Real estate investment trusts (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.
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 beneficial status, at the end of each quarter of the calendar year, at least 75 per cent 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. In addition, income earned by a REIT from leasing real property is generally qualifying gross income under the REIT income tests.
The US Internal Revenue Service (IRS) recently issued proposed regulations intended to clarify the definition of “real property.” These regulations are expected to reduce the volume of private letter ruling requests on the topic of what constitutes real property for REIT purposes. Significantly, they do not purport to change or revoke any prior rulings in this area.
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 is likely to be the most critical inquiry a non-traditional real estate company will face in determining whether its assets will allow it to obtain 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 term “interests in real property” includes “fee ownership” (that is, outright ownership) of, co-ownership of, leasehold interests in, and options to acquire land or improvements on that land (including options to acquire a leasehold interest, but the term does not include mineral, oil, or gas royalty interests.
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)”.
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 tests and lay down a list of examples of real property, including wiring in a building, plumbing systems, central heating or central air-conditioning machinery, pipes or ducts, elevators or escalators installed in a building, and 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 forming part of the real estate under local law) are not real property, for example, machinery, printing presses, transportation equipment that is not a structural component of a building, office equipment, refrigerators, individual air-conditioning units, grocery counters, furnishings of a motel, a hotel, or an office building, etc.
The drafters of the existing regulations could not have foreseen many of the structures and/or assets that are now commonplace. Structures such as wireless towers and wind turbines were not explicitly contemplated by the current regulatory framework. Prior IRS guidance 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”.
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.
IRS rulings and the Whiteco factors
The IRS has issued many private rulings on the qualification of certain assets as real property. When providing rulings on this issue, the IRS has generally considered the asset under the “Whiteco” factors. Whiteco was a case that examined 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 laid down six factors to consider in making this analysis:
- Is the property capable of being moved, and has it in fact been moved?
- Is the property designed or constructed to remain permanently in place?
- Are there circumstances that tend to show the expected or intended length of affixation, that is, are there circumstances that show that the property may or will have to be moved?
- How substantial a job is removal of the property and how timeconsuming is it? Is it readily “removable”?
- How much damage will the property sustain upon its removal?
- 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.
The proposed regulations
The proposed regulations were published on 9 May 2014. They lay down specific types of real property: land and improvements to land that include inherently permanent structures and structural components. The regulations also classify certain assets that are per se land, inherently permanent structures, or structural components and, if an asset does not fall within the specified categories, a set of factors with which to consider 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 “What is a distinct asset?”
In determining whether an asset is a distinct asset, the proposed regulations provide that the following factors be taken into account:
- 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 doing so
- Whether the item is commonly viewed as serving a useful function independent of a larger asset of which it is a part
- 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, the question is whether it constitutes land or whether it falls under the “improvements to land” rubric, either as an inherently permanent structure or a structural component.
Land includes water and air space immediately above 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, in or upon real property does not cause the stored property to be redefined as real property.
Specifically, under the proposed regulations, boat slips and end ties at a marina should generally constitute “land” for R E I T purposes.
Inherently permanent structures
Under the new regulations, “inherently permanent structure” means any permanently affixed building or other structure. Affixation may be to land or to another inherently permanent structure and may be by weight alone. If the affixation is reasonably expected to last indefinitely based on all the facts and circumstances, the affixation is considered permanent. An inherently permanent structure must serve a passive function; a distinct asset that serves an active function, such as an item of machinery or equipment, is not a building or another inherently permanent structure.
The current regulations provide that a building encloses a space within its walls and is covered by a roof. The proposed regulations provide that the term “building” includes the following permanently affixed distinct assets: apartments, houses, hotels, factory and office buildings, warehouses, barns, enclosed garages, enclosed transportation stations and terminals, and stores.
Other inherently permanent structures
Other inherently permanent structures are those that would qualify as real estate assets serving 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.
Under the proposed regulations, other such structures include the following permanently affixed distinct assets: microwave transmission, mobile telephony, broadcast, and electrical transmission towers; telephone poles; parking facilities; bridges; tunnels; roadbeds; rail 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 the relevant legislation.
Factors in determining whether a distinct asset is an inherently permanent structure
If a distinct asset does not serve an active function and does not fall within the specific categories set out above, under the proposed regulations, whether any such structure is an inherently permanent structure is based on all the facts and circumstances, in particular taking the following factors into account:
- The manner in which the distinct asset is affixed to real property
- Whether the distinct asset is designed to be removed or to remain in place indefinitely
- The damage that removal of the distinct 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 distinct asset upon the expiration of the lease)
- The time and expense required to move the distinct asset
Note that this analysis largely mirrors the analysis applied under current law reliant on the Whiteco factors.
A structural component is any distinct asset that is a constituent part of and is integrated into an inherently permanent structure, serves the inherently permanent structure in its passive function, and does not produce or contribute to the production of such income, even if capable of producing income other than consideration for the use or occupancy of space.
If interconnected assets work together to serve an inherently permanent structure with a utility-like function (for example, systems that provide a building with electricity, heat, or water), the assets are considered 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”.
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.
If a distinct asset is not one of those listed above, the question as to whether it is a structural component is based on all the facts and circumstances, in particular taking the following factors into account:
- The manner, time, and expense of installing and removing the distinct asset
- Whether the distinct asset is designed to be moved
- 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
- Whether the distinct asset serves a utility-like function with respect to the inherently permanent structure
- Whether the distinct asset serves the inherently permanent structure in its passive function
- Whether the distinct asset produces income from consideration for the use or occupancy of space in or upon the inherently permanent structure
- Whether the distinct asset is installed during construction of the inherently permanent structure
- Whether the distinct asset will remain if the tenant vacates the premises
- Whether the owner of the real property is also the legal owner of the distinct asset
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.
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.
The proposed regulations, if adopted, should be welcomed by both existing REITs and companies interested in electing REIT status as they (1) offer a clearer framework for determining 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, with a certainty not possible under the existing law.
A version of this article appeared in the Fall 2014 issue of the PREA Quarterly, a publication by the Pension Real Estate Association.