The Treasury Department and the IRS recently issued final regulations (T.D. 9784
) that provide guidance on which assets are real property for the purposes of the quarterly asset test that a real estate investment trust (REIT) is required to satisfy.
Section 856 contains the requirements that a taxpayer must satisfy to qualify as a REIT. One of those requirements is a quarterly asset test that requires at least 75% of the value of the taxpayer’s assets to come from real estate assets, cash and government securities (the REIT asset test). Real estate assets for purposes of the REIT asset test are defined to include real property and interests in real property.
Prior to the issuance of the final regulations, the definition of real property for purposes of the REIT asset test was governed by regulations issued in 1962 (T.D. 6598). In the decades since 1962, the IRS has ruled in various revenue rulings, private letter rulings (PLRs) and other guidance that various assets not expressly covered by the definition in the 1962 regulations qualify as real property for purposes of the REIT asset test. On May 14, 2014, Treasury and the IRS issued proposed regulations (REG-150760-13
) on the definition of real property for purposes of the REIT asset test that largely incorporated the rulings from those revenue rulings, PLRs and other guidance. The final regulations generally adopt the proposed regulations, with some slight modifications and clarifications made in response to public comments.
The question of what constitutes real property can also be a contentious issue for REIT requirements other than the REIT asset test. The preamble to the final regulations emphasizes that the definition of real property in the final regulations is applicable only to the REIT asset test and not to any other aspect of REIT qualification.
The first step in the analytical framework set up by the final regulations is determining which assets must be analyzed separately. A “distinct asset” must be analyzed separately from other assets to which the asset relates to determine if it qualifies as real property. The determination of whether a particular separately identifiable form of property is a distinct asset is based on a facts-and circumstances test that takes the following factors into account:
- Whether the item is customarily sold or acquired as a single unit rather than as a component part of a larger asset
Whether the item can be separated from a larger asset, and if so, the cost of separating the item from the larger asset
Whether the item is commonly viewed as serving a useful function independent of a larger asset of which it is a part
Whether separating the item from a larger asset of which it is a part impairs the functionality of the larger asset
The final regulations broadly define real property as land and improvements to land. Land is defined to include water and air space superadjacent to land. In response to a comment, the preamble clarifies that the definition of land includes both air and water space superadjacent to land even if the taxpayer owns only the air space or water space and does not own an interest in the underlying land.
Inherently permanent structures
Improvements to land are inherently permanent structures (IPS) and their structural components. To qualify as an IPS, an asset can be a building or other inherently permanent structure (OIPS). Whether an asset is a building or an OIPS, to qualify as an IPS it must be permanently affixed to land or to another IPS. An asset is considered permanently affixed if the affixation is reasonably expected to last indefinitely based on all the facts and circumstances. In response to comments, the preamble clarifies that Treasury and the IRS did not mean the term “indefinitely” to mean forever.
The final regulations define a building as an asset that encloses a space within its walls and is covered by a roof. That general definition is supplemented with the following safe harbor list of assets that are buildings as long as they are permanently affixed: houses; apartments; hotels; motels; enclosed stadiums and arenas; enclosed shopping malls; factory and office buildings; warehouses; barns; enclosed garages; enclosed transportation stations and terminals; and stores. In response to a comment, the preamble states that outdoor sports stadiums and amphitheaters may fail to qualify as buildings, but that many would satisfy the definition of an OIPS.
An asset that does not qualify as a building can still qualify as an IPS if it is an OIPS. To qualify as an OIPS, an asset must have a passive function (e.g. to contain, support, shelter, cover, protect or provide a conduit or route) and not an active function (e.g. to manufacture, create, produce, convert or transport). In response to comments, the preamble clarifies that “transport” means “to cause to move,” and that providing a conduit (as with a pipeline or electrical wire) or a route (as with a road or railroad track) is a permitted passive function for qualifying as an OIPS. The final regulations include the following safe harbor list of assets that qualify as OIPS as long as they are permanently affixed: 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; and stationary wharves and docks. If an asset does not serve an active function but is not listed on the safe harbor lists of buildings or OIPSs, the determination of whether that asset is an IPS is a facts-and-circumstances test in which the following factors are taken into account:
- The manner in which the distinct asset is affixed to real property
Whether the distinct asset is designed to be removed or to remain in place indefinitely
The damage that removal of the distinct asset would cause to the item itself or to the real property to which it is affixed
Any circumstances that suggest the expected period of affixation is not indefinite (for example, a lease that requires or permits removal of the distinct asset upon the expiration of the lease)
The time and expense required to move the distinct asset
A structural component is a distinct asset that is a constituent part of, and integrated into, an IPS; serves the IPS 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 such income. If interconnected assets work together to serve an IPS with a utility-like function (for example, systems that provide a building with electricity, heat or water), the assets are analyzed together as one distinct asset that may be a structural component. The final regulations include the following safe harbor list of 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. If a distinct asset is not included on that safe harbor list, the determination of whether it is a structural component is based on a facts-and-circumstances test taking the following factors into account:
- The manner, time and expense of installing and removing the distinct asset
Whether the distinct asset is designed to be moved
The damage that removal of the distinct asset would cause to the item itself or to the IPS to which it is affixed
Whether the distinct asset serves a utility-like function with respect to the IPS
Whether the distinct asset serves the IPS in its passive function
Whether the distinct asset produces income from consideration for the use or occupancy of space in or upon the IPS
Whether the distinct asset is installed during construction of the IPS
Whether the distinct asset will remain if the tenant vacates the premises
Under the proposed regulations, an asset that generates solar energy does not qualify as an IPS because producing solar energy is an active function, not a passive function. The final regulations retain that distinction. The preamble clarifies that even a solar panel that functions both to shelter (a passive function) and to produce energy (an active function) does not qualify as an IPS.
Although an asset that generates solar energy is not an IPS, an asset can qualify as real property if it is a structural component of a qualifying IPS. That principle was illustrated in example nine of the proposed regulations, which was modified by the final regulations with language that is more taxpayer friendly.
In the proposed regulations, example nine concerns an office building and adjacent solar energy site, both of which are leased to a single tenant by a REIT. Although the tenant occasionally transfers excess electricity produced by the solar energy site to a utility company, the solar energy site was designed and intended to produce electricity only to serve the office building. The proposed regulations further stated that the solar energy producing site was designed and constructed specifically for the office building. According to the proposed regulations, the solar energy site was a structural component of the office building (and therefore real property).
In response to a comment that most solar energy producing assets are mass produced, the final regulations revised example nine to replace the language in the proposed regulations that the solar energy site was “designed and constructed specifically for the office building” with language that it was “designed to be appropriate to serve only the electricity needs of the office building.”
The final regulations were not revised, however, in response to a comment that suggested changing “occasionally transfers” to “regularly transfers” in describing the transfer of energy from the solar energy site to a utility company. According to the preamble, Treasury and the IRS are considering whether additional guidance is necessary to address that comment, but will not treat the transfer of excess electricity as affecting the disqualification of a distinct asset as a structural component until such guidance is issued.
In general, the final regulations retain the approach of the proposed regulations by providing that an intangible asset qualifies as real property or an interest in real property to the extent that it derives its value from real property or an interest in real property, is inseparable from that real property or interest in real property and does not produce or contribute to the production of income other than consideration for the use or occupancy of space.
The proposed regulations defined intangible assets to include certain intangible assets established under GAAP as a result of an acquisition of real property or an interest in real property. The preamble clarifies that provision of the proposed regulations by stating that an intangible asset that, in accordance with GAAP, results from a merger, business combination, or stock or asset acquisition may qualify as real property or an interest in real property.
In response to a comment, the final regulations were modified to clarify that an intangible asset may be partially an interest in real property and partially an asset other than an interest in real property. Specifically, the final regulations clarify the treatment of in-place above-market leases by including a new example in which a REIT treats 70% of the value of a lease as an interest in real property because 70% of the value of the lease is attributable to income that qualifies as rent from real property pursuant to Section 856(d)(1).
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