September 9, 2016
On August 31, 2016, the Internal Revenue Service (the "IRS") and the Department of the Treasury ("Treasury") issued final regulations clarifying the definition of "real property" for real estate investment trust ("REIT") purposes. The final regulations largely follow the proposed regulations issued in May 2014, with limited changes. The IRS and Treasury received numerous written and electronic comments and held a public hearing on the proposed regulations, but declined to incorporate most comments into the final regulations. We have summarized below a general overview of the final regulations and some noteworthy features and observations.
One of the requirements that a taxpayer must satisfy to qualify as a REIT is that, at the close of each quarter, at least 75 percent of the value of its total assets must be represented by real estate assets, cash and cash items, and government securities. Under the Internal Revenue Code, "real estate assets" include real property (including interests in real property and interests in mortgages on real property). The final regulations define the term "real property" for purposes of this quarterly asset test, as well as for other relevant REIT purposes, through the following series of defined terms:
"Real property" includes "land" and "improvements to land."
"Land" includes air space and water space superjacent to land (even if the taxpayer owns only the air space or water space and does not own an interest in the underlying land) and natural products (e.g., crops, water, ores and minerals) that have not been severed from the land.
"Improvements to land" means "inherently permanent structures" and their "structural components."
An "inherently permanent structure" is any permanently affixed "building" or "other inherently permanent structure." Affixation may be to land or to another inherently permanent structure and may be by weight alone.
A "building" is a structure that encloses a space within its walls and is covered by a roof, such as a house or warehouse. It’s worth noting that an open air stadium does not qualify as a building because it does not have a roof, but it may qualify as real property as an other inherently permanent structure.
An "other inherently permanent structure" is a structure that is permanently affixed to land or to another inherently permanent structure and that serves a passive function (e.g., supporting or sheltering) rather than an active function (e.g., manufacturing or producing).
The regulations specifically identify cell transmission towers, silos and oil and gas storage tanks, among others, as other inherently permanent structures as long as they are permanently affixed. The final regulations make clear that the list of qualifying assets contained in the regulations is not all-inclusive. Therefore, other assets may qualify as other inherently permanent structures if they meet a facts and circumstances test described in the final regulations.
"Structural components" are distinct assets that are integrated into an inherently permanent structure, serve the structure in its passive function, and even if capable of producing income (other than as consideration for the use or occupancy of space), do not produce or contribute to the production of any such income.
Whether a distinct asset is a structural component is determined under a facts and circumstances test. For example, while an elevator in an office building may transport people (an active function), it can qualify as a structural component as it facilitates the occupancy of space in the building (a passive function) and generally would not produce or contribute to the production of income other than for the use or occupancy of space. Moreover, for a structural component (e.g., an air-conditioning system) owned by a REIT to qualify as an interest in real property, the REIT must also have an ownership interest in the inherently permanent structure that the structural component serves (e.g., the building in which the component is installed). In addition, if a REIT holds an interest in a mortgage secured by a structural component, that mortgage will be treated as a real estate asset only if the mortgage is also secured by a real property interest in the inherently permanent structure that the component serves.
Mixed Guidance about Solar Energy Systems
A number of commenters had suggested that solar panels should be included within the definition of real property (as inherently permanent structures). In finalizing the proposed regulations, the IRS and Treasury rejected those comments, affirming the view that solar panels generally are active business assets that are not, standing alone, real property, though the final regulations note that the mounts for the solar panels and exit wires may qualify as real property under the facts and circumstances test applicable to other inherently permanent structures.
In contrast, certain smaller-scale solar energy systems that are designed to serve a single building owned by a REIT may be eligible to be treated as structural components under the final regulations, at least where the quantity of any excess electricity transferred to the local utility company during the year does not exceed the quantity of electricity purchased from the local utility for the same year. The preamble to the final regulations notes that the IRS and Treasury are still considering under what circumstances a sale of excess electricity to a utility would impact the classification of a solar energy system as a structural component. As a result of the prevalence of such sales and the lack of clarity regarding when a solar system will qualify as real property, the final regulations leave a cloud of uncertainty over whether a REIT’s investment in solar energy systems will be treated as investments in real property.
Passive Transport Assets are Potentially Real Property
The proposed regulations had indicated that assets serving a transport function were not real property as a result of serving an active function. The final regulations retain the concept that transport is an active function, but the preamble to the final regulations clarifies that transport means to cause to move. Examples in the final regulations make clear that providing a conduit (e.g., a pipeline) or route (e.g., a road or railroad track) is a permitted passive function, but note that equipment like compressors that facilitate the movement of gas in a pipeline are not structural components. The clarification of the meaning of transport should be helpful for REITs investing in certain energy and infrastructure assets.
Indefinite Inherently Permanent Structure Requirement Clarified
The proposed regulations required that to qualify as real property, an inherently permanent structure that is affixed to real property must be expected to be affixed indefinitely. Commenters had expressed concern that a structure would need to be affixed forever to satisfy this requirement. The final regulations retain this requirement, but the preamble to the final regulations clarifies that the IRS and Treasury do not believe that a structure must be affixed forever to be an inherently permanent structure, stating that the relevant inquiry is whether the facts and circumstances indicate that the structure will be affixed indefinitely to land or another inherently permanent structure.
Additions to Enumerated List of Inherently Permanent Structures
The final regulations expand on the list of structures that are buildings that, if permanently affixed, qualify as real property, by adding to the list of buildings motels, enclosed stadiums/arenas and enclosed shopping malls.
The final regulations confirm that an intangible asset is real property or an interest in real property if the asset derives its value from real property, is inseparable from the real property, and does not independently produce or contribute to the production of income (other than income derived as consideration for the use or occupancy of space). For example, a license or similar right that is solely for the use, enjoyment or occupation of land and that is in the nature of a leasehold or easement generally is an interest in real property, while a license to operate a business is not real property. Commenters had requested that intangible assets related to above-market leases (where the REIT was the lessor) and below-market leases (where the REIT was the lessee) be conclusively treated as real property assets. The IRS and Treasury rejected those comments, providing instead that an interest in an above-market or below-market lease is an intangible interest that qualifies as an interest in real property only to the extent that the lease derives its value from rents from real property. An example to the final regulations makes clear that the value attributable to an above-market lease may be bifurcated and treated as partially an interest in real property and partially a non-real estate asset.
Impact on Prior Private Letter Rulings
One commenter to the proposed regulations had requested that the final regulations provide that taxpayers would be able to continue to rely on previously-issued private letter rulings, even if those rulings were inconsistent with the final regulations. The IRS and Treasury explicitly rejected this request in the preamble to the final regulations, indicating that to the extent a previously issued letter ruling was inconsistent with the final regulations, the letter ruling would be revoked prospectively from the date of the final regulations. Accordingly, REITs with letter rulings should review them carefully to confirm that the rulings are not inconsistent with the final regulations.
The following Gibson Dunn lawyers assisted in preparing this client alert: Brian Kniesly, Jeff Trinklein, Eric Sloan, Arthur Pasternak, Benjamin Rippeon, David Sinak, Paul Issler, Michael Cannon and Mark Dreschler.
Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For further information, please contact the Gibson Dunn lawyer with whom you usually work or any of the following members of the Tax Practice Group:
Art Pasternak - Co-Chair, Washington, D.C. (+1 202-955-8582, firstname.lastname@example.org)
Jeffrey M. Trinklein - Co-Chair, London/New York (+44 (0)20 7071 4224 / +1 212-351-2344), email@example.com)
Brian W. Kniesly – New York (+1 212-351-2379, firstname.lastname@example.org)
David B. Rosenauer - New York (+1 212-351-3853, email@example.com)
Eric B. Sloan – New York (+1 212-351-2340, firstname.lastname@example.org)
Romina Weiss - New York (+1 212-351-3929, email@example.com)
Benjamin Rippeon – Washington, D.C. (+1 202-955-8265, firstname.lastname@example.org)
Hatef Behnia – Los Angeles (+1 213-229-7534, email@example.com)
Paul S. Issler – Los Angeles (+1 213-229-7763, firstname.lastname@example.org)
Dora Arash – Los Angeles (+1 213-229-7134, email@example.com)
Scott Knutson – Orange County (+1 949-451-3961, firstname.lastname@example.org)
David Sinak – Dallas (+1 214-698-3107, email@example.com)
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