The Internal Revenue Service has released proposed regulations that provide an analytical framework for determining whether an asset will be treated as qualifying “real property” for purposes of the rules applicable to a real estate investment trust (REIT).1 While the basic underpinnings of the analysis remain the same as current law, much of the current guidance with respect to specific asset types is found in private letter rulings, which technically cannot be relied upon as binding precedent. In addition to expressly articulating the parameters of “real property” for REIT purposes, the proposed regulations provide specific examples of qualifying asset classes.
To qualify as a REIT, at least 75% of the total gross value of a company’s assets must be comprised of real estate assets, cash and cash items, and government securities as of the close of each quarter of the taxable year. Both the current and proposed regulations define real estate assets, in relevant part, as “real property,” namely: (1) land and (2) improvements to land, such as buildings and other inherently permanent structures, including their structural components. 2 However in an additional category, the proposed regulations also bless intangible assets, such as inseparable, real estate- related goodwill and certain licenses and permits, as real property.
The proposed regulations provide that a “distinct asset” must first be identified and analyzed separately from any other associated assets to determine the classification of such asset. A particular, separately identifiable item of property will be treated as a distinct asset based on the facts and circumstances, which take into account whether the item is customarily treated as a separate unit, is separable from other components, taking into account the costs of separation, is commonly viewed as a useful independent item, and is (not) functionally necessary to a larger asset such that separation would impair such functionality.
The proposed regulations also elaborate on each real property category in clearer fashion. Land is defined to include air and water space superjacent to land and unsevered natural products and deposits, making it clear that boat slips and air rights are generally real property for these purposes. An inherently permanent structure is defined as a permanently affixed building or other structure, in which the proposed rules clarify that affixation can be based on weight alone and permanence can be based on reasonable expectations. Such structures must serve a passive function, such as to contain or shelter, rather than an active function, such as to manufacture or produce. If an asset is not enumerated in the proposed regulations or other published guidance and does not serve an active function, the asset will be classified based on factors such as the manner of affixation, the intended permanence of the asset, the damage, time and cost of removal, and any circumstances that suggest a finite period of usage (such as a lease provision that requires or permits removal at lease termination). While these are generally not surprising guidelines, the inclusion of discretionary removal rights may be a negative factor.
The approach to structural components is similar. Structural components are defined as distinct assets, yet at the same time must be integrated and a constituent part of an inherently permanent structure and held with an “equivalent” interest in the underlying permanent structure. They must serve a passive function, even if they are capable of an active function. Furthermore, an asset may be considered together with other assets, despite the general separation of distinct assets, if they work together to serve a utility-like function. Despite the somewhat contrary definition, typical examples are provided, such as building systems. In the event an asset is not listed in the regulations or other published guidance, the regulations provide factors similar to the factors noted above for permanent structures and also consider the function and ownership of the asset.
Overall the proposed regulations outline a workable approach to asset classification and grant safe harbor treatment for listed assets, while examples clarify the components that do and do not qualify as real property, which is helpful in regards to asset classes such as solar energy sites, pipeline transmission systems, data centers, and cold storage warehouses. These regulations are proposed to be effective beginning in the quarter after they are finalized.