The Internal Revenue Service recently released a private letter ruling regarding the treatment of certain assets as qualifying “real estate” for real estate investment trust (REIT) purposes. That ruling effectively enabled the taxpayer to convert from a corporation to a REIT.
The taxpayer is a records storage company that provides storage for paper, media records and other items in large warehouse storage facilities. The taxpayer leases and owns space by acquiring leasehold interests and often acquires customers by acquiring the assets of other storage companies or by absorbing the costs incurred by the customer to terminate existing arrangements with other storage companies.
The IRS ruling is significant because it represents an expanded willingness of the IRS to treat non-conventional assets related to real estate as qualifying real estate assets for REIT purposes.
Set forth below is a summary of the key points addressed in this letter ruling.
Racking: permanent attributes
The taxpayer has extensive steel racking and shelving systems at its warehouses. The IRS ruled that the racking was real property for REIT testing purposes because of the racking’s permanent attributes. Among the attributes cited by the IRS: the racking requires a building permit and certificate of occupancy; is made from cold-rolled steel or heavy-duty structural steel; is custom designed by an engineer or architect; is anchored to the floor; and is designed to likely outlast the useful life of the building in which it is installed.
Proper treatment of intangibles
Another key issue in the letter ruling was the proper treatment of two types of intangibles possessed by the taxpayer. The taxpayer has “lease contract intangibles,” which are the GAAP intangibles attributable to the premium paid by the taxpayer to acquire a lessee’s below-market rent leaseholds. The IRS ruled that because the lease contract intangibles cannot exist without the underlying leaseholds, they are inextricably and compulsorily tied to the below-market leasehold interests and are therefore “interests in real property” and “real estate assets” for REIT testing purposes.
The taxpayer also has “storage contract intangibles,” which are the GAAP intangibles created when the taxpayer acquired other record storage companies or record storage agreements, and which are attributable to (i) termination fees paid by the taxpayer; (ii) pick-up and move costs and costs incurred by the taxpayer related to the acquisition of large volume accounts; and (iii) costs allocated to the acquisition of storage agreements. The IRS ruled that because the storage contract intangibles are associated only with the storage rental element of the storage contracts and are inseparable from and inextricably and compulsorily tied to the storage contracts , and have no value separate and apart from the storage rental element of the storage contracts, the storage contract intangibles are "interests in real property" and "real estate assets" for REIT testing purposes.
Change in depreciation
The taxpayer had previously been depreciating the racking as “personal property” and amortizing the contract intangibles using a 15-year straight line method. In order to bring its depreciation methodology in line with its view of these assets for REIT purposes, the taxpayer filed an election to change its method of depreciation of these assets to the longer period proper for “real property” and “interests in real property.” The IRS, while not ruling directly on the issue, clearly accepted this change of depreciation methodology.
Income from CFCs, PFICs and QEFs
In addition to its United States operations, the taxpayer conducted substantially the same operations outside the United States through foreign subsidiaries that were either controlled foreign corporations (CFCs) or passive foreign investment companies (PFICs). An issue addressed by the ruling was whether certain income attributable to the taxpayer’s CFCs and PFICs1 was considered gross income that helped the taxpayer satisfy the “good income” tests applicable to REITs (“good income”). The ruling notes that the legislative history underlying the tax treatment of REITs indicates that a central concern behind the good income tests is that a REIT’s gross income should largely be comprised of passive income.
Foreign personal holding company income and PFIC inclusions: Congressional policy objectives
With respect to the taxpayer’s CFCs, the IRS ruled that the taxpayer’s gross income attributable to the CFCs’ “foreign personal holding company income” (which is generally comprised of dividends, interest, royalties, rents and annuities) is “generally passive income” and therefore such income could be treated as good income without interfering with or impeding Congressional policy objectives. Similarly, the IRS ruled that, because PFICs earn income that is “foreign personal holding company income” and such income “generally is passive income,” the taxpayer’s gross income attributable to its PFICs could also be treated as good income without interfering with or impeding Congressional policy objectives. The IRS therefore ruled that the taxpayer's gross income attributable to its CFCs’ foreign personal holding company income and the PFICs will be considered good income.
Section 956 inclusions
The taxpayer also expects to pledge the stock or assets of one or more of its CFCs (a “pledge”), giving rise to an income inclusion to the taxpayer. The taxpayer represented that the REIT used the debt to acquire, improve or develop interests in real property that produce good income, which the IRS viewed as having a close nexus to the REIT's business of owning and renting in real property. The IRS ruled that income inclusions attributable to a pledge will be considered good income to the extent that the pledge secures a taxpayer debt that is used to finance the acquisition of real estate assets that give rise to good income.