Real Estate
In Letter Ruling 201139005, the IRS ruled that, after a restructuring transaction, an eligible independent contractor will continue to be treated as managing and operating a hotel on behalf of a taxable real estate investment trust (REIT) subsidiary for purposes of Sec. 856(d)(8)(B). As such, the taxable REIT subsidiary (TRS) will not be treated as operating or managing a lodging facility in violation of Sec. 856(l)(3)(A). The IRS also ruled that rents received by the REIT from the leasing of the hotel to the TRS will qualify for the related-party rent exception of Sec. 856(d)(8)(B) and thus constitute qualifying income for purposes of the 75% and 95% REIT income tests.
Facts
The taxpayer is a REIT that, through LLC 1, a disregarded entity, owns Hotel, which is leased to TRS. TRS is wholly owned by the taxpayer, and the taxpayer and TRS have jointly elected to have TRS treated as a taxable REIT subsidiary under Sec. 856(l).
LLC 2, a disregarded entity owned by Company, manages Hotel. LP, a limited partnership, employs the persons providing services at Hotel. LLC 2 owns a limited partnership interest in LP. LLC 3, a disregarded limited liability company that is wholly owned by LLC 2, owns a general partnership interest in LP.
The taxpayer represented that Company is an independent contractor under Sec. 856(d)(3) and is actively engaged in the trade or business of operating qualified lodging facilities under Sec. 856(d)(9)(A). The taxpayer also stated that LLC 2 and Company are owned by persons unrelated to the taxpayer.
The taxpayer proposed the following restructuring of the business arrangement:
TRS will sublease Hotel to LP and acquire LLC 2’s limited partnership interest in LP. This ownership will not grant TRS any operational or management authority over Hotel, although TRS will have certain governance rights if specified extraordinary circumstances occur. LLC 2 and LP will enter an agreement under which LLC 2 will continue to manage Hotel. LP will continue to employ the persons currently providing services at Hotel.
Company will acquire the interest in LLC 3 that LLC 2 currently owns. Company will continue to wholly own LLC 2, and both will continue to be owned by persons unrelated to the taxpayer.
Ruling and Analysis
To qualify as a REIT, an entity must derive at least 95% of its gross income from sources listed in Sec. 856(c)(2) and at least 75% of its gross income from sources listed in Sec. 856(c)(3). Rents from real property are among the sources listed in both sections.
Generally, under Sec. 856(d)(2)(B), the term “rents from real property” does not include any amount received or accrued, directly or indirectly, from any corporation if the REIT owns, directly or indirectly, 10% or more of the value or voting interests of that person. However, Sec. 856(d)(8)(B) creates an exception to the general rule: Amounts paid to a REIT by a TRS shall not be excluded from “rents from real property” by reason of Sec. 856(d)(2)(B) when a REIT leases a qualified lodging facility to a TRS, and the property is operated on behalf of the TRS by a person who is an eligible independent contractor.
With respect to any qualified lodging facility, Sec. 856(d)(9)(A) defines the term “eligible independent contractor” as any independent contractor if, at the time such contractor enters into a management agreement or similar service contract with the TRS to operate the facility, the contractor (or any related person) is actively engaged in the trade or business of operating qualified lodging facilities for any person who is not a related person with respect to the REIT or the TRS.
Sec. 856(d)(9)(D)(i) generally defines the term “qualified lodging facility” as any lodging facility unless wagering activities are conducted at or in connection with that facility by any person who is engaged in the business of accepting wagers and who is legally authorized to engage in the business at or in connection with that facility.
Sec. 856(l)(3)(A) prohibits a TRS from directly or indirectly operating or managing a lodging facility.
The IRS explained that, under the proposed structure, Company, through LLC 2, will continue to manage and operate Hotel. Although TRS will own an interest in LP, TRS will have no authority to direct the operations or management of Hotel. TRS will have only limited governance rights in LP arising in extraordinary circumstances. Thus, Company will be treated as managing and operating Hotel on behalf of TRS for purposes of Sec. 856(d)(8)(B), and TRS will not be treated as operating or managing a lodging facility under Sec. 856(l)(3)(A).
In addition, because an interest in a qualified lodging facility will be leased by a REIT to a TRS of the REIT and the qualified lodging facility will be managed and operated on behalf of the TRS by an eligible independent contractor, the requirements of Sec. 856(d)(8)(B) will be met. Therefore, rent paid by TRS to LLC 1 will not be excluded from rents from real property by reason of Sec. 856(d)(2)(B) and will be qualifying income for purposes of the REIT gross income tests.
Implications
REITs that own hotels or health care properties are allowed to lease all or a portion of the properties to a TRS under the special rule of Sec. 856(d)(8)(B), which exempts the rents received by the REIT from the related-party rent rule of Sec. 856(d)(2)(B). To qualify for the exception, the TRS must hire an entity that qualifies as an eligible independent contractor to operate the property. Moreover, an entity may qualify as a TRS only if, among other requirements, the TRS does not directly or indirectly operate or manage a lodging facility or a health care facility.
Letter Ruling 201139005 provides some insight concerning when an eligible independent contractor, and not a TRS, is treated as operating or managing a lodging facility. See also Letter Ruling 201041034 for a similar holding.
EditorNotes
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 michael.dell@ey.com.
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.
