Editor: Michael Dell, CPA
In Letter Ruling 201034010, the IRS ruled that apparent “data center” buildings, including their structural components, constitute real property for purposes of the REIT asset and income tests and that services furnished in connection with leasing space in the buildings will not cause any amounts received from tenants to be treated as other than rents from real property.
The taxpayer is a newly formed domestic corporation that will elect to be taxed as a real estate investment trust (REIT). The taxpayer intends to conduct all its business through LP, a newly formed limited partnership, in which it will be the general partner and a substantial limited partner.
LP intends to acquire, purchase, develop, and construct buildings, which it will lease to unrelated tenants. The space offered to tenants generally falls into two categories: wholesale space and retail co-location space. For the wholesale space, tenants typically rent designated space under leases generally ranging from three to ten years. Co-location space or a “meet-me” room is often an area in a building where tenants can connect with each other through telecommunication and networking media and exchange data. For retail co-location space, a customer is typically entitled to the use of a specially identified co-location suite, cage, or cabinet located in a common shared area under a license and service agreement. These agreements generally have terms ranging from one to three years. The tenants will normally use the space to accommodate their telecommunications, computing, and electronic data storage equipment, including computer servers and personnel.
Within each building, the tenant space may be constructed on raised flooring to accommodate the electric, ventilation, and air conditioning systems required by tenants. The buildings differ from other office buildings because of the magnitude and quality of the electrical power and air conditioning furnished to tenants and the redundancies built into the electrical and air conditioning systems.
The major structural components of the buildings are:
- Electrical distribution and redundancy system (electrical components);
- Heating, ventilation, and air conditioning system (HVAC components);
- Humidification system (humidification components);
- Security system (security components);
- Fire protection system (fire protection components); and
- Telecommunication infrastructure (telecommunication components).
Each component is designed and constructed specifically for the particular building of which it is a part, and they are all intended to remain permanently in place. The electrical components provide an uninterrupted power supply to the property through redundancy. The HVAC components maintain a room temperature of between 70° and 72°F. The humidification components maintain humidity levels in the tenants’ spaces in the range of 45–55%. The security components typically include a single point of access to the building, which is staffed at all times by a security firm or an LP employee. The fire protection components include fire alarms and suppression systems. The telecommunications components provide tenant access to third-party telecommunications providers.
The taxpayer, through a taxable REIT subsidiary (TRS), will provide connectivity services such as facilitating a tenant’s access to other tenants’ equipment within a building or between buildings. The taxpayer or the tenants will adequately compensate the TRS for such services.
The taxpayer represents that the buildings are inherently permanent structures and that each of the structural components described above is designed and constructed to remain permanently in place.
LP also provides services related to the operation and maintenance of the buildings, such as providing utilities, controlled humidity, security, fire protection, common area maintenance and cleaning, and building upkeep. The taxpayer represents that these services are ordinary, necessary, usual, and customary.
Law and Analysis
Regs. Sec. 1.856-3(d) provides that the term “real property” means land or improvements thereon, such as buildings or other inherently permanent structures. Real property also includes interests in real property. The term covers, for example, a building’s wiring, plumbing systems, central heating or air conditioning machinery, pipes or ducts, elevators or escalators installed in the building, or other items that are structural components of the building. The term does not include assets that are accessories to the operation of a building (such as machinery, printing presses, transportation equipment that is not a structural component of the building, office equipment, refrigerators, individual air conditioning units, grocery counters, and motel or hotel furnishings), even though such items may be fixtures under local law.
Citing Rev. Ruls. 73-425 and 75-424, the IRS determined that the taxpayer’s buildings and structural components are inherently permanent structures. Although the buildings and structures facilitate the technology businesses of tenants occupying the buildings, the buildings and structural components themselves are not “assets accessory to the operation of a business.” Accordingly, the IRS ruled that the taxpayer’s buildings, including the structural components, are real property for purposes of Secs. 856(c)(2)(C) and (c)(3)(A) and are real estate assets for purposes of Secs. 856(c)(4)(A) and (c)(5)(B).
The IRS explained that many of the services described by the taxpayer are usual or customary services rendered in connection with the operation and maintenance of the properties and are not primarily for the tenants’ convenience. Other services that may constitute personal services to a tenant will be provided through independent contractors from whom the taxpayer will not derive any income or through a TRS owned by LP. Accordingly, the IRS ruled that the services provided by the taxpayer through LP in connection with the leasing of the buildings will not cause any amounts received from tenants to be treated as other than rents from real property under Sec. 856(d).
Letter Ruling 201034010 is the third private letter ruling in which the IRS has concluded that apparent data center buildings, including their structural components, constitute real property for purposes of the REIT asset tests. (See prior Letter Rulings 200921019 and 200752012.) In general, data centers are buildings that tenants use to house computer systems and associated components, such as telecommunications and storage systems, and that have specific power and air conditioning needs that exceed those required in an office building.
Letter Ruling 201034010, unlike the earlier rulings, indicates that the buildings may also offer co-location space to tenants, which the ruling describes as a suite, cage, or cabinet located in a common shared area of a building. While the ruling did not separately address the treatment of the amounts the taxpayer will receive from tenants for the use of the co-location space, one can infer that the income from such space presumably qualifies as rents from real property. However, it should be noted that the ruling indicates that a TRS will be used to provide connectivity services such as facilitating a tenant’s access to other tenants’ equipment within a building or between buildings. Hopefully, a future ruling will address co-location space in more detail.
Michael Dell is a partner at Ernst & Young LLP in Washington, DC.
For additional information about these items, contact Mr. Dell at 202-327-8788 or firstname.lastname@example.org.