REITs must be aware of the unique tax rules for hedging instruments

ARTICLE | September 27, 2021

Authored by RSM US LLP

A real estate investment trust (REIT) is generally taxed as a corporation, yet escapes the double taxation imposed by the corporate tax regime through a dividends-paid deduction. REIT tax compliance is highly complicated and designed to ensure that REITs primarily invest in real estate. As such, a REIT must pass many tests including, but not limited to, the 95-percent and 75-percent annual gross income tests¹  in order to maintain its tax-advantaged REIT status. When evaluating its sources of gross income for purposes of conducting these tests, a REIT must assess the nature of its hedges and ensure its compliance with various administrative requirements related to hedge identification to determine how to appropriately classify its hedge income for purposes of the 95-percent and 75-percent income tests.

REIT hedging transactions

REITs often use hedging instruments, such as an interest rate swaps or caps, to mitigate the risk associated with interest rate or currency fluctuations. Any income from such instruments must be evaluated for REIT income testing purposes as the rules that exist are often overlooked in practice.

For purposes of the REIT income tests, a non-qualified hedge will produce income that is included in the denominator, but not the numerator. This is generally referred to as “bad” REIT income because it reduces the fraction and makes it more difficult to meet the tests. In contrast, a qualified hedge will produce income that is excluded from both the numerator and denominator of both the 95-percent and 75-percent gross income tests. It will thus neither help nor hurt in applying these tests.

In order to constitute a qualified hedge for REIT purposes² , the hedging transaction must be classified as a hedge for tax purposes³ , be properly identified⁴ , and relate to either 1) interest rate fluctuations with respect to debt used to acquire or carry real estate assets, or 2) currency fluctuations with respect to a qualifying item under the REIT income tests.⁵  Any hedging transaction that fails to satisfy all of these requirements will be categorized as a non-qualified hedge.

It is important to note that the identification of a hedging instrument must be done contemporaneously with the execution of the hedge. Specifically, the REIT must properly identify the hedge before the close of the business of the applicable execution date.⁶  Given the extremely time-sensitive nature of these rules, it is easy to see how an unwary REIT could run afoul of the administrative requirements.⁷

Recent private letter rulings (PLRs)

Two recent private letter rulings (PLRs)⁸  serve as a helpful reminder of the hedge identification requirements. While the recent PLRs do not analyze the validity of the hedges and whether they have been appropriately identified for tax purposes, these taxpayer-favorable PLRs supplement similar IRS guidance issued in 2014⁹ and discuss the relevant guidance that exists related to hedges and REIT’s. All of these PLRs address both original and counteracting hedges.

Despite the generally favorable outcome of the rulings, the IRS stopped short of ruling on whether the arrangements in question actually constituted hedging transactions.¹⁰ Instead, the PLRs relied on taxpayer representations that the arrangements were hedging transactions for tax purposes. The IRS favorable rulings with respect to the original hedges are not surprising in light of the applicable statutory language.¹¹  The more noteworthy aspect of the rulings is perhaps the courts' reliance on the discretionary authority subsequently referenced in the statute¹²  in determining that the counteracting hedges meet the REIT hedge criteria.

With regards to the PLRs, taxpayers should be mindful that they are specific to the taxpayer to whom they are issued. They may not be relied upon as authority with respect to tax positions taken by any other taxpayers. Nonetheless, PLRs can be relied upon to augment an argument that there is “authority” for purposes of avoiding tax penalties imposed on positions lacking a “reasonable basis” or “substantial authority.” Thus, PLRs provide perspective, but no guarantees of how the IRS may interpret a similar issue for an unrelated taxpayer.

Takeaways

It is worth noting that a recently released IRS 2015-16 Priority Guidance Plan includes a regulations project addressing the REIT income tests, but the timing and scope of such regulations remain largely uncertain. It is unknown whether any new guidance will address the REIT hedging transaction rules, and if so, whether any such guidance will be received favorably in the REIT community.

At the time a hedge is acquired, the risk that it could generate enough bad REIT income to compromise a REIT's qualification may appear inconsequential, even if it is considered a non-qualified hedge. However, the risk of major, unexpected changes in interest rates or currency values should not be disregarded. Thus, a healthy focus on full technical compliance with all of the rules may be warranted.

At the end of the day, the hedging transaction identification requirements a REIT must adhere to are not overly burdensome, particularly compared to many other REIT rules. However, a lack of awareness of the rules, and their very time-sensitive identification requirements, can yield unwanted consequences. By recognizing and considering the issue, a REIT has a better chance of mitigating such problems. As always, taxpayers who have already entered into or are considering entering into a hedging transaction should contact their tax advisors to discuss the implications of the identification requirements and related rules.

1 See sections 856(c)(2)-(3).

2 See section 856(c)(5)(G).

3 See section 1221(b)(2).

4 See section 1221(a)(7).

5 See sections 1221(b)(2)(A) and 856(c)(5)(G)(i)-(ii).

6 See sections 856(c)(5)(G)(i)-(ii) and 1221(a)(7).

7 A REIT, or any pass-through entity a REIT is invested in that enters into a hedge must contemporaneously identify and memorialize the identification of, the hedging transaction in its books and records. This documentation should specifically denote that the identification of the hedging instrument is being made for tax purposes. The file memorandum, or similar document, should generally include the following: 1) the effective date of the hedging transaction, 2) a description of the hedging instrument, 3) a description of the hedging transaction, and 4) the amount hedged. The applicable regulations provide further detailed guidance on the documentation requirements. See Reg. section 1.1221-2(f)(1).

8 See PLRs 201527012 and 201527013

9 See PLR 201406009

10 See section 1221(a)(7) and Reg. section 1.1221-2(b)

11 See section 856(c)(5)(G)(i)

12 See section 856(c)(5)(J)