November 11, 2011 | By Keith Martin in Washington, DC

REITs can count income earned from selling carbon dioxide offset credits as good income, the IRS said. 

REITs, or real estate investment trusts, are legal entities whose units are publicly traded. The capital raised is used to make real estate investments. The REIT is not taxed on its annual income, other than capital gains, as long as earnings are distributed to investors. Any tax is at the investor level. To qualify as a REIT, the entity must satisfy
several tests. There are both 95% and 75% income tests. At least 95% of the REIT’s income each year must be passive income and at least 75% must be passive income  specifically from real estate investments. At least 75% of its assets must also be real estate, cash, cash items like receivables and government securities.

Congress gave the IRS broad authority in 2008 to treat other income as good income for both the 95% and 75% income tests “in appropriate cases consistent with the  purposes of the REIT provisions.”

The IRS looked at a REIT that is a general partner in a partnership that owns standing timber. The partnership signed a three-year contract with a broker who buys and resells carbon dioxide offset credits. These are credits that companies buy to offset their greenhouse gas emissions. There are both “compliance” and “voluntary” markets for such offset credits. 

Companies that are required by law to have offsets buy and sell credits in the compliance market. 

The REIT agreed in a contract it signed with the broker not to harvest any timber on certain parcels during the three-year term of the contract, other than thinning for forest management reasons. The broker is paying the REIT the public exchange price for carbon credits times the amount of carbon the trees are assumed to absorb. If the REIT harvests timber in violation of the contract, then it can substitute another parcel. Otherwise, it must repay the broker part of what it receives for carbon offsets as a penalty.

The IRS said that the carbon offset credits are so closely linked to the use of the underlying land that the payments the REIT receives for its offset credits under the contract should be treated as good income for both the 95% and 75% income tests. The IRS explained its position in Private Letter Ruling 201123005. The agency made the ruling public in late June. The IRS told another timber REIT the same thing in Private Letter Ruling 201123003. 

The conclusions only hold for REITs that are not in the business of selling carbon offset credits. In the second ruling, the IRS said carbon credits are not inventory held for sale to customers. That ruling involved a US REIT that was selling carbon offset credits that it received from a foreign government for maintaining forests in a foreign  country.