Is an Intangible Right a Real Estate Asset for REIT Asset Tests?
June 12, 2020
By Eric Kea, CPA
REITs are allowed a deduction for dividends paid to shareholders. The dividends paid deduction most often wipes out federal income, and therefore no federal income tax is paid by a REIT. This is in contrast to the tax treatment of C corporations, which are not allowed a deduction for dividends and which are generally subject to federal income tax. As is typical under the Internal Revenue Code (“IRC”), however, something beneficial comes at a cost (i.e., complexity). In order to be granted the favorable status as a REIT, the taxpayer in question has to meet specified tests on a quarterly and annual basis. Please see our article on the basics of REITS for more details.
Asset tests for REITs include one whereby at least 75% of a REIT’s assets must consist of real estate assets, certain government securities, cash, and cash items. The term “real estate assets” may sound intuitive, but it is not. It is so far from intuitive that the IRC and regulations do not provide a bright line definition. The IRS recently issued Private Letter Ruling (“PLR”) 202012012, which deals in part with whether or not an intangible right is a real estate asset for purposes of the 75% asset test. A second question was posed in this PLR on whether or not certain facts could cause rents received to be excluded from the definition of rents from real property.
- Taxpayer #1, which is not a REIT, owns real property which it leases to unrelated parties.
- A REIT purchased the leases from Taxpayer #1, but not the real property itself.
- The REIT recorded the agreements or a memoranda of the agreements with the appropriate county office in each case.
- The REIT also entered into successor leases or options for successor leases (collectively, the “Lease Rights”) in each case that allowed it to step in and become the tenant and be able to re-lease to new third parties if a particular lease expired or terminated early.
Question and Answer #1 - Are the Lease Rights an Intangible Asset Qualifying as Real Property?
An intangible asset can be a real estate asset for REIT purposes if its value is derived from the real estate, the value cannot be separated from the real property or interest in such, and the intangible does not contribute to the generated income other than by the use or occupancy of space.
In the PLR, the IRS concluded that the ownership of the Lease Rights was in fact an intangible asset which meets the requirements for an intangible asset to be considered a real estate asset.
Moreover, the IRS also concluded that the Lease Rights are not like a contract with respect to the property, but instead provide an interest in the rights under a lease with respect to real property. Taking this into account, along with a successor lease, or options to acquire a successor lease, make the Lease Rights a traditional lease. A lease of real property is included in the definition of a real estate asset.
Question and Answer #2 - Are Certain Rents Received from Third Parties Excluded from the Definition of Rents from Real Property?
An additional issue was analyzed in the PLR. For certain types of real property leased by third parties, the third party pays rent not only as a set amount to a REIT, but also an additional amount calculated by a formula. This additional rent via formula is commonly referred to as percentage rent. When it comes to REIT income tests, a formula based upon sales results in rents still qualifying for the REIT income test, but a formula based upon income or profits of a lessee generally results in bad income. 75% of a REIT’s gross income must be derived from qualifying rents from real property and certain other qualifying income.
In the PLR, the formula rent received by the REIT includes a reduction from revenue for agency fees and continuity discounts. Thus, the formula is not gross revenue multiplied by a percentage but something less than that. The question then becomes whether the reductions result in the formula being based upon income or profits multiplied by a percentage, which would generate bad income. The agency fees are effectively a lease commission paid to a broker and the PLR states this, while the continuity fees are effectively a rebate paid to certain customers.
With regard to the agency fees, the IRS found them to be similar to sales taxes or credit card fees, where both items are allowed as a subtraction in a percentage rent calculation. As for the continuity discount, the IRS also reached a favorable conclusion. The use of the rebate in the prior paragraph was on purpose as the IRS stated that it is proper to reduce the sales by the given continuity fee, as the sales by which percentage rent would be calculated would be overstated if the amount was not subtracted. Therefore, the IRS acknowledged the economic reality of the agreement of the parties, and recognized that reductions for only some items -- but not all -- does not result in percentage rent based upon income or profits.