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Jesse A. Criz DLA Piper LLP (US)

Robert J. LeDuc DLA Piper LLP (US)

Benjamin Karr Briggs DLA Piper LLP (US)

IRS Clarifies REIT Definition Of “Real Property” in New Proposal Regulations REITS ARE AN INTEGRAL PART of the US commercial real estate market. Many REITs are publicly traded. In addition, private REITs are a commonly employed investment vehicle in the private real estate market, particularly when non-US investors or tax-exempt investors are involved.   All REITs, both public and private, are creatures of the Internal Revenue Code of 1986, as amended. As such, REITs are subject to an array of tax requirements that are generally beyond the scope of this article.   A REIT is generally viewed (with certain significant exceptions) as a C corporation for purposes of the Code.1 In order to qualify as a REIT and avoid federal (and often state) income taxation at the corporate level, a REIT must meet a number of technical tax requirements. In order to maintain a favorable status, at the end of each quarter of the calendar year, at least 75% of a REIT’s assets must consist of “real estate assets,” certain cash items, receivables, and federal government securities. Real estate assets include real property and mortgage loans, among other items.   In addition, income earned by a REIT from the rental of real property is generally qualifying gross income under the REIT income tests.   The Internal Revenue Service recently issued proposed regulations intended to clarify the definition of “real property.” The proposed regulations are expected to reduce the volume of private letter ruling requests on the topic of what constitutes real property for REIT purposes. Significantly, the proposed regulations do not purport to change or revoke any prior rulings in this area.   This article will summarize the proposed regulations, which are the first published guidance on this topic since 1975, and outline what constitutes real property for REIT purposes under this new guidance.

Real Estate Assets A key issue for most companies seeking to obtain or maintain REIT status is whether most of their assets constitute real estate assets. Further, this question will likely be the most critical inquiry a nontraditional real estate company will face

in determining whether its assets will allow it to obtain favorable REIT status.   The Code defines real estate assets as interests in real property, interests in mortgages on real property, shares in other REITs, and certain other short-term investments in debt and equity.   The precise meaning of the term “real property” is what the proposed regulations are intended to clarify. The term “interests in real property” includes fee ownership and coownership of land or improvements thereon, leaseholds of land or improvements thereon, options to acquire land or make improvements thereon, and options to acquire leaseholds of land or improvements thereon, but the term does not include mineral, oil, or gas royalty interests.2   These key REIT definitions under the Code are further interpreted under the current Treasury regulations, which define the term “real property” as “land or improvements thereon, such as buildings or other inherently permanent structures thereon (including items which are structural components of such buildings or structures)” (emphasis added).3   The current regulations further provide that local law definitions are not controlling for the purposes of determining the meaning of real property as used for the REIT tests4 and set forth a list of examples of real property: n  Wiring in a building n  Plumbing systems n  Central heating or central air-conditioning machinery n  Pipes or ducts n  Elevators or escalators installed in a building n  Other items that are structural components of a building or another permanent structure   Finally, the current regulations clarify that assets “accessory to the operation of a business” (even though such items may be termed fixtures under local law) are not real property and provide a list of examples: n Machinery n  Printing presses n  Transportation equipment that is not a structural component of a building

1. Treas. Reg. 1.856-1(e). 2. 856(c)(5)(C). The term also includes any property (not otherwise a real estate asset) attributable to the temporary investment of new capital but only if such property is stock or a debt instrument and only for the one-year period beginning on the date the real estate trust receives such capital. 3. 1.856-3(d). 4. Ibid. 12  PREA Quarterly, Fall 2014

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    Structures such as cell towers and wind turbines were not explicitly contemplated by the         provide new guidance that is intended to help taxpayers more easily determine    n  Office equipment n Refrigerators n  Individual air-conditioning units n  Grocery counters n  Furnishings of a motel, a hotel, or an office building, etc.   Under current guidance, the IRS has provided taxpayers with a practical framework to determine what constitutes real property. However, the drafters of the existing regulations could not have foreseen many of the structures and/or assets that are now commonplace. Structures such as cell towers and wind turbines were not explicitly contemplated by the current regulatory framework, and the proposed regulations provide new guidance that is intended to help taxpayers more easily determine whether certain structures constitute real property for REIT purposes.   Prior IRS guidance in Rev. Rul. 73-425 interpreted the current regulations as indicating that “a structural component is not considered real property for this purpose unless the interest held therein is included with an interest held in the building or inherently permanent structure to which the structural component is functionally related” (emphasis added).   This guidance however does not resolve whether an improvement on land that is not a building should be considered an “inherently permanent structure” and thus real property, or whether tangible property that is affixed to a building (or other real estate asset) should be considered “a structural component of such building or structure” and therefore be included with the larger building or structure as real property.

this issue, the IRS has generally analyzed the asset under the so-called Whiteco factors.5 Whiteco6 was a case that analyzed whether certain property was either an inherently permanent structure or a tangible personal property for purposes of the now-repealed investment tax credit rules.   Whiteco set forth six factors to consider in making this analysis: n  Is the property capable of being moved, and has it in fact been moved? n  Is the property designed or constructed to remain permanently in place? n  Are there circumstances that tend to show the expected or intended length of affixation, i.e., are there circumstances that show that the property may or will have to be moved? n  How substantial a job is removal of the property and how time-consuming is it? Is it “readily removable”? n How much damage will the property sustain upon its removal? n  What is the manner of affixation of the property to the land?   The IRS, guided by the current regulations and the Whiteco factors, has ruled that data centers, sign superstructures, and rooftop sites for wireless towers are all real property.7

The Proposed Regulations

The proposed regulations were published on May 9, 2014.8 These regulations, specifically Prop. Reg. Section 1.856-10 “Definition of Real Property,” attempt to provide a clearer framework to analyze the qualification of certain assets as real property for REIT purposes. IRS Rulings and the Whiteco Factors The IRS has issued many private rulings on the qualification   The proposed regulations set forth specific types of of certain assets as real property. When providing rulings on real property: land and improvements to land that in5. See, e.g., Rev. Rul. 80-151, 1980-1 CB 7, PLR 201204006 (January 27, 2012), PLR 201143011 (October 28, 2011), PLR 199904019 (February 1, 1999), PLR 8931039 (May 8, 1989), PLR 8738051 (June 24, 1987), PLR 8726006 (March 13, 1987). “Although not conclusive, cases classifying property as either real property or personal property for purposes of the investment tax credit under former Section 38 (repealed by the Tax Reform Act of 1986, P.L. 99-514) are instructive in determining whether assets constitute real estate assets. The classification of property for purposes of the investment tax credit is analogous to such determinations for REIT purposes. In fact, the legislative history underlying the investment tax credit describes “assets accessory to a business” eligible for the credit largely the same as Section 1.856-3(d) describes “assets accessory to the operation of a business” that are not considered real estate assets for REIT purposes. See S. Rept. No. 1881, 87th Cong., 2d Sess. (1962), 1962-3 C.B. 716, 722.” PLR 199904019 (February 1, 1999). 6. Whiteco Industries, Inc. v. Commissioner, 65 T.C. 664 (1975). 7. See, e.g., PLR 201034010 (August 27, 2010) (data centers); PLR 201204006 (January 27, 2012) (signs and sign superstructures); and PLR 201129007 (July 22, 2011) (wireless and broadcast communication towers). 8. Prop. Treas. Reg. 1.856-10, Fed. Reg. Vol. 79, No. 93. The IRS and the Treasury Department view these proposed regulations as a clarification of the existing definition of real property and not as a modification that will cause a significant reclassification of property. As such, these proposed regulations are proposed to be effective for calendar quarters beginning after these proposed regulations are published as final regulations in the Federal Register. 9. Technically, the proposed regulations define real property as land and improvements to land. However, the proposed regulations define improvements to land as consisting of inherently permanent structures and their structural components. 10. Prop. Treas. Reg. 1.856-10(e). 14  PREA Quarterly, Fall 2014

current regulatory framework, and the proposed regulations    whether certain structures constitute real property for REIT purposes. clude inherently permanent structures and structural components.9   The regulations also provide safe harbors enumerating certain assets that are per se land, inherently permanent structures, or structural components and, if an asset does not fall within such safe harbor, a set of factors with which to analyze the asset.   Significantly, the proposed regulations indicate that the analysis as to whether an asset is real property applies to “distinct assets,” so the first question is whether an asset in question is a distinct asset under the regulations or part of a larger asset.

Land Land includes water and air space superjacent (immediately above) to land and natural products and deposits that are unsevered from the land. Natural products and deposits, such as crops, water, ores, and minerals, cease to be real property when they are severed, extracted, or removed from the land. The storage of severed or extracted natural products or deposits, such as crops, water, ores, and minerals, in

Distinct Assets The proposed regulations provide that “a distinct asset is analyzed separately from any other assets to which the asset relates in order to determine if the asset is real property, whether as land, an inherently permanent structure, or a structural component of an inherently permanent structure.”10   In analyzing whether an asset is a distinct asset, the proposed regulations instruct that the following factors be taken into account: l  Whether the item is customarily sold or acquired as a single unit rather than as a component part of a larger asset l  Whether the item can be separated from a larger asset and, if so, the cost of separating the item from the larger asset l  Whether the item is commonly viewed as serving a useful function independent of a larger asset of which it is a part l  Whether separating the item from a larger asset of which it is a part impairs the functionality of the larger asset   Once a distinct asset has been identified, it can be analyzed under the proposed regulations to see if it constitutes land or falls under the “improvements to land” rubric, either as an inherently permanent structure or a structural component. PREA Quarterly, Fall 2014  15

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2014 or upon real property does not cause the stored property to be recharacterized as real property.11   The proposed regulations clarify that land includes water rights and air space superjacent to land. Specifically, under the proposed regulations, boat slips and end ties at a marina should generally constitute “land” for REIT purposes.12

  There is also a safe harbor under the new regulations for these other inherently permanent structures. The proposed regulations provide that other inherently permanent structures include the following permanently affixed distinct assets: microwave transmission, cell, broadcast, and electrical transmission towers; telephone poles; parking facilities; bridges; tunnels; roadbeds; railroad tracks; transmission lines; Inherently Permanent Structures pipelines; fences; in-ground swimming pools; offshore drillUnder the new regulations, “inherently permanent struc- ing platforms; storage structures such as silos and oil and gas ture” means any permanently affixed building or other storage tanks; stationary wharves and docks; and outdoor structure.13 Affixation may be to land or to another inher- advertising displays for which an election has been properly ently permanent structure and may be by weight alone. made under Section 1033(g)(3).17 If the affixation is reasonably expected to last indefinitely based on all the facts and circumstances, the affixation is Factors in Analyzing Whether a Distinct Asset considered permanent. Is an Inherently Permanent Structure   An inherently permanent structure must serve a passive Provided that a distinct asset does not serve an active function function; a distinct asset that serves an active function, such and does not fall within the safe harbors set forth above, the as an item of machinery or equipment, is not a building or proposed regulations indicate that whether any such strucanother inherently permanent structure. ture is an inherently permanent structure is based on all the facts and circumstances, in particular taking the following Buildings factors into account:18 The regulations provide that a building encloses a space l  The manner in which the distinct asset is affixed to real within its walls and is covered by a roof.14 property   The proposed regulations set forth a safe harbor relating l  Whether the distinct asset is designed to be removed or to to land. In particular, the proposed regulations provide that remain in place indefinitely the term “building” includes the following permanently l  The damage that removal of the distinct asset would cause affixed distinct assets: apartments, houses, hotels, factory to the item itself or to the real property to which it is affixed and office buildings, warehouses, barns, enclosed garages, l  Any circumstances that suggest the expected period of afenclosed transportation stations and terminals, and stores.15 fixation is not indefinite (for example, a lease that requires or permits removal of the distinct asset upon the expiration of Other Inherently Permanent Structures the lease) Other inherently permanent structures that would qualify l  The time and expense required to move the distinct asset as real estate assets serve a passive function, such as to con-   Note that this analysis largely mirrors the analysis applied tain, support, shelter, cover, or protect, and do not serve an under current law reliant on the Whiteco factors. active function, such as to manufacture, create, produce, convert, or transport.16 Structural Components A structural component is any distinct asset that is a constituent part of and is integrated into an inherently permanent 11. Prop. Treas. Reg. 1.856-10(c). structure, serves the inherently permanent structure in its 12. Prop. Treas. Reg. 1.856-10(g) Example 2. This achieves a similar passive function, and does not produce or contribute to the result to current service rulings—PLR 201310020 (March 8, 2013) but would allow all taxpayers to rely on such a position. production of such income, even if capable of producing 13. Prop. Treas. Reg. 1.856-10(d) 14. Prop. Treas. Reg. 1.856-10(d)(2)(ii)(A). income other than consideration for the use or occupancy 15. Prop. Treas. Reg. 1.856-10(d)(2)(ii)(B). of space.19 16. Prop. Treas. Reg. 1.856-10(d)(2)(iii)(A). 17. Prop. Treas. Reg. 1.856-10(d)(2)(iii)(B).   If interconnected assets work together to serve an inher18. Prop. Treas. Reg. 1.856-10(d)(2)(iv). ently permanent structure with a utility-like function (for ex19. Prop. Treas. Reg. 1.856-10(d)(3)(i). ample, systems that provide a building with electricity, heat, 16  PREA Quarterly, Fall 2014

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2014 or water), the assets are analyzed together as one distinct asset that may be a structural component.   Importantly, “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” (emphasis added).   If a distinct asset is customized in connection with the rental of space in or on an inherently permanent structure to which the asset relates, the customization does not affect whether the distinct asset is a structural component.   The regulations provide a safe harbor. Specifically, the proposed regulations establish that the following distinct assets and systems are “structural components”: 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.20   Provided that a distinct asset does not fall within the safe harbor set forth above, the proposed regulations indicate that whether it is a structural component is based on all the facts and circumstances, in particular taking the following factors into account:21 l  The manner, time, and expense of installing and removing the distinct asset l  Whether the distinct asset is designed to be moved l  The damage that removal of the distinct asset would cause to the item itself or to the inherently permanent structure to which it is affixed l  Whether the distinct asset serves a utility-like function with respect to the inherently permanent structure l  Whether the distinct asset serves the inherently permanent structure in its passive function l  Whether the distinct asset produces income from consideration for the use or occupancy of space in or upon the inherently permanent structure l  Whether the distinct asset is installed during construction of the inherently permanent structure

l  Whether the distinct asset will remain if the tenant vacates the premises l  Whether the owner of the real property is also the legal owner of the distinct asset Intangible Assets If an intangible asset, including an intangible asset established under Generally Accepted Accounting Principles as a result of an acquisition of real property or an interest in real property, derives its value from real property or an interest in real property, is inseparable from that real property or interest in real property, and does not produce or contribute to the production of income other than consideration for the use or occupancy of space, then the intangible asset is real property or an interest in real property.22   The proposed regulations also clarify the status of licenses and permits—a license, a permit, or another similar right solely for the use, enjoyment, or occupation of land or an inherently permanent structure that is in the nature of a leasehold or an easement generally is 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 because it produces or contributes to the production of income other than consideration for the use or occupancy of space.23

Conclusion The proposed regulations, if adopted, should be welcomed by both existing REITs and companies interested in electing REIT status as the proposed regulations (1) offer a clearer framework for analyzing whether an asset will be considered real property for the REIT requirements; (2) essentially formalize existing letter rulings and thinking regarding certain permanent structures, structural components, water and air rights, and intangibles; and (3) greatly aid in the classification of certain assets as real property, which result could likely not be reached with certainty under existing law.  n Jesse Criz and Robert LeDuc are Partners and Benjamin Karr Briggs is an Associate at DLA Piper LLP (US).

20. Prop. Treas. Reg. 1.856-10(d)(3)(ii). 21. Prop. Treas. Reg. 1.856-10(d)(3)(iii). 22. Prop. Treas. Reg. 1.856-10(f )(1). Cf PLR 200813009 (March 28, 2008). 23. Prop. Treas. Reg. 1.856-10(f )(2). 18  PREA Quarterly, Fall 2014