Local governments frequently encourage economic development by acquiring property with public bonds, then leasing the property to real estate developers. Because the local government owns the property, it is exempt from real property taxes. The local government can preserve its tax base by requiring the real estate developer to make payments in lieu of taxes, called PILOTs, to the local government. What has not been clear is whether the federal income tax deduction for real property taxes applies to PILOTs. The analysis used by the IRS in a recent Private Letter Ruling holding that a real estate developer's PILOTs qualified as deductible real property taxes for federal income tax purposes, will provide useful guidance for real estate developers and their tax advisors facing this issue.
In PLR 200926023, dated March 25, 2009, the IRS considered a real estate developer's request for a ruling that the developer could deduct PILOTs to a local government as real property taxes. In this case, the real estate developer entered into a ground lease with the government agency that owned the property and built a condominium building. The lease required the developer to pay the government agency, as the landlord under the lease, an annual PILOT equal to the real estate taxes that would have been paid to the city where the property was located as if the property was not exempt from real estate taxes. Any late payment of the PILOT would bear interest at the same rate the city charged for late payment of taxes. In addition, as condominium units would be sold, PILOT payments would be included as part of each owner's common charges payable to the condominium board, which the board would remit to the landlord.
The IRS ruled that the PILOT qualified as a deductible real property tax because it satisfied a three-prong test set forth in a Revenue Ruling over 38 years old, that is Rev. Rul. 71-49, dated January 1, 1971, which provides that a PILOT will be treated as a real property tax if:
- The payments are measured by and are equal to the amounts imposed by the regular taxing statutes;
- The payments are imposed by a specific state statute (even though the vehicle of a lease agreement is used); and
- The proceeds are designated for a public purpose rather than for some privilege, service, or regulatory function, or for some other local benefit tending to increase the value of the property upon which the payments are made.
The IRS also ruled that the condominium owners could deduct their respective shares of the PILOT payments included in their common charges.
Although only the taxpayer receiving a Private Letter Ruling can rely on it, this IRS ruling provides valuable guidance to real estate developers and their advisors. Based on the reasoning used by the IRS in this ruling, developers should ensure that leases that include PILOTs calculate the PILOT based on the taxes that would be payable if the property was not exempt from real property taxes, that the PILOTs are required by a specific state statute, and that the proceeds from the PILOTs can only be used for public purposes.