IRS rules REIT’s interest rate cap ID failure was inadvertent

The IRS concluded in a series of rulings (PLR 202419004, PLR 202419005, PLR 202419006, PLR 202419007, PLR 202419008, PLR 202419009) that a Taxpayer’s failure to timely identify its interest rate cap under the hedge identification rules was due to Taxpayer’s inadvertent error. The late identification did not preclude the hedging transaction from satisfying the hedge identification requirements. As a result of the ruling, the Taxpayer was able to exclude income and gain from the interest rate cap from the REIT gross income tests under Sections 856(c)(2) and (3).

In the PLRs, the Taxpayer was a limited liability company that elected to be treated as a real estate investment trust as defined in Section 856 (“REIT”). The Taxpayer was wholly owned by Funds. The Taxpayer had a wholly owned subsidiary, Company A, which was treated as a disregarded entity of the Taxpayer for federal income tax purposes.

Company A issued a debt instrument (the “Note”) to a lender to finance its purchase of real estate assets. As part of the note agreement, Company A was required to enter into an interest rate cap agreement (“Interest Rate Cap”). On the same date as the note was issued, Company A entered the Interest Rate Cap to manage risk of interest rate fluctuations related to payments Company A was required to make under the note.

Section 856(c) provides that, to qualify as a REIT for any taxable year, an entity must derive at least 95 percent of its gross income from sources listed in Section 856(c)(2) and at least 75% of its gross income from sources listed in Section 856(c)(3).

Section 856(c)(5)(G)(i) provides that income of a REIT from a hedging transaction (as defined in Section 1221(b)) that is clearly identified pursuant to Section 1221(a)(7) does not constitute gross income under Section 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.

Under Section 1221(b)(2)(A)(ii), a “hedging transaction” includes any transaction entered into by the taxpayer in the normal course of the taxpayer’s trade or business primarily “to manage risk of interest rate” with respect to borrowings incurred by the taxpayer. A taxpayer must clearly identify a hedging transaction before the close of the day on which the taxpayer entered into the transaction, and the absence of an identification establishes that the transaction is not a hedging transaction. However, if a taxpayer does not make an identification, the taxpayer may treat the transaction as a hedging transaction if the failure to identify was due to an “inadvertent error” and other requirements are met. 

In the PLR, a law firm provided the Funds with REIT tax advice and inquired about whether Funds had properly identified hedging transactions similar to the Interest Rate Cap, but the Funds informed law firm they were unaware of any hedge identification requirements.

Funds also consulted with its accounting firm, which was familiar with the rules regarding REIT compliance. However, the accounting firm erroneously believed no identification of the hedging transaction was required for purposes of the REIT gross income tests under Section 856(c).

At a later date, the law firm informed Funds and the Taxpayer that they were required to comply with the hedge identification requirements for the amounts payable under the Interest Rate Cap to be excluded from gross income for purposes of the REIT gross income tests. The law firm advised Funds and taxpayer to promptly identify the Interest Rate Cap as a hedge, even if late, to comply as quickly as possible. The Taxpayer executed the hedge identification for the Interest Rate Cap. Following the late identification, the Funds and Taxpayer established procedures to require the execution of a hedge identification form for subsequent transactions to ensure the hedge identification rules are satisfied.

Taxpayer asserted that it relied on Accounting Firm’s expertise and advice and therefore did not follow the hedge identification requirements at the time it entered the Interest Rate Cap.

The IRS ruled that Taxpayer’s failure to identify the Interest Rate Cap was due to the Taxpayer’s inadvertent error and the timing of the late identification did not cause the Interest Rate Cap to be treated as not satisfying the hedge identification requirements. Accordingly, the Taxpayer was able to treat the late identification of the Interest Rate Cap as satisfying the hedge identification requirements for purposes of excluding gross income under Section 856(c)(5)(G)(i).

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