On May 9, 2014, the Internal Revenue Service and U.S. Department of the Treasury issued proposed regulations (the Proposed Regulations) under Section 856 of the Internal Revenue Code (the Code) to clarify the definition of “real property” for purposes of Code Sections 856 through 859 relating to real estate investment trusts (REITs).  The Proposed Regulations consolidate existing published and non-published guidance in order to 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 Proposed Regulations provide taxpayers with much needed clarity and will enable REIT formations in many instances without the need to engage in a costly and time-consuming private letter ruling process.

Property that qualifies as REIT real estate assets under the Proposed Regulations include, among others, microwave, cell and electrical transmission towers; bridges; tunnels; in-ground swimming pools; and outdoor advertising displays for which an election under Code Section 1033(g)(3) has been properly made.  In addition, the examples included in the Proposed Regulations also indicate that certain other assets, such as perennial fruit-bearing plants, boat slips and end ties in a marina, a large sculpture that is permanently affixed to the inside of a building, the electrical and telecommunications infrastructure system of a data center, the foundations, rack and exit wire supporting or connecting to the solar panels of a solar energy site, goodwill related to the acquisition of stock of a corporation that owns a landmark hotel, and a land use permit to place a cell tower on federal government land abutting a federal highway also constitute REIT real estate assets.  However, bus shelters, modular partition wall systems and a license to operate a casino are not considered real property under the Proposed Regulations.

The Proposed Regulations also state that certain intangible assets, such as licenses and permits, may constitute real property or an interest in real property.  The Proposed Regulations will be effective for calendar quarters after they are published as final regulations in the Federal Register.

Background

Code Section 856 sets forth the requirements for a taxpayer to qualify as an REIT for federal income tax purposes.  One of the requirements is that at the end of each calendar quarter of the taxpayer’s taxable year, at least 75 percent of the value of the taxpayer’s total assets must be represented by real estate assets, cash and cash items (including receivables), and government securities.

Code Section 856(c)(5)(B) defines “real estate assets” to include real property and interests in real property.  Treas. Reg.  § 1.856-3(d), which was promulgated in 1962, defines “real property” as including “land or improvements thereon, such as buildings or other inherently permanent structures thereon,” and includes “interests in real property.”

Between 1969 and 1975, the IRS issued various revenue rulings addressing whether certain assets qualify as real property for purposes of Code Section 856.  Since then, REITs have sought to invest in a variety of other types of assets that are not directly addressed by those revenue rulings, and have sought and received private letter rulings from the IRS with respect to these assets.  [See, e.g., Private Letter Ruling 201314002 (Oct. 9, 2012) (data center and infrastructure); Private Letter Ruling 201310020 (Dec. 5, 2012) (boat slips and end ties in a marina); Private Letter Ruling 201204006 (Oct. 24, 2011) (outdoor advertising signs).]  However, since private letter rulings are limited to their particular facts and, thus, cannot be relied upon by other taxpayers, the IRS and Treasury recognized a need to provide further published guidance on the definition of real property for REIT purposes.

The Proposed Regulations are the result of an IRS working group that was established in May 2013 to study its current standards for determining what constitutes real property for purposes of the REIT tax provisions.  The working group was formed around the same time as many C Corporations publicly announced that they were exploring REIT conversions and would seek IRS private letter rulings in connection therewith.  As a result, the IRS temporarily halted work on private letter ruling requests from taxpayers seeking REIT conversion rulings and rulings concerning assets other than land, buildings and structures traditionally held by REITs pending the outcome of the working group study on this issue.  In November 2013, the IRS announced that the working group had completed its review regarding the definition of real property for REIT purposes and that it was resuming its review of pending private letter ruling requests from taxpayers on these issues.

Proposed Regulations

The definition of real property in the Proposed Regulations is consistent with the definition in Treas. Reg. § 1.856-3(d) and other published guidance, which includes land, inherently permanent structures and structural components.  See Prop. Treas. Reg. §§ 1.856-10(a)-(d).

Land

The Proposed Regulations define “land” to include not only a parcel of ground but the air and water space directly above the parcel.  The definition also includes crops and other natural products of land (such as ores and minerals), until the crops or other natural products are extracted or removed from the land.  See Prop. Treas. Reg. § 1.856-10(c).

Inherently Permanent Structures

The Proposed Regulations define “inherently permanent structures” to include any permanently affixed building or other structure.  The Proposed Regulations also include a safe harbor list that identifies certain types of buildings and other inherently permanent structures.  If an asset is one of the types of buildings or other inherently permanent structures identified in the safe harbor, the asset will constitute real property for purposes of Code Sections 856 through 859.

Buildings

The Proposed Regulations define a “building” as enclosing a space within its walls and covered by a roof.  Types of buildings identified in the safe harbor list include: houses, apartments, hotels, factories, office buildings, warehouses, barns, enclosed garages, enclosed transportation stations and terminals, and stores.  See Prop. Treas. Reg. § 1.856-10(d)(2)(ii).

Other Inherently Permanent Structures

The Proposed Regulations provide that “other inherently permanent structures” serve a passive function, such as to contain, support, shelter, cover, or protect, and do not serve an active function, such as to manufacture, create, produce, convert, or transport.  Types of other inherently permanent structures identified in the safe harbor list include: 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) to treat the outdoor advertising display as real property.  See Prop. Treas. Reg. § 1.856-10(d)(2)(iii). 

If an asset is not a type of building or inherently permanent structure described in the safe harbor lists or other published IRS guidance, a facts and circumstances test is applied to determine whether the asset is an inherently permanent structure.  Factors to be taken into account in making this determination include:

• The manner in which the asset is affixed to real property;

• Whether the asset is designed to be removed or to remain in place indefinitely;

• The damage that removal of the asset would cause to the item itself or to the real property to which it is affixed;

• Any circumstances that suggest the expected period of affixation is not indefinite (for example, a lease that requires or permits removal of the asset upon the expiration of the lease); and

• The time and expense required to move the asset

See Prop. Treas. Reg. § 1.856-10(d)(2)(iv).

Structural Components

The Proposed Regulations define a “structural component” as any distinct asset that is a constituent part of and integrated into an inherently permanent structure, serves the inherently permanent structure in its passive function and, even if capable of producing income other than consideration for the use or occupancy of space, does not produce or contribute to the production of such income. The Proposed Regulations further provide that structural components are real property only if the interest held therein is included with an equivalent interest held by the taxpayer in the inherently permanent structure to which the structural component is functionally related.  See Prop. Treas. Reg. § 1.856-10(d)(3)(i).

The Proposed Regulations provide a safe harbor list that identifies certain types of structural components, including: wiring; plumbing systems; central heating and air conditioning systems; elevators or escalators; walls; floors; ceilings; permanent coverings of walls, floors and ceilings; windows; doors; insulation; chimneys; fire suppression systems, such as sprinkler systems and fire alarms; fire escapes; central refrigeration systems; integrated security systems; and humidity control systems.  See Prop. Treas. Reg. § 1.856-10(d)(3)(ii).

If an asset is not one of the types of structural components identified in the Proposed Regulations or other published IRS guidance, a facts and circumstances test is applied to determine whether the asset is a structural component.  Factors to be taken into account in making this determination include:

• The manner, time and expense of installing and removing the asset;

• Whether the asset is designed to be moved;

• The damage that removal of the asset would cause to the item itself or to the inherently permanent structure to which it is affixed;

• Whether the asset serves a utility-like function with respect to the inherently permanent structure;

• Whether the asset serves the inherently permanent structure in its passive function;

• Whether the asset produces income from consideration for the use or occupancy of space in or upon the inherently permanent structure;

• Whether the asset is installed during construction of the inherently permanent structure;

• Whether the asset will remain if the tenant vacates the premises; and

• Whether the owner of the real property is also the legal owner of the asset

See Prop. Treas. Reg. § 1.856-10(d)(3)(iii). 

Distinct Asset

To determine whether an asset is land, an inherently permanent structure or a structural component, the Proposed Regulations first test whether the asset is a “distinct asset.”  Each distinct asset is tested individually to determine whether the distinct asset is real or personal property.  Assets specifically listed in the Proposed Regulations safe harbors as types of buildings, other inherently permanent structures and structural components are distinct assets.   See Prop. Treas. Reg. § 1.856-10(e)(1).

Other assets not described in one of the safe harbors are tested based on a facts and circumstances test using certain factors.  All the factors must be considered, but no single factor is determinative.  To determine whether an asset is a distinct asset under the Proposed Regulations, factors to be considered include:

• Whether the item is customarily sold or acquired as a single unit rather than as a component part of a larger asset;

• Whether the item can be separated from a larger asset and, if so, the cost of separating the item from the larger asset;

• Whether the item is commonly viewed as serving a useful function independent of a larger asset of which it is a part; and

• Whether separating the item from a larger asset of which it is a part impairs the functionality of the larger asset

See Prop. Treas. Reg. § 1.856-10(e)(2).

Intangible Assets

The Proposed Regulations also provide that an intangible asset that derives its value from real property or an interest in real property, that is inseparable from such real property or interest in real property and does not produce or contribute to the production of income other than for use or occupancy is an interest in real property for purposes of Code Sections 856 through 859.  The Proposed Regulations provide that a license, permit or other similar right solely to use, enjoy or occupy land or an inherently permanent structure that is in the nature of a leasehold or an easement is treated as an interest in real property.  However, such license, permit or other right to engage in or operate a business is generally not considered an interest in real property.  See Prop. Treas. Reg. § 1.856-10(f).

Examples

The Proposed Regulations include 13 examples that illustrate the application of the rules to specific assets and whether such assets are considered real property.  As noted above, the IRS concludes in the examples that certain assets constitute real property for REIT purposes.  See Prop. Treas. Reg. § 1.856-10(g).

Effective Date

The IRS and Treasury view the Proposed Regulations as a clarification of the existing definition of real property in the current regulations, and, therefore, the Proposed Regulations will be effective for calendar quarters after they are published as final regulations in the Federal Register.  A public hearing is scheduled for September 18, 2014, and all comments on the Proposed Regulations are due by August 12, 2014.