United States

IRS issues proposed REIT regulations further defining real property

TAX ALERT  | 

On May 9, 2014, the U.S. Department of the Treasury issued proposed regulations defining the term “real property” for real estate investment trust (REIT) asset test purposes under section 856(c)(4). These proposed regulations generally confirm conclusions reached in recent rulings and provide a safe harbor list of assets that will automatically qualify as real property. However, these proposed regulations do not provide guidance regarding whether various types of income from the operation of these assets will qualify as rents from real property for purposes of the REIT gross income tests.

REITs were created in 1960 as a type of tax entity designed to encourage public investment in the real estate industry. REITs are taxed as corporations, yet escape the double taxation of corporations through a dividends-paid deduction. However, REIT tax compliance is highly complicated and designed to ensure that REITs are only investing in real estate. As such, there are many tests a REIT must pass in order to maintain its tax-advantaged REIT status. One specific test is that at the close of each quarter, 75 percent of the REIT’s asset value must be comprised of real estate assets, cash, certain cash equivalents, and government securities.1 In an ever-changing investment environment, certain real estate investors wanted to use REITs to invest in various types of realty that were not specifically defined by statute. Since the tax ramifications of failing to meet the REIT tests are highly undesirable, many investors sought IRS guidance on the treatment of these assets by requesting private letter rulings (PLRs). In response to the high number of PLRs received, the IRS and Treasury have released proposed regulations that substantially expand and refine the definition of real estate assets for purposes of the 75-percent asset test. These regulations also provide 13 detailed examples of common scenarios and explain how to interpret each situation under these proposed regulations.

The historical definition of real estate assets is real property, including interests in real property and interests in mortgages on real property.2 This has been further defined through previously issued regulations to mean land, improvements to land, buildings, other inherently permanent structures, and structural components of buildings. Real estate assets do not include personal property such as machinery, equipment or furnishings.3 The newly proposed regulations refine the definition of real estate assets in all of these areas, add a “distinct” asset test, and provide further clarification for the treatment of assets in active and passive functions. It should be noted that these new definitions are only for purposes of REIT determination and have no effect on the definition of real estate or real property for other tax purposes, including investment tax credit and Foreign Investment in Real Property Tax Act purposes.

Distinct asset test

When determining whether an asset is real or personal property, the proposed regulations provide that each distinct asset must be tested individually and analyzed separately from any other related asset. While this is a facts and circumstances approach, the proposed regulations provide the following factors to be used in making such determinations:4

  • Whether the item is customarily sold or acquired as a single unit (as opposed to as a component of a larger asset)
  • Whether the item can be separated from a larger asset and the related cost of separation
  • Whether the item is commonly viewed as having a useful function independent of the larger asset
  • Whether the separation of the item would impair the functionality of the larger asset

While each of these factors must be considered, no single factor is determinative. The distinct asset concept appears in each subsection of the proposed regulations.

Land

Land is traditionally viewed as a parcel of ground. The proposed regulations expand the definition of land to include air and water space directly above the parcel of land, as well as crops or other natural products of the land (deposits, water, ores or minerals), as long as they are still affixed to the land.5 The severing, extraction or removal of crops and natural products from the land will cause such items to cease to be real property, and the mere storage of the extracted crops on the land does not convert them back to real property. The proposed regulations highlight how water space can qualify as real property by providing an example involving a REIT that rents boat slips to customers.6

Improvements to land (buildings, permanent structures and structural components)

An inherently permanent structure that qualifies as real property is an improvement to land, such as a building, other permanent structure, or structural component of real property. Inherently permanent structures must be permanently affixed structures, meaning the method of attachment and weight of the structure must indicate that the asset will remain indefinitely.7 Additionally, the structure must serve a passive function, meaning a distinct asset cannot contribute to the active process of creating, manufacturing, producing, converting or transporting an asset. Examples of buildings, permanent structures and structural components are:

Building

Permanent Structure

Structural Component

Houses

Transmission towers

Wiring

Apartments

Telephone poles

Plumbing

Hotels

Parking facilities

HVAC systems

Factories

Bridges

Elevators

Office buildings

Tunnels

Escalators

Warehouses

Roadbeds

Walls

Barns

Railroad tracks

Floors

Enclosed garages

Transmission lines

Ceilings

Enclosed transportation stations

Pipelines

Permanent wall/floor/ceiling coverings

Stores

Fences

Windows

 

Offshore drilling platforms

Doors

 

Storage structures

Insulation

 

In-ground swimming pools

Fire suppression systems

 

Stationary wharves/docks

Central refrigeration systems

 

Outdoor advertising displays8

Integrated security systems

   

Humidity control systems

 

In addition to the items listed above, a facts and circumstances evaluation can be performed to determine whether a distinct asset is a building, permanent structure or structural component. Some of the considerations include:9

  • 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 the real property to which it is affixed
  • Circumstances that suggest the expected period of affixation is not indefinite (a lease or contract that requires removal of the asset at a certain time)
  • Whether the distinct asset serves the inherently permanent structure in its passive function
  • Whether the distinct asset serves a utility-like function with respect to the inherently permanent structure
  • Whether the owner of the real property is also the legal owner of the distinct asset

Intangible assets

The proposed regulations provide that intangible assets (even those established under GAAP) can in fact be real property. These intangible assets must be inseparable from the real property, must derive their value from the real property, and cannot produce or contribute to the production of income (other than in consideration for the use or occupancy of space). For example, a license or permit for the use, enjoyment or occupation of land is considered real property, while a license or permit to engage in or operate a business is generally not real property because it contributes to the production of income not in consideration for use of the space.10

Takeaway

The proposed regulations provide some of the most substantial REIT-related guidance that the Treasury has issued since REITs were formed in the1960s. Similar to the recently released tangible property regulations, these REIT regulations refine the definition of real property and provide methodologies to determine if an asset qualifies as real property. Additionally, detailed examples are provided to illustrate real-world interpretations of the new rules. As always, taxpayers should contact their tax advisors to discuss the consequences of these proposed regulations in anticipation of the Sept. 18, 2014, public hearing to address any comments or concerns over the regulations.

1 See section 856(c)(4).

2 See section 856(c)(5)(B).

3 See Reg. section 1.856-3(d).

4 See Prop. Reg. section 1.856-10(e).

5 See Prop. Reg. section 1.856-10(c).

6 See Prop. Reg. section 1.856-10(g), Example 2.

7 See Prop. Reg. section 1.856-10(d)(2).

8 Subject to an election to be treated as real property under section 1033(g)(3).

9 See Prop. Reg. sections 1.856-10(d)(2) and (d)(3).

10 See Prop. Reg. section 1.856-10(f).


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