Can Short-Term be Long-Term for REIT Income Purposes?

Private Letter Rulings (“PLRs”) are guidance on tax issues drafted by the IRS with regard to a particular taxpayer under a very specific set of facts.  As such, only the taxpayer involved with the PLR is allowed to cite the PLR as precedent.  A PLR, however, is a very good indication of how the IRS will view a transaction materially similar to the facts of a PLR.

PLR 202012003 discusses a fact pattern involving storage warehouses and the many nuances surrounding them. The significance of qualifying rent is discussed in this PLR due to the unique fact pattern that is presented. What appears to be short-term usage of space is discussed in the context of long-term lease arrangements.

Income tests for REITs include a test whereby 75% of a REIT’s gross income must come from rents from real property, mortgage loan interest, dividends from ownership of other REITs, and/or gain from the sale of real property.  A 95% income test also exists, whereby 95% of a REIT’s gross income must be from sources qualifying for the 75% income test plus interest or dividends from any source that do not meet the 75% income test.  Please see our article on the basics of REITS for more details.

PLR 202012003 focused on four different questions, two of which relate to whether or not monies received represent rents from real property.  The third question relates to whether other monies received in certain instances can be excluded as gross income for REIT test purposes. The fourth question does not relate to a specific REIT test, but rather whether certain contributions to a REIT are taxable exchanges. 

Basic Facts:

1. The primary business of the REIT and a certain operating partnership (“OP”), collectively the “Company Group,” is to own and operate storage warehouses.
2. The Company Group enters into leases for:
   1. An entire warehouse.
   2. A set amount of reserved space for a set term that is generally one year.
   3. Non-exclusive space in a warehouse where the Company Group determines the specified storage rate per pallet that will be charged to a customer, which includes the number of days it is anticipated that a unit of goods will be stored; hereinafter referred to as a “Storage Agreement.”
   4. Representations made by the REIT include that the provision of certain conditions at a warehouse is customary by similar warehouses of this type in the geographic area and is not provided for the convenience of customers.
3. Customers generally do not have access to the inside of storage facilities. Storage Agreements provide that lack of access requires a warehouse to provide handling services. Such handling services are charged for and contain a profit component.  The revenue for providing such handling services will be to the benefit of a taxable REIT subsidiary (“TRS”) owned by the REIT and customers will be notified as such.
4. Any income earned by a TRS will be determined at an arm’s-length amount customary in the geographic region for similar services performed by similar warehouses.
5. A TRS may lease space from the REIT/OP; such space will be less than 10% of total leased space in a particular warehouse and any rental payments for such space will be at arm’s-length. Also, the REIT will treat such rental income from a TRS as not qualifying for the 75% income test as well as the 95% income test, if the amount leased in a particular warehouse is greater than 10% of total rental space.
6. Certain employees of the REIT/OP may perform services that are to the benefit of a TRS. Such TRS will reimburse the REIT/OP for the cost of such services on a dollar-for-dollar basis with no profit. Likewise, certain employees of a TRS may perform services that are to the benefit of the REIT/OP. The REIT/OP will reimburse the TRS for the cost of such services on a dollar-for-dollar basis with no profit.
7. The TRS and REIT/OP may advance certain other expenses on the behalf of the other, and such sharing of expenses will be allocated amongst the REIT, OP, and TRS on a fair and equitable basis.

The Questions and the Answers

Q. Do payments from customers under the Storage Agreements qualify as rents from real property?

A. The IRS has historically ruled that rentals less than 30 days will generally not qualify as rents from real property, even if the rents would otherwise clearly qualify. However in this PLR, the IRS concludes that the amounts received for rent under the Storage Agreements are rents from real property for purposes of the 75% test. The favorable IRS conclusion appears to be based on the fact that a Storage Agreement itself is long term, meaning that the customer is leasing space long term (i.e., longer than 30 days) even though a particular product may be stored less than 30 days. Furthermore, the IRS provides that the income from the provision of certain services under the Storage Agreements (specific services which are redacted in the PLR) is similar to the income from the provision of heat and also the provision of the utility of power or electricity and, therefore, for purposes of determining whether the income is qualifying income for REIT qualification purposes, is income that would be excluded from unrelated business taxable income under IRC Sec. 512(b)(3) if received by an organization described in IRC Sec. 511(a)(2). This is even though some of the space under the Storage Agreements may be used for a short-term time period (i.e., if products are moved in and out quickly).

Q. Will rents received by the REIT from a TRS represent rents from real property for those instances where the total space rented by a TRS in a warehouse is less than 10% and the rent is calculated at arm’s-length?

A. A TRS is, in part, a corporate subsidiary of a REIT that elects to be a TRS, is taxable as a C corporation that cannot be consolidated with a REIT, and performs services that a REIT cannot provide for which the REIT cannot derive income from. The PLR concludes that rents received by the REIT from a TRS represent rents from real property.

The conclusion for rents from the TRS is straightforward but also brings up another concept for REITs, in that rents from real property exclude related party rents.  In this case, the TRS is clearly related to the REIT/OP.  The IRS concludes that rental income from a TRS is rents from real property, but only to the extent that the space leased in a warehouse is less than 90%, and the rent is determined at arm’s-length equal to amounts charged for rent from non-related tenants.  The less than 90% and arm’s-length requirement is statutory, and if met such rents are excluded from related party rents.  It is stated in the facts of the PLR that the TRS rents not meeting these requirements would not be treated as rents from real property so this adverse fact pattern is not addressed.

Q. Will expense reimbursements received by the REIT from a TRS be excluded from both the 75% and 95% income tests?

A. The third question brings up the importance of what constitutes gross income. As stated, a REIT must pass both 75% and 95% gross income tests to maintain REIT status.  An important question is raised about expense reimbursements and whether they represent gross income and if yes, whether they are rents from real property. The IRS reaches a favorable conclusion by allowing such reimbursements to be excluded from gross income for REIT testing purposes as long as there is no profit element in the reimbursement.

Q. Will contributions of OP interests to the REIT by certain OP members be treated as a taxable event?

A. The fourth question raises an issue that does not relate to the general REIT income or asset tests. Factually, certain members of the OP contributed their OP interests to the REIT in exchange for stock of the REIT.  A general rule exists whereby a contribution to a corporation will be tax free if certain requirements are met.  As is typical under the IRC, it is common that an exception to the general rule exists, which in this case is a rule providing that the non-taxable rule will not apply to contributions to an investment company.  A REIT is an investment company for this purpose.  However, this taxable treatment does not apply for a contribution to a REIT if there is no diversification to the transferors.

The IRS concludes that the transfers in question are not to an investment company, but unfortunately provides no discussion or support for its conclusion.