LTR 201314002 has caused quite a buzz in the investment community. Stock pickers want to know how far the envelope can be pushed on the definition of a real estate investment trust. The ruling seemed to allow it to be pushed fairly far, to include racks in buildings where computer servers are stored, called data centers. However, two companies in somewhat similar businesses recently filed information with the SEC indicating that the IRS was closely examining whether their real estate should receive REIT treatment.

Facts

A domestic consolidated group headed by a parent is now in the business of owning or leasing from their owner’s buildings, and leasing or subleasing data centers in the buildings to customers. The group will form Taxpayer, which will elect to be taxed as a REIT. The REIT will be the general partner of an operating partnership (OP); the limited partners will be affiliates of the group. The REIT business will be operated by the OP. The initial REIT business will be contributed by the group’s contribution of some of its buildings to the OP through the REIT or the limited partner members. The REIT will engage in a public offering, which is not explained in the LTR. Evidently, the funds raised by the IPO will be used to expand the real estate holdings of the REIT.

The rented space will be floor space—or in some cases, shelf space—caged off within the REIT’s buildings to hold the tenant’s data center equipment. The tenants also may rent space for satellite communication equipment and they have access to common areas for loading, etc.

In addition to the usual services provided in commercial building space, the data centers require specialized equipment as follows: cooling, raised floors, special electrical, security, fire protection and telecommunication components—which will be in the buildings. The existence of these special features of the buildings, which are necessitated by the special needs of the tenants’ data centers, necessarily will involve related services provided to REIT to the tenants.

In addition to these “normal” though specialized building services, REIT will provide what are called “remote hands” services to tenants, such as replacing cables, etc. The LTR makes a distinction between the remote hands services and smart hands services, which involve “technical and content support” and electronic access to the tenant’s computers requiring a password, etc. Any such services will be provided by a taxable REIT subsidiary or independent contractors, which may be members of the parent’s group. Other affiliates in the group now supply these services to the general public.

Evidently the existing consolidated group has a trademark that is well known in the data center leasing business, which trademark (or rights thereto) will be transferred to the REIT along with existing leases to tenants.

It appears that the overall effect of the transaction is to allow the tenants to continue to have in effect a “turnkey” utilization of the buildings, with most if not all necessary ancillary services being provided, if not by the REIT, then by related parties.

Rulings

The ruling is an extension of Rev. Rul. 75-424, 1975-2 CB 270. It ruled that microwave transmitting and receiving towers are qualifying REIT real property. Similarly, the LTR rules that even though the space to be leased by the REIT is set up to meet the technological needs of its customers, it is still qualifying real estate.

The trademark and other intangibles also produce qualifying REIT income because they are part of the REIT real estate leasing business.

To the extent the rents reflect charges for the specialized services required to support data centers, or those services are charged for separately, they produce qualifying REIT income because those services are ordinary and necessary for this particular and specialized type of real property. This ruling flows directly from the microwave tower ruling, which similarly involved specialized real estate.

The fact that other members of the group contract as independent contractors to provide services to the tenants that the REIT could not itself provide does not adversely affect the REIT’s qualification. Those services are not provided as part of the leases.

The OP will loan employees to the taxable REIT subsidiary that will provide services to the tenants. This is permissible as long as reimbursed on an arm’s length basis.

What Does Parent Get?

Although not made clear by the LTR, it is likely that the parent will get the cash from the REIT’s IPO in the form of the sale price of the rest of its real estate and real estate intangibles that it did not initially contribute to the REIT. Thus, the REIT described in this ruling reflects a somewhat different plan from that pursued by other recent plans reported in news accounts and SEC filings to separate a real estate component from an operating business.

The group in the ruling will continue to do the active management “smart hands” business services it apparently has always done. In addition, it will have monetized its real estate assets. In contrast, other recent REIT conversion cases have involved active businesses that happen to be conducted in real estate that the business would like to spin off under Section 355. The principal problem in those cases is that the real estate is not provided to third parties but has to be provided to the Distributing Corporation. A REIT cannot lease to a commonly controlled entity, with the control level being very low (10 percent).

Therefore, if there are substantial overlapping shareholders, the REIT spinoff cannot be used. The common control test thwarts most such spinoffs because having such a significant shareholder is relatively common. However, news reports indicate Penn National Gaming found a way around the problem by using the stock of Controlled to redeem the larger shareholder of Distributing down below 10-percent ownership of Controlled.

IRS Working Group

Recent SEC filings by at least two corporations that evidently had REIT ruling requests pending state that “IRS has formed an internal working group to study what constitutes ‘real estate’ for purposes of the REIT provisions of the Code.”

It is not surprising that the IRS may have decided to reassess REIT rulings. However, that reassessment well could result in no change in ruling standards. In the aggregate, the benefits approved in the LTR might seem generous, but each one is the result of separate, well-considered regulatory decisions, including the REIT spin business ruling, Rev. Rul. 2001-29, 2001-1 C.B. 1348), the use of the taxable REIT subsidiary and the microwave tower ruling. Of course, the taxpayers can still do the spinoffs without a ruling.