PLRs provide favorable REIT income testing guidance regarding failures to identify hedging transactions due to inadvertent error

In brief

What happened?

The IRS issued a series of private letter rulings 202419004 through 202419009 (the PLRs), addressing the issue of whether a real estate investment trust’s (a REIT’s) failure to timely identify interest rate caps as hedging transactions under the hedge identification requirements (the Hedging Identification Requirements) was due to an inadvertent error under Reg.  1.1221-2(g)(2)(ii)(B). The IRS held that the late identifications were due to an inadvertent error and therefore did not violate the Hedging Identification Requirements.  

Why is it relevant?  

The IRS has ruled in the past whether income from hedging transactions can be excluded for purposes of the REIT income tests. However, these PLRs are the first of their kind issued to REITs where the IRS ruled on the ‘inadvertent error’ rule as it related to missed hedge identification statements.   

Action items to consider  

REITs that may have entered into hedging transactions and failed to properly identify those transactions under the Hedging Identification Requirements may want to consider seeking guidance from the IRS or consult their tax advisers to determine whether the inadvertent error exception may apply to them. 

Hedging transaction  

The taxpayer REITs in the PLRs wholly owned disregarded entities that entered into loans with floating interest rates for the purpose of acquiring real estate assets. The loans required the disregarded entities to enter into interest rate cap agreements, under which the disregarded entities received income once the target interest rate was exceeded. The taxpayer REITs did not identify the interest rate caps as hedging transactions because the taxpayer REITs’ external accountants, who were generally familiar with and knowledgeable about the rules regarding REIT compliance matters, viewed the interest rate caps as conditions precedents of the loans and not as separate, strategic investments and, therefore, not as separate instruments upon which a hedge identification may be made.   

Upon inquiry by the taxpayer REITs' legal counsel, the taxpayer REITs were advised that they were required to comply with the Hedge Identification Requirements to exclude the interest rate cap income from the REIT Income Tests. Legal counsel further advised that the taxpayer REITs promptly identify the interest rate caps as hedges to comply as closely as possible with the Hedge Identification Requirements. The taxpayer REITs then executed the hedge identification statements for the interest rate caps that satisfied the Hedge Identification Requirements (except for the timing requirements).    

The taxpayer REITs represented that they treated the interest rate caps as hedging transactions for all open years and that the interest rate caps were the only hedging transactions entered into by the taxpayer REITs during any tax year open under the statute of limitations on assessment. The taxpayer REITs further represented that they relied on the advice of external accountants in failing to timely identify the interest rate caps, which was memorialized in an internal memorandum. The internal memorandum concluded that the taxpayer REITs' failure to identify the interest rate caps was not deliberate, but rather was an accidental oversight. Finally, the taxpayer established procedures to properly and timely identify any future hedges.  

Treasury regulations provide that if a taxpayer does not make an identification that satisfies the general regulatory requirements, the taxpayer may treat gain or loss from the transaction as ordinary income or loss if (1) the transaction is a hedging transaction, (2) the failure to identify the transaction was due to inadvertent error, and (3) all of the taxpayer’s hedging transactions in all open years are being treated on either original or, if necessary, amended returns as generating ordinary income or ordinary gains.  

The IRS analyzed the issue of whether the taxpayer REITs failed to identify the hedging transactions due to an ‘inadvertent error.’ The regulations do not specifically define the term ‘inadvertent error,’ and the IRS noted in its analysis that in the absence of a specific definition in the regulations, the term should be given its ordinary meaning, citing case law. The IRS looked to Black’s Law Dictionary for the meaning of the term ‘inadvertence,’ which is defined as "[a]n accidental oversight; a result of carelessness."   

The IRS held that, based on the specific facts and circumstances below, the taxpayer REITs' failure to identify the interest rate caps fell within the inadvertent error exception.   

• The taxpayer REITs relied on the advice and expertise of the accounting firm, which mistakenly believed that entering into a tax identification consistent with the Hedge Identification Requirements was not necessary because the interest rate caps were not strategic investments separate from the loans but were only entered into because they were required under the loans. 
• Upon learning that the interest rate caps were not properly identified, the taxpayer REITs made reasonable and substantial efforts to correct the unidentified interest rate caps in accordance with the Hedge Identification Requirements (other than with respect to the timing requirements). 
• Upon becoming aware of the Hedge Identification Requirements and the applicability to the interest rate caps, the taxpayer REITs established a procedure to properly and timely identify any future hedge.  

Observation: Although the PLRs were the first issued to REITs addressing the inadvertent error rule, the IRS’s analysis has been consistent with prior IRS memoranda addressing the inadvertent error exception and the specific language for other hedging transactions. These PLRs provide meaningful insight for REITs because they help establish how the IRS may view the scope of inadvertence. Specifically, the sophistication of the taxpayer and its advisers, promptly addressing non-identified hedging transactions, and establishing procedures to identify subsequent hedges all appear to be considered in the facts and circumstances of whether a claimed oversight may be considered inadvertent. In that regard, it appears that the IRS seems to consider a taxpayer’s corrective actions following a failure to timely identify a particular hedging transaction as a material factor in determining whether the error was inadvertent.