IRS Rules a Zero Income REIT Qualifies for Both Income and Asset Tests

After many years of uncertainty, the IRS addressed the issue of whether a real estate investment trust (REIT) with zero gross income and/or zero gross assets could still qualify as a REIT.  

In Private Letter Ruling 202440007, the IRS advised the requesting taxpayer that its lack of assets and income did not cause it to fail the gross income or asset tests to be considered a REIT. 

The Gross Income and Assets Tests 

IRC Sec. 856 provides that a REIT must satisfy two gross income tests annually—the “75% gross income test” and the “95% gross income test.” REITs must also satisfy a 75% quarterly asset test.     

The 75% gross income test under IRC Sec. 856(c)(3) provides that at least 75% of a REIT’s gross income must consist of rents from real property, interest on mortgages on real property, gain from the sale of real property that is not “dealer property,” and several other categories of gross income.

The 95% gross income test under IRC Sec. 856(c)(2) requires that at least 95% of a REIT’s gross income consist of items that are included in the 75% gross income test, as well as interest and dividends from any source, and gains from the sale of securities.  

The 75% gross assets tests under IRC Sec. 856(c)(4)(A) provides that at the end of a calendar quarter, at least 75% of a REIT’s gross assets must consist of real property, cash, and cash items and Government securities.   

The common thread linking the gross income items included in both the 75% and 95% gross income tests is that all these items are passive in nature. Thus, a REIT cannot actively operate a business but must take a more passive role in owning and deriving income from real property.   

Treasury Regulations  

Treas. Reg. Sec. 856-2(c) implies that the 75% and 95% percentage requirements are tested in accordance with a fraction, with the numerator equal to the amount of the annual passive income and the denominator equal to the total gross income.  Accordingly, one interpretation could be that where both the numerator and denominator are zero, the result could not satisfy the “at least” requirement.  Another view is that in instances where the REIT had zero gross income and/or zero gross assets, the 75% and 95% tests should not apply for that taxable year. 

The IRS’ Application of IRC Sec. 856 

The IRS rejected both these approaches in Private Letter Ruling 202440007 and instead ruled that the taxpayer’s  REIT that had zero gross income and/or zero gross assets for a taxable year nevertheless satisfied the gross income and asset test requirements. Noting that the purpose of the provisions of the gross income tests is to ensure that the gross income is passive and that the assets are of a certain nature, the IRS reasoned that this did not extend to a requirement that a REIT has gross income or gross assets in the first instance. As explained by the IRS, 75% and/or 95% of zero gross income equals zero, and thus, “at least” zero of the REIT’s gross income should be considered derived from the enumerated sources under the gross income tests. Similarly, 75% of zero gross assets equals zero, and again, “at least” 75% of the REIT’s assets is considered to be represented by the enumerated items under the gross asset test.  

As a practical matter, REITs confronted with a zero income problem have generally purchased a nominal amount of shares of a publicly traded REIT or collateralized mortgage-backed securities (CMBS), both of which satisfy the gross income and gross asset tests. As a result of the issuance of Private Letter Ruling 202440007, a zero income/asset REIT may not  have to resort to the purchase of publicly traded REIT shares or CMBS.  

It is important to note that Private Letter Rulings are only applicable to the specific facts and circumstances of the requesting taxpayer and may not be relied on by other taxpayers.  If you have questions about REIT taxation or need assistance with complex tax issues, contact EisnerAmper using the form below.  

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