IRS Rules that Developer Can Deduct Payments in Lieu of Taxes (PILOTs)

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August 18, 2009

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: 

  1. The payments are measured by and are equal to the amounts imposed by the regular taxing statutes;
  2. The payments are imposed by a specific state statute (even though the vehicle of a lease agreement is used); and
  3. 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.

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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.

Should you wish to discuss this federal tax development in more detail, please contact any one of the following attorneys in the Firm's Tax Department:

Atlanta, Georgia 
Nedom A. Haley  404.221.6505  nhaley@bakerdonelson.com 
Michael M. Smith  404.589.3419  mmsmith@bakerdonelson.com 
Michael S. Evans  404.221.6517  mevans@bakerdonelson.com 

Birmingham, Alabama 
Thomas J. Mahoney Jr.  205.250.8346  tmahoney@bakerdonelson.com 
Robert T. Gardner  205.250.8373  rgardner@bakerdonelson.com 
Vincent J. Schilleci  205.244.3827  vschilleci@bakerdonelson.com 

New Orleans, Louisiana 
Robert Nuzum  504.566.5209  rnuzum@bakerdonelson.com 

Baton Rouge, Louisiana 
Alton E. "Biff" Bayard III  225.381.7019  abayard@bakerdonelson.com 
Brandon A. Lagarde  225.381.7022  blagarde@bakerdonelson.com 

Jackson, Mississippi 
James K. Dossett Jr.  601.351.2482  jdossett@bakerdonelson.com 
Jon D. Seawright  601.351.8921  jseawright@bakerdonelson.com 
David P. Webb  601.969.4678  dwebb@bakerdonelson.com 

Memphis, Tennessee 
William H.D. Fones Jr.  901.577.2247  wfones@bakerdonelson.com 
Adam C. Flock  901.579.3125  aflock@bakerdonelson.com 

East Memphis, Tennessee 
James R. "Josh" Hall Jr.  901.579.3126  joshhall@bakerdonelson.com 
Christopher J. Coats  901.579.3127  ccoats@bakerdonelson.com 

Nashville, Tennessee 
Carolyn W. Schott  615.726.7312  cschott@bakerdonelson.com 
John B. Burns  615.726.5599  jburns@bakerdonelson.com 

Chattanooga, Tennessee 
Carl E. Hartley  423.756.2010  chartley@bakerdonelson.com 
Thomas A. Caldwell  423.209.4104  tcaldwell@bakerdonelson.com 

Knoxville, Tennessee 
Angelia M. Nystrom  865.971.5170  anystrom@bakerdonelson.com 

Washington, D.C. 
James W. McBride  202.508.3467  jmcbride@bakerdonelson.com 
Scott D. Smith  202.508.3430  sdsmith@bakerdonelson.com 

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