.856-3(g) deems a REIT that is a partner in a partnership to own its proportionate share of each of the assets of the partnership and to be entitled to the income of the partnership attributable to that share. For purposes of Sec. 856, a partner’s share of partnership income is based on the partner’s capital interest in the partnership. Additionally, the gross income of the partnership shall retain the same character in the hands of the partners as in the hands of the partnership.
As defined in Sec. 1221(b)(2)(A)(ii), a “hedging transaction” includes any transaction entered in the normal course of a taxpayer’s trade or business primarily to manage, among other things, interest-rate risk or price risk related to borrowings made by the taxpayer. Under Sec. 1221(a)(7), the hedging transaction must be clearly identified as such before the close of the day on which it was entered into. Regs. Sec. 1.1221-2(f)(2)(i) requires a taxpayer that enters into a hedging transaction to make a substantially contemporaneous identification of the item, items, or aggregate risk being hedged and provides that an identification is not substantially contemporaneous if it is made more than 35 days after entering into the hedging transaction.
The IRS’s Conclusion
The IRS determined that the taxpayer’s swap does not meet the definition of a hedging transaction under Sec. 1221(b)(2)(A)(ii) because the taxpayer entered into it to manage risks associated with borrowing incurred by another taxpayer (LLC 2). Nonetheless, the IRS stated that, solely for purposes of the income tests of Secs. 856(c)(2) and (3), the determination of whether a swap constitutes a hedging transaction must take into account Regs. Sec. 1.856-3(g), which treats the taxpayer as owning a certain percentage of the assets and earning a certain percentage of the income of LLC 2. While the loan is a liability rather than an asset of LLC 2, the IRS concluded that it is consistent with the purposes of the REIT gross income rules to attribute to the taxpayer the liability for its proportionate share of the loan for purposes of Secs. 856(c)(2) and (3).
Accordingly, the IRS ruled that the swap income is not includible in the taxpayer’s gross income for purposes of determining whether the taxpayer has satisfied the 95% and 75% gross income tests of Secs. 856(c)(2) and (3).
Letter Ruling 201137004 is the first private letter ruling addressing whether income received by a REIT under a hedge can qualify for the income test exclusion under Sec. 856(c)(5)(G) when the REIT is hedging indebtedness of a lower-tier partnership (i.e., another taxpayer). The IRS reached a sensible result in allowing the application of Sec. 856(c)(5)(G), a rule that applies solely for purposes of the REIT income tests, because under the look-through rule of Regs. Sec. 1.856-3(g), the REIT was treated as the issuer of its pro-rata portion of the applicable debt of the partnership. It is not entirely clear whether the IRS’s conclusion was based solely on its discretion under Sec. 856(c)(5)(J)(i) to treat an item of income that does not otherwise qualify for the 75% or 95% income as not constituting gross income for purposes of the income tests, or whether the IRS concluded that Sec. 856(c)(5)(G) was applicable as a result of the interaction with Regs. Sec. 1.856-3(g).
Note that while income from the hedge qualified for Sec. 856(c)(5)(G) treatment (i.e., exclusion for purposes of the 75% and 95% REIT gross income tests), the REIT would not qualify for treatment afforded hedging transactions under Sec. 1221 or 446—i.e., losses on disposition of the hedging transaction would not automatically qualify for ordinary loss treatment, and timing of income, expense, gain, or loss on the hedge would be determined outside the hedge timing rules (e.g., under Regs. Sec. 1.446-3).
Michael Dell is a partner at Ernst & Young LLP in Washington, DC.
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