On May 9, 2014, the Internal Revenue Service (the “IRS”) released new proposed regulations intended to codify its current private letter ruling policy in respect of what constitutes “real property” for purposes of the real estate investment trust (or “REIT”) rules. In doing so, the IRS provides a new doctrinal framework for analyzing this issue. The definition of “real property” in the REIT context is of paramount importance because it determines what types of real estate related businesses can be conducted in REIT form. The effective date of the taxpayer-friendly proposed regulations will be the date on which final regulations are published.
In 1960, the REIT rules were enacted by Congress with a focus on traditional office and residential buildings. In the 70s, the investment tax credit became available with respect to investments in personal property, but not real property, and case law, regulations and rulings developed to determine which property investments were eligible for the investment tax credit. The investment tax credit case law favored a broad interpretation of personal property and a narrow definition of real property in order to permit taxpayers more access to the favorable investment tax credit rules. The investment tax credit was repealed in 1986, but even after that repeal those rules have often been used to determine the definition of real property for other purposes, including what is “real property” for REIT qualification purposes.
In 2004, the IRS started to issue a series of private letter rulings that confirmed step by step the potentially broad definition of “real property” in the REIT rules, given how the statute and the regulations are drafted. In particular, local law does not determine what counts as “real property” for purposes of the REIT rules. Under this chain of taxpayer-friendly REIT rulings, the IRS blessed, for instance, cold storage warehouse REITs, data center REITs, pipeline REITs, cell-tower REITs, timber REITs and billboard REITs.
In 2013, the IRS announced that it had created an internal working group to review its private letter ruling policy regarding what should be treated as “real property” for REIT purposes. The new proposed regulations are the work product of this internal IRS working group, which is why the IRS could come out fairly quickly with these proposed regulations after having just recently announced such a regulatory project on April 2, 2014.
One issue that reportedly had caused the IRS to be concerned in this context is that in different parts of the income tax different definitions of “real property” had developed. For example, it may be possible for a taxpayer to treat an asset as “real property” for REIT purposes, but as personal property for purposes of calculating depreciation deductions. According to the preamble to the proposed regulations, “In drafting these regulations, the Treasury Department and the IRS have sought to balance the general principle that common terms used in different provisions should have common meanings with the particular policies underlying the REIT provisions.” These proposed regulations, however, clearly seek to define “real property” only for REIT purposes, and for no others.
The important conceptual development is that the IRS introduces a new separate framework in the REIT rules to determine what constitutes “real property” solely for REIT purposes, thereby cutting off the link of the REIT rules to the old, now completely outdated investment tax credit rules. Under this new framework, one must first determine the “distinct asset” (that is, the unit subject to classification) and then determine whether this distinct asset is either a “per se” real asset because it is specifically listed in the proposed regulations as such an asset or whether this distinct asset passes muster under a facts and circumstances test modeled after the criteria developed in the Tax Court’s 1975 Whitecocase.1 The new twist is that the IRS now directly inquires into the “passive function” (e.g.,protection) or “active function” (e.g., manufacturing) of an asset. The “per se real property” listed in the proposed regulations makes clear that the various “modern” types of REITs (such as data center REITs) are permissible under the new proposed regulations. This is important because one key purpose of the new proposed regulations is to minimize the need for private letter rulings in this area of the law so that the IRS can reallocate its scarce resources to other income tax projects.
We have the following initial observations:
- The proposed regulations specifically are limited to defining what constitutes “real property” for purposes only of the REIT rules, potentially allowing taxpayers to treat an asset as real property for those purposes, but not necessarily for all other purposes.
- The proposed regulations are taxpayer-friendly because they codify to a large extent the generally favorable current positions the IRS has taken in its private letter ruling process. This is important because there had been speculation in the market that the IRS might reverse or otherwise limit its interpretation of the term “real property” for REIT purposes as a result of the working group’s review of the issues.
- The proposed regulations are contrary to the approach advocated by Chairman of the House Committee on Ways and Means, Representative Dave Camp (R.-Mich.), in his proposed Tax Reform Act of 2014 (the “Camp Proposals”). The Camp Proposals would significantly restrict the scope of the definition of “real property.” We suspect future fundamental corporate tax reform may include similar proposals. Under current law, however, the IRS clearly believed that it had reached generally correct conclusions in its private letter rulings on these issues.
- The scope of the taxpayer-friendly proposed regulations is limited. They do not, for example, clarify issues around what constitutes an “interest in a mortgage” (e.g.,mezzanine loans, “to be announced” contracts), a sub-category of the term “real property.”
- The proposed regulations do not bless in a broad sense “solar power plants” as good “real property” because the photovoltaic modules, which represent the bulk of the value of solar power plants, are characterized as personal property due to their active function. Moreover, the proposed regulations do not clarify other issues in connection with renewable energy assets (e.g., hydropower plants).
- The IRS has not used the proposed regulations to issue additional guidance in respect of issues that are under discussion in the market place or could otherwise be expected to come up in the private letter ruling program (e.g., infrastructure projects).
- Given the nature of the proposed regulations as a “clarification” of what the law currently is, we hope that the IRS will rethink the effective date of the proposed regulations. The effective date of the proposed regulations should be prospective only in respect of “new guidance” provided by the regulations.
- We expect that real estate industry groups (such as NAREIT) will comment extensively on the proposed regulations. Accordingly, we expect various changes and clarifications in the final regulations.