On August 30, 2016, the Treasury Department and the IRS issued final regulations defining “real property” under the real estate investment trust (REIT) rules. The final regulations—which adopt the previously proposed regulations with only a few clarifying changes—define real property for REIT purposes by, among other things, providing a safe harbor list of assets and establishing a facts and circumstances test to analyze other assets. The regulations apply to taxable years beginning after August 31, 2016, though taxpayers are allowed to rely on these rules for taxable periods beginning on or before the effective date.
In 2014, the Treasury Department and the IRS issued proposed regulations that defined “real property” to include land, inherently permanent structures and structural components, enumerated a safe harbor list of assets that would automatically qualify as real property, and established a framework using a facts-and-circumstances approach to determine whether other assets are real property. The starting point for this analysis was to determine whether an item was a “distinct asset” based on all of the facts and circumstances, as the proposed regulations required each distinct asset (i.e., each unit of property) to be analyzed separately from any other assets to determine if the asset qualified as real property. This framework is finalized without substantive change and applies for all REIT qualification purposes.
Safe Harbor List
The regulations include a safe harbor list of assets that will automatically qualify as real property for REIT qualification purposes, many of which were previously the subject of published and private IRS rulings. The regulations expand on the list of per se inherently permanent structures contained in the previously proposed regulations to include motels, enclosed stadiums and arenas, and enclosed shopping malls. And, although the per se structural components enumerated in the proposed regulations is finalized without change in the regulations, the preamble indicates that the Treasury Department and the IRS may add other systems to this safe harbor in future guidance.
The Treasury Department and the IRS received numerous requests from commenters asking that certain other distinct assets be included on the safe harbor list. According to the preamble, car charging stations, healthcare facilities, electrical distribution and redundancy systems, telecommunication systems, equipment comprising a building management system, and solar energy generating and heating systems were not included in the safe harbor because the Treasury Department and the IRS are not convinced that such assets satisfy the relevant facts-and-circumstances analysis in all cases. Similar requests with respect to energy storage components, solar photovoltaic (PV) panels, related wiring and functionally related transformers, power conditioning equipment, and electrical power inverters and related wiring were denied on the basis that the Treasury Department and the IRS currently believe that such assets are fundamentally active and, as such, are incapable of qualifying as inherently permanent structures (although the preamble suggests that some or all of the foregoing may qualify as structural components of inherently permanent structures depending on the facts and circumstances).
If an asset does not fall within a safe harbor, its status as real property will turn on a facts-and-circumstances analysis that focuses largely on the asset’s moveability (or lack thereof) and passiveness (or activeness), as well as the nature of the income generated by the asset. Generally, assets that manufacture, create, produce or transport a product, or that convert one thing into another, are considered active, while assets that merely provide support, protection, cover or shelter (and do not also serve an active function) are considered passive.
In response to the proposed regulations, commenters requested that examples be added or modified to specifically address the real property qualification of wind facilities, storage facilities, timber, electric transmission and distribution systems, and concentrating solar power systems. The Treasury Department and the IRS concluded that each of the foregoing may be analyzed using the general standards provided in the regulations and declined to provide specific guidance with respect to such assets.
Retaining the definition as proposed, the final regulations provide that land includes water and air space superjacent to the land as well as natural products and deposits (such as crops, water, ores and minerals) that are not severed, extracted or removed from the land. The storage of severed or extracted natural products or deposits in or upon real property does not cause the stored property to qualify as real property.
Inherently Permanent Structures
The final regulations are substantively similar to the previously proposed regulations and provide that inherently permanent structures are buildings and other structures that (1) are permanently affixed (including by weight alone) to land or to another inherently permanent structure and (2) serve a passive function. For this purpose, affixation is permanent if the affixation is reasonably expected to last indefinitely. An asset that serves an active function, such as producing goods, is not an inherently permanent structure. If an asset is not listed under the safe harbor as a per se inherently permanent structure, a facts-and-circumstances test will determine whether the asset qualifies as real property.
One clarification made was in response to concerns from commenters that the application of the term “indefinitely” as a measure of an asset’s permanence was unclear. The Treasury Department and the IRS explain in the preamble that they do not intend the term indefinitely to mean forever, but declined to give any additional guidance.
Another clarification made in response to comments was to the definition of “transport.” The preamble clarifies that the Treasury Department and the IRS intend that the term transport means “to cause to move” when referring to a prohibited active function. Accordingly, the regulations include providing a conduit (such as in the case of a pipeline or electrical wire) or route (as in the case of a road or railroad track) as a permitted passive function of an inherently permanent structure.
Consistent with the proposed regulations, the final regulations provide that a structural component is an asset that (1) constitutes part of an inherently permanent structure, (2) serves the inherently permanent structure in its passive function, and (3) does not produce or contribute to the production of income other than consideration for the use or occupancy of space (even if capable of producing such income). If the components of a system work together to serve the inherently permanent structure with a utility-like function (e.g., systems that provide a building with electricity, heat or water), the entire system is analyzed as an asset that may be a structural component. If an asset serves an active function, the asset may be real property if it is a structural component that serves a utility-like function with respect to the inherently permanent structure of which it is a constituent part. If an asset or system integrated into an inherently permanent structure is not listed under the safe harbor as a per se structural component, a facts-and-circumstances test will determine whether such asset or system qualifies as real property.
The most significant change in this analysis is to the “equivalent interest” requirement for structural components. Under the proposed regulations, a distinct asset was considered a structural component only if the interest held therein was coupled with an equivalent interest held by the taxpayer in the inherently permanent structure to which the structural component is functionally related. Commenters pointed out that such a requirement is inconsistent with industry practices, and that an asset should qualify as a structural component even if the REIT owns the asset but leases from another party the building served by the structural component. To address these concerns, the regulations require only that the taxpayer hold a legally enforceable real property interest with respect to the space in the inherently permanent structure served by the distinct asset.
In keeping with the proposed regulations, the regulations provide that a license or permit solely for the use, occupancy or enjoyment of real property in the nature of a leasehold or easement generally qualifies as an interest in real property. However, a license or permit to engage in or operate a business generally is not real property or an interest in real property. In addition, an intangible asset—including an intangible asset established under generally accepted accounting principles (GAAP) as a result of an acquisition of real property or an interest in real property—qualifies as real property for REIT qualification purposes if it (1) derives its value from real property or an interest in real property, (2) is inseparable from that real property or interest in real property, and (3) does not produce or contribute to the production of income other than consideration for the use or occupancy of space.
The most significant change from the proposed regulations with respect to intangibles is the addition of an example and discussion in the preamble addressing in-place above-market leases in which the REIT is the lessor and below-market leases in which the REIT is the lessee. A lease of real property that produces both rents from real property under Section 856(d)(1) and other income that does not so qualify is, in part, an interest in real property and, in part, an asset other than an interest in real property. To the extent the portion of the lease that is an interest in real property has value, that portion is considered real property for REIT qualification purposes. Thus, the regulations provide that an intangible asset may be, in part, an interest in real property and, in part, an asset other than an interest in real property.
The Treasury Department and the IRS specifically rejected a request to include in the definition of real property intangible assets that are derived from services that produce income other than consideration for the use or occupancy of space (e.g., workforce-in-place and customer-based intangibles). The regulations clarify that such assets are separable from real property and do not qualify as real property.
The preamble notes that a request to include renewable energy credits was similarly rejected, concluding that such credits do not qualify as intangible real property assets under the regulations because they may be sold separately from any real property to which they relate.
And, finally, a request to include intangible assets resulting from a merger, business combination or stock or asset acquisition in the definition of real property was also rejected, though the preamble indicates such intangibles may so qualify under the general facts-and-circumstances analysis.
Additional Guidance Regarding Net Metering of Electricity
Notably, the Treasury Department and the IRS are continuing to consider whether additional guidance is necessary to address the circumstances under which a distinct asset that serves an inherently permanent structure may produce electricity that is also sold to third parties and qualify as a structural component of the inherently permanent structure for REIT purposes.
Until additional guidance is published, in any taxable year in which the inherently permanent structure does not have net sales of electricity to the grid (i.e., sales of volumes in excess of the volume of electricity used by the inherently permanent structure), the IRS (a) will not treat the sale of excess electricity as affecting the qualification of such distinct assets as structural components of the inherently permanent structure for REIT asset test purposes, (b) will treat any income resulting from the sale of such excess electricity as not constituting gross income (i.e., neither qualifying nor non-qualifying) for REIT income test purposes, and (c) will not treat any net income resulting from such sale as constituting net income derived from a prohibited transaction for REIT qualification purposes.
This update is intended only to provide a general summary of certain tax provisions and not to constitute tax advice for any particular situation or taxpayer. If you have any questions about any of these tax provisions or their applicability to your particular circumstances, please contact any of the authors of this update.