The IRS issued final regulations (T.D. 9784) clarifying the definition of real property for purposes of the real estate investment trust (REIT) provisions. The regulations went into effect Aug. 31, 2016, and adopt, with modifications, the proposed regulations (REG-150760-13), which were published in the Federal Register on May 14, 2014.
Sec. 856(c)(4)(A) requires at least 75% of the value of the REIT's total assets to consist of real estate assets (which include real property), cash and cash items, and government securities at the close of each quarter of the REIT's tax year. In addition, Sec. 856(c)(3) requires at least 75% of a REIT's annual gross income to consist of rents from real property and certain other prescribed sources of real estate-related income.
Before T.D. 9784, the definition of real property found in Regs. Sec. 1.856-3(d) consisted of one paragraph that was promulgated in 1962. The IRS issued several revenue rulings between 1969 and 1975, and many private letter rulings in recent years, addressing whether certain assets qualify as real property.
Treasury and the IRS realized the need to update the guidance on the definition of real property under Secs. 856 through 859 and issued proposed regulations on May 14, 2014, to define real property for purposes of those sections. Regs. Sec. 1.856-10 has now been finalized and went into effect Aug. 31, 2016. Regs. Sec. 1.856-3(d) has been modified and now references Regs. Sec. 1.856-10 for the definition of real property.
Like the proposed regulations, the final regulations define real property to include land and improvements to land. "Improvements to land" are further defined to include inherently permanent structures and their structural components.
The final regulations retain the proposed regulations' definition of land. Land is defined to include the land parcel, as well as the water and air space superjacent to land, 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 land when they are severed, extracted, or removed from the land.
Inherently Permanent Structures
The final regulations retain the proposed regulations' definition for inherently permanent structures with some clarifications. The final regulations define inherently permanent structures as "any permanently affixed building or other permanently affixed structure" (emphasis added). If the affixation is expected to last indefinitely, based on all of the facts and circumstances, the affixation is considered to be permanent. However, any distinct asset serving an "active function," such as an item of machinery or equipment, does not qualify as a building or other inherently permanent structure.
As with the proposed regulations, the final regulations explain that an asset must serve a passive function, such as to "contain, support, shelter, cover, or protect," rather than an active function, such as to "manufacture, create, produce, convert, or transport" to qualify as an inherently permanent structure. In the preamble to the final regulations, the IRS acknowledges that the term transport could describe both "passive conduits used for transportation and machines that push or pull items through or along a conduit." Treasury and the IRS intend the term transport to mean to cause to move. Therefore, the final regulations clarify that providing a conduit (e.g., a pipeline or an electrical wire) or route (e.g., a road or a railroad track) is a permitted passive function of another inherently permanent structure. The IRS goes on to clarify in the preamble to the final regulations that assets, such as machinery and equipment, that may serve active and passive functions are excluded from the definition of inherently permanent structures because the final regulations retain the requirement that an inherently permanent structure not serve an active function.
The final regulations retain the proposed regulations' definition of "building" and list the following examples: permanently affixed houses; apartments; hotels; factory and office buildings; warehouses; barns; enclosed garages; enclosed transportation stations and terminals; and stores. In response to comments received regarding the definition of building, the final regulations added the following examples: motels; enclosed stadiums and arenas; and enclosed shopping malls. The IRS clarifies in the preamble to the final regulations that outdoor and unenclosed structures may fail to meet the definition of a building but that those types of structures would likely satisfy the definition of "other inherently permanent structures." Treasury and the IRS view that definition as more appropriate for those structures.
The final regulations retain the examples provided in the proposed regulations for other inherently permanent structures, which include microwave transmission, cell, broadcast, and electrical transmission towers; telephone poles; parking facilities; bridges; tunnels; roadbeds; railroad 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 under Sec. 1033(g)(3) to treat them as real property has been properly made.
As in the proposed regulations, the final regulations provide that the determination of whether a particular asset not included in the safe harbor lists is treated as another inherently permanent structure is based on all of the surrounding facts and circumstances. The final regulations retain the five factors listed in the proposed regulations that must be taken into account in making that determination. The IRS clarifies in the preamble to the final regulations that it views the term "indefinitely" to not mean forever and that a distinct asset must be analyzed using these five factors to determine whether such an asset is an inherently permanent structure. These factors have been used by the IRS in prior rulings and are based on the decision of Whiteco Industries, 65 T.C. 664 (1975), acq., 1980-1 C.B. 1.
The final regulations retain Example 4 from the proposed regulations. This example illustrates these rules and concludes that bus shelters owned by a REIT, each consisting of four posts, a roof, and panels bolted to the sidewalk that are disassembled and moved when bus routes change, are not permanently affixed under the facts-and-circumstances analysis and, thus, do not constitute real property.
The final regulations retain the proposed regulations' definition of structural components with some clarifications. The final regulations define a structural component as a distinct asset that (1) is a constituent part of, and integrated into, an inherently permanent structure; and (2) serves the inherently permanent structure in its passive function (and, even if capable of producing income other than consideration for the use or occupancy of space, does not produce or contribute to the production of that income).
The final regulations retain the proposed regulations' list of distinct assets that constitute structural components. The final regulations clarify that structural components must be "integrated into the inherently permanent structure and held together with a real property interest in the space in the inherently permanent structure served by that distinct asset or system." Under the final regulations, the following distinct assets constitute 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; security systems; and humidity control systems. The final regulations clarify that for a mortgage secured by a structural component to qualify as a real estate asset, the mortgage must also be secured by the inherently permanent structure served by the structural component.
The final regulations retain the determination in the proposed regulations that a particular asset not listed in the safe-harbor list is treated as a structural component based on all of the surrounding facts and circumstances. The proposed regulations identified nine factors that must be taken into account in making the determination. However, in the preamble to the final regulations, the IRS clarifies that a distinct asset will be a structural component if a REIT holds a legally enforceable real property interest in the space in the inherently permanent structure that the structural component serves. Therefore, the ninth factor that required the owner of the real property to also be the legal owner of the distinct asset has been deleted from the final regulations and replaced with the more flexible standard of a legally enforceable real property interest.
The final regulations retain Example 6 from the proposed regulations. This example illustrates these rules in connection with a data center building owned by a REIT. The central heating and air conditioning system, integrated security system, fire suppression system, and humidity control system are listed as safe-harbor structural components and, therefore, are real property. Under a facts-and-circumstances analysis, the electrical system and telecommunication infrastructure system are also treated as structural components of the building and, thus, are real property.
Distinct Asset Testing
The final regulations retain the proposed regulations' distinct asset testing. The final regulations provide that each distinct asset is tested individually under the regulations. Thus, in testing whether a particular property is real property, it is necessary to first identify whether the particular property consists of one or more distinct assets. The determination of whether a particular separately identifiable item of property is a distinct asset is based on all of the surrounding facts and circumstances. The final regulations identify four factors that must be taken into account in making the determination. Each distinct asset not specifically enumerated in the safe-harbor lists of real property types described earlier must be evaluated to determine whether it serves a passive or an active purpose. Distinct assets with an active function will not be treated as real property unless they are structural components that serve a utility-like function for the inherently permanent structure of which they are a constituent part. Similarly, if an asset produces income other than consideration for the use or occupancy of space, the asset will not be treated as real property.
Examples 8 and 10 in the final regulations illustrate these concepts. In Example 8, a REIT owns a solar energy site (consisting of the following distinct assets: land, photovoltaic modules, mounts—i.e., the foundation and racks that support the photovoltaic modules—and an exit wire) that is leased to a tenant. The land is real property. The mounts are designed and constructed to remain permanently in place (and have a passive function) and, thus, are inherently permanent structures under a facts-and-circumstances determination. The photovoltaic modules are items of machinery or equipment that do not serve the mounts in their passive function of providing support. As such, they are not structural components and, thus, not real property. The exit wire is an inherently permanent structure and, thus, real property.
Example 10 addresses a natural gas pipeline transmission system (consisting of the following distinct assets: underground pipelines, isolation valves and vents, pressure control and relief valves, meters, and compressors). The regulation concludes that the pipelines are listed as safe-harbor inherently permanent structures and, thus, constitute real property. Under a facts-and-circumstances analysis, the isolation valves and vents, pressure control valves, and relief valves are structural components of the pipelines and, thus, real property, while the meters and compressors are not structural components because they do not serve the pipelines in their passive function of providing a conduit for the tenant's natural gas.
The final regulations retain the proposed regulations' clarification that certain intangible assets are also treated as real property. For an intangible asset to be treated as real property, the intangible asset must (1) derive its value from real property; (2) be inseparable from the real property; and (3) not produce or contribute to the production of income other than consideration for the use or occupancy of space.
The final regulations also provide that a license, permit, or other 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 easement, generally is an interest in real property, while 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. Example 12 illustrates that a special-use permit from the government to place a cell tower on federal government land is an interest in real property. Example 13 illustrates that a license to operate a casino (granted by a state) in a building is not real property.
The final regulations modify Examples 1, 5, 6, 7, 8, and 10 to provide that the REIT in each example does not operate the property and does not provide services to the lessee. The final regulations also revise Example 9 to provide that the size and other specifications of the solar energy system were created to serve the office building's needs and no facts indicate that the system will not remain in place indefinitely.
The final regulations eliminated the proposed regulations' Example 11, which addressed whether goodwill established under GAAP as a result of the acquisition of stock of a corporation that owned a hotel qualifies as real property for purposes of Secs. 856 through 859. In that example, the portion of the acquisition cost allocated to the hotel was limited to the hotel's depreciated replacement cost. Treasury and the IRS were advised that depreciated replacement cost is no longer the standard under GAAP for valuing property such as the hotel, so Example 11 in the proposed regulations was deleted. Example 11 in the final regulations provides a new example that illustrates the principles used to test intangible assets: an above-market lease accounted for under GAAP. It concludes that the value of the above-market lease that constitutes real property is limited to the portion of the above-market lease that derives its value from real property.
The final regulations apply to tax years that begin after Aug. 31, 2016. For asset test purposes, taxpayers may rely on the final regulations for quarters that ended prior to Aug. 31, 2016.
REITs that own traditional types of rental properties, such as office, apartment, retail, industrial, and hotel properties, will be generally unaffected by the final regulations. The final regulations will be more significant to REITs that are contemplating owning nontraditional types of rental properties, such as infrastructure assets. REITs that have been considering owning and leasing solar energy sites to a lessee that are used by the lessee to produce electricity sold to the grid should note that the final regulations conclude in Example 8 that the photovoltaic modules (that convert solar photons into electricity) do not constitute real property because, under these circumstances, the modules are items of machinery that do not serve in a passive capacity. In contrast, Example 9 concludes that similar solar energy site assets mounted on land adjacent to a rental office building (or solar shingles installed on the roof of the office building), which are designed and used to produce electricity to serve the office building, qualify as a structural component of the office building (under a facts-and-circumstances analysis) and, therefore, are real property.
In response to comments, the IRS is considering whether additional guidance is necessary to address circumstances in which a distinct asset that serves as an inherently permanent structure may produce electricity that is sold to third parties and qualify as a structural component of the inherently permanent structure for REIT purposes. Until the IRS issues further guidance, the final regulations provide that, in any tax year in which (1) the quantity of excess electricity transferred to the utility company during the tax year from distinct assets does not exceed (2) the quantity of electricity purchased from the utility company during the tax year to serve the inherently permanent structure, the IRS:
- Will not treat the transfer of the excess electricity as affecting the distinct assets' qualification as structural components of the inherently permanent structure for REIT purposes;
- Will not treat any income resulting from the transfer of excess electricity as gross income under Sec. 856(c)(5)(J)(i) for purposes of Secs. 856(c)(2) and (3); and
- Will not treat net income from the transfer of the excess electricity as net income derived from a prohibited transaction under Sec. 857(b)(6).
Treasury and the IRS recognize that the term "real property" is defined in several provisions of the Code. The final regulations define it solely for purposes of Secs. 856 through 859.
Michael Dell is a partner at Ernst & Young LLP in Washington.
For additional information about these items, contact Mr. Dell at 202-327-8788 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.