PATH Act Modifies REIT Prohibited-Transaction Safe Harbors

By Travis J. Rose, CPA, MBT, Washington, and Stephanie Tran, J.D., LL.M., Los Angeles

Editor: Annette B. Smith, CPA

A real estate investment trust (REIT) is subject under Sec. 857(b)(6)(A) to a 100% tax on "net income derived from prohibited transactions," which generally includes net income from the sale or other disposition of property described in Sec. 1221(a)(1)—i.e., property primarily held by the REIT for sale to customers in the ordinary course of a trade of business (so-called dealer property)—and not pursuant to a foreclosure.

Congressional intent behind enactment of Sec. 857(b)(6) was to "prevent a REIT from retaining any profit from ordinary retailing activities such as sales to customers of condominium units or subdivided lots in a development project" (S. Rep't No. 94-938, 94th Cong., 2d Sess. 470 (1976)). However, Congress also believed that "REITS should have a safe harbor within which they can modify the portfolio of their assets without the possibility that a tax would be imposed equal to the entire amount of the appreciation in those assets" (S. Rep't No. 95-1263, 95th Cong., 2d Sess. 178-179 (1978)).

Safe Harbor

Before being amended by the Protecting Americans From Tax Hikes (PATH) Act of 2015 (passed as part of the Consolidated Appropriations Act, 2016, P.L. 114-113), Sec. 857(b)(6)(C) provided a safe harbor under which a prohibited transaction did not include the sale of a real estate asset if the following requirements were met:

  1. The REIT has held the property for more than two years;
  2. The aggregate expenditures made by the REIT, or any partner of the REIT, within the two-year period preceding the sale of the property that are includible in the basis of the property do not exceed 30% of the property's sales price;
  3. (a) No more than seven sales of property have been made by the REIT during the tax year (the seven-sales test), (b) the aggregate adjusted basis of the property sold by the REIT during the tax year does not exceed 10% of the aggregate adjusted basis of all assets held by the REIT as of the beginning of the tax year, or (c) the fair market value (FMV) of the property sold by the REIT during the tax year does not exceed 10% of the total FMV of all assets held by the REIT as of the beginning of the tax year;
  4. If the property is land or improvements not acquired through foreclosure or lease termination, the property was held by the REIT for at least two years for the production of rental income; and
  5. If the seven-sales test of Sec. 857(b)(6)(C)(iii)(I) (item 3(a) above) is not met, substantially all the marketing and development expenditures relating to the property sold were made through an independent contractor from which the REIT does not receive any income.
PATH Act of 2015 Modifications

The PATH Act of 2015 made several amendments to the prohibited-transaction safe-harbor test under Sec. 857(b)(6)(C) that will apply for sales of property in 2016 and later tax years:

  1. The 10% limitation of Secs. 857(b)(6)(C)(iii)(II) and (iii)(III), items 3(b) and 3(c) above, is increased to 20%, provided that the aggregate basis or FMV of property sold by the REIT during the three-year period ending with the current tax year does not exceed 10% of the REIT's aggregate basis or FMV over the same three-year period.
  2. In applying the substantially all test under Sec. 857(b)(6)(C)(v), marketing and development expenditures made by a taxable REIT subsidiary (TRS) of the REIT are included in addition to those made by an independent contractor.

In extending the alternative safe-harbor requirement under Sec. 857(b)(6)(C)(v) (the alternative test if the seven-sales test is not met) to include the marketing and development expenditures made by a TRS, it appears Congress sought to provide parity between the use of a TRS and an independent contractor, similar to the rules governing the concept of "impermissible tenant service" under Sec. 856(d)(7). However, uncertainty remains regarding the interpretation and application of the safe-harbor test under Sec. 857(b)(6)(C)(v).

For example, in determining whether a particular sale of property has met the requirement of Sec. 857(b)(6)(C)(v), a taxpayer needs to determine what constitutes "substantially all" and what are considered "marketing and development expenditures" for purposes of applying Sec. 857(b)(6)(C)(v). Given the lack of guidance addressing this language, questions arise as to whether other tax rules that have similar goals to Sec. 857(b)(6) can be used. For example, courts have applied a list of seven factors in "dealer" cases to determine whether real property is held for investment or sale to customers (see, e.g., Winthrop,417 F.2d 905 (5th Cir. 1969)). Although these dealer cases do not directly involve REITs, the IRS has issued private letter rulings addressing REIT prohibited transactions that acknowledge the useful application of the principles of these cases (see Letter Rulings 200945025, 201340004, and 201315004). Thus, the principles in both the impermissible tenant services and dealer cases may be helpful in determining the proper interpretation of Sec. 857(b)(6)(C)(v).


The 2015 PATH Act expands the safe-harbor test for prohibited transactions under Sec. 857(b)(6)(C)(v) by including the market and development expenditures of a TRS, in addition to those of an independent contractor, and by expanding the 10% limitation under Secs. 857(b)(6)(C)(iii)(II) and (iii)(III) to 20%. However, given the limited guidance and lack of private letter rulings addressing this area, proper application of these rules remains unclear.

One observation is that the inclusion of development costs in the safe-harbor requirement under Sec. 857(b)(6)(C)(v) seems duplicative given the overlap with the safe-harbor requirement under Sec. 857(b)(6)(C)(ii). Development costs allocable to real property are capitalized and includible in the basis of that property under Sec. 263A and thus are inherently limited by the 30% safe-harbor requirement of Sec. 857(b)(6)(C)(ii). Yet, without further guidance on the application of Sec. 857(b)(6)(C)(v), it remains simply an observation. The contrary interpretation would be that since the various safe-harbor requirements from Secs. 857(b)(6)(C)(i)-(v) are conjunctive except where noted, the development costs in Sec. 857(b)(6)(C)(v) are intended for a different purpose than in Sec. 857(b)(6)(C)(ii). Consequently, the IRS should issue published guidance interpreting how Sec. 856(b)(6)(C)(v) should be applied for this alternative safe harbor to be practically useful to taxpayers.


Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.

For additional information about these items, contact Ms. Smith at 202-414-1048 or

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.

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