Prop. Reg. section 1.856-10 will define real property that will satisfy the income and asset requirements for REITs. It will replace Reg. section 1.856-3(d). It claims to be a clarification of existing law and not a modification that would cause significant reclassifications for existing REITs, and that seems to be true. It embodies the positions stated in the much briefer current regulation, plus several revenue rulings and letter rulings issued over the years.
The regulation aims to rationalize the process of identifying real property so that REITs can decide for themselves whether they own real property, thus taking pressure off the letter ruling process. This could be of particular assistance to taxpayers desiring to form REITs in what might the waning days before the enactment of various threatened statutory amendments curtailing the use of REITs.
Steps in Process
The proposed regulation organizes the identification of real property as follows. First, identify distinct assets owned by the REIT that may be eligible to be real property. An asset is distinct if it is separable in fact or function from another property that is potentially real property. The ability to separate distinct assets normally should be taxpayer favorable because it prevents, for example, one piece of machinery in a structure from converting the entire structure into a machine. The distinct asset approach may have been applied in practice, but is not stated in the current regulation.
Second, classify the distinct asset as either land or improvements. These are the two categories specified in section 856(c)(5)(C). Land can include air and water rights and crops before severance from the land or from plants and trees. Anything that is not land may be an improvement, which must include at least one inherently permanent structure and may also include structural components of the inherently permanent structure. The current regulation uses the same four major terms: land, improvements, inherently permanent structure and structural components.
Third, an inherently permanent structure is defined by (1) an overarching passive function and permanence test, (2) a “good list,” and (3) a facts and circumstances test. The proposal defines a structural component in the same three part way, but the two definitions have a subtle difference. When the distinct asset is a candidate for a permanent structure, it must first satisfy a threshold test asking whether it serves an active function: if it does, it cannot be a building or other inherently permanent structure, even if it looks like a building or is quite permanent.
The existence of this threshold test of function is the reason the facts and circumstances test asks solely about permanence, because function has been assessed as a threshold matter for structures. Therefore, as between the two basic tests of function and permanence, the proposed regulation gives priority to the functional test.
An inherently permanent structure is either (1) a building, or something that functions like a building, (2) some other inherently permanent structure like a shelter, or (3) a permanently affixed asset on the good list: microwave transmission, cell, broadcast, and electrical transmission towers; telephone poles; parking facilities; bridges; tunnels; roadbeds; railroad tracks; transmission lines; pipelines; fences; in-ground swimming pools; offshore drilling platforms; storage structures such as silos and oil and gas storage tanks; stationary wharves and docks; and outdoor advertising displays for which an election has been properly made under section 1033(g)(3).
There are no real surprises here. Although billboards might be moveable, the election to treat them as real property in section 1033(g)(3) applies for all purposes of the income tax chapter. The data center example is built on the microwave transmission tower ruling, Rev. Rul. 75-424, 1975-2 C.B. 269, and LTR 201314002, LTR 201037005, LTR 201034010, LTR 200921019, LTR 200752012 (to house servers), .
Fourth, the structural component is a distinct asset that is part of a permanent structure: if you don’t have an inherently permanent structure you can’t have a structural component. Components have more potential to fall out of the real property definition than structures. Therefore, components must not perform an active function (as with the overarching rule for structures), which means they must not contribute to the production of income from an active function when the structure in inherently associated with an active income producing function. The regulation tries to explain such passive-component-within-active-business components by reference to utility-like functions.
If the component is not on the good list – (the wiring in a building, plumbing systems, central heating or central air-conditioning machinery, pipes or ducts, elevators or escalators installed in a building, or other items which are structural components of a building or other permanent structure) – and does not perform a utility-like function, then the facts and circumstances test must be applied. It asks in various ways whether it is permanently affixed to the land and passive in function.
The prototype of an active function asset is machinery and equipment, and yet a building’s central air conditioning equipment is is good REIT property for three reasons. First, the HVAC system usually is not a distinct asset. Second, although the regulation does not define active function, it refers several times to manufacturing, creating, producing, converting, or transporting as examples of active functions; the HVAC does no such function. In contrast, a refrigerator does usually perform such a function. Third, the HVAC can be called a utility-like function, which is a sort of safe harbor.
This last distinction between machinery-like structural components and active machinery that is not a structural component is probably the most difficult aspect of the test, and always has been. The complexity can be wholly avoidable if the component is on either of the good lists or is viewed as utility-like in function. Although the proposed regulation itself does not state a bad list, the preamble does: assets accessory to the operation of a business, such as machinery, printing press, transportation equipment which is not a structural component of the building, office equipment, refrigerators, individual air-conditioning units, grocery counters, furnishings of a motel, hotel, or office building, etc. even though such items may be termed fixtures under local law.
The distinction between utility-like and active is shown in the cold storage warehouse example, based on LTR 200027034 and LTR 199904019. You might think that a cold storage warehouse would be an active function, because the entire structure seems like the business. But if that were so, then the cell tower could not be qualifying property. The regulation’s recognition of utility-like functions actually makes it easier to view the cold storage warehouse as a structural component, because it is performing the utility-like function of cooling: that is the particular occupancy feature of the rented space, just as the electronics are the special utility-like features of the data center, Example 6.
The complex cases are best illustrated by the regulation’s solar energy site, solar powered building, and pipeline transmission system examples. The regulation states that the permanent structures in all three examples are real property. However, the photovoltaic modules in the energy site and the meters and compressors in the pipeline are distinct assets that are not structural components. They do not serve the passive function of occupancy but rather are used in the sale and transmission of energy and oil. As to the meters, this seems to be a change from LTR 200937006, which involved a pipeline with meters on both ends and included the meters in the qualifying system.
The exclusion of the PV Modules is based on Rev. Rul. 75-424. It ruled favorably on the microwave transmission tower but excluded the antennae, waveguides, transmitting, receiving, and multiplex equipment, and the prewired modular racks are “assets accessory to the operation of a business.” Presumably all of these items are analogous to the PV Modules.
In thee ruling the racks seem to have been like a prefabricated partition that is placed in the building and could be removed. Example 7 of the proposed regulation says that modular partitions are not structural components. But when the IRS issued the data center rulings the “wire cages” that were to hold a customer’s equipment were likened to chain link fence and were ruled to be part of the real property, and evidently were not deemed similar to the prewired modular racks in the microwave tower ruling. Evidently racks, shelves and the like are particularly troublesome categories to the IRS. The generally favorable cold storage warehouse ruling caveated treatment of the shelves. LTR 199904019.
The PV Modules in the solar energy site are not real property because of their active income producing function. But when the identical solar field is built next to a solar powered building in a permanent installation that serves only that building (Example 9), the PV Modules are not distinct assets and are structural components. This is based on
Rev. Rul. 73-425, 1973-2 CB 222, ruling that a total energy system that is integrated with a permanent structure is a structural component.
The most problematic cases are those in which the special nature of the space provided makes it seem like the owner is providing a service, as might seem to be true of the cold storage warehouse, the data center, the solar powered building and the pipeline. In that type of case, the characterization basically comes down to the two main considerations on which the entire proposed regulation is based: (1) the active versus passive (i.e., occupancy related or utility-like) function of the distinct asset, and (2) its removability from the land and the expectation that it would be removed.
The examples show that function trumps moveability: the special infrastructure in the data center is relatively moveable, but is a structural component because it serves a utility-like function. Similarly, the PV Module might be removed from the solar powered building but it not intended to be. Conversely, the meters and compressors are much more closely related to the active use of the pipeline, and are removable, so they are not structural components. Similarly, bus shelters that are bolted down to the sidewalk, can be and are expected to be removed, and are all about the active function of the owner’s business; they are not real property.
Services Customarily Furnished
The proposed regulation does not mention services customarily furnished to tenants, because they are addressed in Reg. section 1.856-4. Nevertheless, the two regulations are intertwined. The data center and cold storage warehouse examples in particular raise the issue of whether rent is being charged for services or for space occupancy. Reg. section 1.856-4(b)(1) specifies that rent does not qualify for the 75% rental income test if it is in substance charged for services to tenants that are not customarily furnished (1) in the geographic market, and (2) in buildings of a similar class.
The “similar class” variable provides the flexibility that is essential to converting what might appear to be freezing services, or technological services into property rent. However, the authorities on such structures do not actually preclude the possibility that part of the rent might be treated as payment for non-customary services. For example, the cold storage warehouse rulings rule only on the property classification. However, in both of the rulings the warehouse owner sold the service part of its business before it became a REIT. LTR 199904019 described the services as: “services typically provided in both the cold and dry storage industries, including shipping and handling, billing, order management and distribution related services.”
This suggests that the taxpayers who sought the ruling believed, and the IRS did not dispute, that the basic underlying function of providing a cold storage was an occupancy of a “similar class” to all cold storage occupancies, and thus was a passive activity and not a charge for an active service.
In contrast, the data center rulings do contain specific representations and rulings that the specialized electronic and other services in the data centers are customarily furnished in data centers and so produce passive income. LTR 201314002. These rulings seem to have originated in the computer or data center rulings. LTR 200752012.
Reg. section 1.856-4(b)(1) is confusing in that it says charges for customary services are rents from real property but then says the services must be furnished through a subcontractor. Actually Reg. section 1.856-4(b)(5) states an entirely separate rule that independent contractors must furnish services to tenants. The confusion was reduced by a 1986 amendment that allows a taxable REIT subsidiary to perform some services and also allows the REIT to perform services that would not produce UBIT to a charity. Section 856(d)(7)(C).
Example 11 labeled goodwill is actually the trophy property example, based on LTR 200813009. It is not surprising that hotels are typically held by REITs (that do not operate the hotels). The ruling usefully held that the goodwill value associated by GAAP with a trophy property would be a qualifying real estate assets and not a separate asset that might cause violation of the 75% asset test.
The example differs slightly from the ruling and the proposed regulation itself, by stating that if the hotel had been bought in a taxable asset acquisition all of the cost would have been allocated to the building for tax purposes. Thus, if the incremental value of the building were due to something other than the location and nature of the building itself (think of the Mount Washington Hotel on Mount Washington, N.H.), such as an operating system or a franchise or a trademark, that would be a separate asset for tax valuation purposes and might or might not be inseparable from the realty value.
A casino might be a trophy property, but example 13 shows that a casino permit to operate a business is not real property. By contrast, LTR 9843020 ruled that a ski permit was an interest in real property because it was the real property (ski permit on government lands). Similar to a ski permit is a concession arrangement to manage real property. LTR 200705013. That ruling treated the concession agreement as tantamount to a leasehold.
In addition to the definitional process described above and the 13 examples, the regulation also aims to reduce confusion by eliminating the concept used in the existing regulations of “assets accessory to the operation of a business,” which would not be real property. The proposal admits that many structural components can be in fact accessory to the operation of a business, in those difficult cases where the real property seems to also provide a service. Therefore, the regulation intends to shift to a functional approach, asking whether the distinct asset (a) serves a passive function like real property occupancy, or (b) serves an active function such as producing, manufacturing or creating a product, and even if it does can still be real property, if (c) the function is utility-like.
The examples of application of the facts and circumstances tests are fairly one sided and so it is hard to tell whether there is a counting rule for equally weighted factors or not. In any event, the examples show the dominance of the functional test. They also show that the presence of some bad factors does not preclude qualification of a structural component as real property.
In the past definitions of real property in other parts of the code such as section 48 and the depreciation rules had been relied upon for section 856 purposes. The Treasury recognizes that (1) other sections have been pulled in other directions (away from real property characterization), and that therefore (2) a common definition should not be sought. In general this decision should tend to make it easier to find real property for section 856 purposes.
A complete list of the examples follows:
- fruit on trees qualifies;
- marina qualifies;
- very heavy indoor sculpture qualifies;
- bus shelters do not qualify;
- cold storage warehouse qualifies;
- data center qualifies;
- modular partitions do not qualify;
- solar energy site qualifies except for the photovoltaic modules that actually convert the sunlight to energy, though the wire carrying the electricity out is real property;
- solar power building solar field qualifies entirely;
- pipeline transmission building qualifies except for meters and compressors that make the oil move;
- goodwill of trophy hotel qualifies when it is not separately amortizable for tax purposes;
- land use permit for cell tower qualifies;
- license to operate a casino does not qualify.
Written by Jack Cummings, Counsel, Tax | Alston & Bird LLP