Service addresses REIT's temporary investment of new capital.

In Letter Ruling 200740004, the Service determined that a real estate investment trust (REIT) qualified for the "temporary investment of new capital" rules for purposes of the REIT income and asset tests when the REIT loaned the proceeds of its public debt offering to its operating partnership (OP) and the OP, in turn, temporarily invested the proceeds in stock and debt instruments. The Service also ruled that the loan from the REIT to the OP (and the interest received by the REIT thereon) is ignored for purposes of the REIT asset and income tests, to the extent of the REIT's capital interest in the OP.

Facts

A REIT is the OP's managing partner and owns a certain percentage of its outstanding common units. The OP owns and operates numerous real properties throughout the United States through a variety of partnerships and disregarded entities.

The REIT raised capital through a public offering of senior convertible debentures. Under certain circumstances, these debentures are convertible into REIT common stock. The net proceeds from these debentures were loaned to the OP for convertible OP debt, with terms that substantially mirror the debentures. The OP will ultimately use these proceeds to acquire real estate and to fund working capital; in the interim, the OP has temporarily invested the proceeds in stock and debt instruments (including money market funds) during the one-year period beginning on the date on which the REIT received the net proceeds from the debentures.

The REIT intends to raise additional capital through another public offering of additional convertible senior debentures with terms similar to those already issued. The REIT intends to use the proceeds to fund the OP's operations by similarly loaning the net proceeds to the OP. The OP will temporarily invest the proceeds in stock and debt instruments (including money market funds) during the one-year period beginning on the date the REIT receives the net proceeds.

Neither debt will be secured by an interest in real property, and the REIT represents that these debts will be treated as indebtedness for federal income tax purposes.

Analysis

Under Sec. 856(c)(2), a REIT must derive at least 95% of its gross income from specific sources, including dividends, interest, and rents from real property. Under Sec. 856(c)(3), a REIT must also derive at least 75% of its gross income from certain real estate sources, including rents from real property and "qualified temporary investment income." Sec. 856(c)(5)(D)(i) defines qualified temporary investment income as any income (1) attributable to a stock or debt instrument, (2) attributable to the temporary investment of new capital, and (3) received (or accrued) during the one-year period beginning on the date the REIT receives such capital. Under Sec. 856(c)(5)(D)(ii), "new capital" means any amount received by the REIT either in exchange for REIT stock or in a public offering of REIT debt obligations with maturities of at least five years.

Under Regs. Sec. 1.856-3(g), a REIT that is a partner in a partnership is deemed to own its proportionate share of each of the partnership's assets and to be entitled to the partnership's share of the income attributable to that share.

The Service explained that the REIT must account for its proportionate share of the OP's income and assets under Regs. Sec. 1.856-3(g).Therefore, the assets or income with which the OP would repay its loan to the REIT will be accounted for by the REIT in accordance with Regs. Sec. 1.856-3(g). If payments on the debt from the OP to the REIT are treated as income by the REIT, this income will be counted twice, to the extent of the REIT's allocable share of income from the OP. Accordingly, the Service ruled that, to the extent payments on the loan from the REIT to the OP are reflected in the REIT's income and assets derived from its capital interest in the OP, those payments should not be treated by the REIT as separate income or assets, but rather should be disregarded for Sec. 856(c) purposes.

The REIT's proportionate share of the OP's income and assets is treated by the REIT as if the REIT earned the income and held the assets directly. Therefore, the character and attributes of the income and assets will be the same whether the REIT earns income and holds assets directly or through its OP interest. Accordingly, the Service ruled that, for Sec. 856(c)(3) purposes, any income that satisfies the definition of "qualified temporary investment income" may be treated as such by the REIT, whether earned by the REIT directly or through its OP interest, beginning on the dates on which the REIT receives the proceeds from its debentures. Also, for purposes of Sec. 856(c)(4)(A), any property attributable to the temporary investment of new capital, whether held directly by the REIT or through its OP interest, will be treated as a real estate asset for the one-year period beginning on the dates on which the REIT received the proceeds from the debentures.

Implications

This ruling should be viewed as favorable to taxpayers. The Service ruled that the taxpayer qualified for the "temporary investment of new capital" provisions, even though the REIT loaned, rather than contributed, the proceeds of a public debt offering to the OP when the OP, in turn, temporarily invested the proceeds in qualifying stock and debt instruments. In addition, this is the third time the Service has ruled that the "self-charged rule" applies in connection with a REIT's loan to a partnership in which the REIT owns a significant interest (see also Letter Rulings 9514006 and 200234054). However, the ruling presumably applies only to the extent the qualified investments made by the OP can be traced to the loan from the REIT.

FROM MARK FISHER, CPA, ALAN MUNRO, CPA, AND DIANNE UMBERGER, WASHINGTON, DC