Before Congress created Real Estate Investment Trusts, or “REITs,” in 1960, investments in commercial real estate were only available to institutions and wealthier individuals. The introduction of REITs allowed small, mom and pop investors to access these financial opportunities.
To qualify as a REIT, an entity—which can be a corporation, trust or even a limited liability company—must comply with a number of technical requirements set out in the Internal Revenue Code, including: it must (i) pay at least 90 percent of its taxable income to shareholders; (ii) derive most of its income from real property; and (iii) must be widely held.
Property historically owned by REITs werefairly traditional in nature, such as apartments, hotels, shopping malls, retail stores, office buildings, warehouses, or industrial facilities. However, recently the REIT structure has been used more creatively to consolidate and finance less traditional property types, such as cell phone towers, billboards, timber and agricultural lands, transportation and energy infrastructure, data centers, and single family homes.
The move by creative property owners and developers, financiers, and lawyers to utilize the REIT structure for more non-traditional property types has grown after the Internal Revenue Service (IRS) recently clarified the meaning of permissible types of income derived from “real property.” Prior to the recent IRS pronouncements, the Code defined real property as “land or improvements thereon, such as buildings or other inherently permanent structures thereon (including items which are structural components of such buildings or structures).” However, the Code did not go into much detail as to the meaning of these terms. The IRS’ revised guidance provides a more detailed framework for analyzing whether assets would qualify as real property for purposes of the REIT provisions of the Code.
Under the new guidelines, “real property” is defined as land and improvements to land; land includes superadjacent water and air space, and natural products and deposits that are unsevered from the land. Improvements to land include “inherently permanent structures” and their structural components; an inherently permanent structure is any permanently affixed building or other permanently affixed structure. Affixation may be to land or to another inherently permanent structure and may qualify by weight alone. If the affixation is reasonably expected to last indefinitely based on all the facts and circumstances, the affixation is considered permanent. Furthermore, to be considered to be an inherently permanent structure, the asset must serve a “passive function” that contains, supports, shelters, covers, protects or provides a conduit or route as compared to an “active function” that serves to manufacture, create, produce, convert, or transport, which is more akin to equipment.
The guidance provides that typical inherently permanent structures include a variety of building types, such as 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.
Less traditional asset types recognized by the IRS as being inherently permanent structures include the following distinct assets, if 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; stationary wharves and docks; and outdoor advertising displays.
For asset types not specifically listed in the guidance, the determination of whether an asset is an inherently permanent structure is based on all the facts and circumstances. In particular, the following factors must be taken into account: (i) the manner in which the distinct asset is affixed to real property; (ii) whether the distinct asset is designed to be removed or to remain in place indefinitely; (iii) the damage that removal of the distinct asset would cause to the item itself or to the real property to which it is affixed; (iv) any circumstances suggesting 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); and (v) the time and expense required to move the distinct asset.
The examples provided in the guidance highlight the distinctions between permanent assets and therefore qualifying assets, and those that are not.
For instance, certain parts of solar energy installations qualify as real property and certain parts do not. The mounts that hold the solar panels are real property because they are permanently affixed to the land and difficult to remove, while the solar panels that generate the electricity would not be considered real property because they are easily removed from the mounts. Likewise, energy pipeline transmission systems are treated as real property because they act as conduits for the delivery of gas that are permanently affixed to the land. The isolation valves, vents, and pressure control and relief valves, would also be deemed to be real property because they cannot be removed without rendering the pipeline transmission system inoperable.
Data centers, including its electrical systems, telecommunication infrastructure, heating and cooling systems, integrated security and fire suppression systems, and racks for the computer servers, all of which comprise a series of interconnected assets integrated into the building, constitute real property. Traditional and digital billboards operated by outdoor advertising companies can qualify as being real property, whereas advertising placed on buses or bus shelters and benches do not qualify as they are easily removed.
Certain governmental permits or licenses can create permissible “leasehold interests” in real property such as cell towers affixed to the land or to other buildings. Leases of agricultural land to a farmer/tenant to cultivate the plants and to harvest the crop is a qualifying asset. Leases of Marina boat slips connected to docks, in turn affixed to land, are considered to be leases of real property.
Even a large “indoor art sculpture” weighing 5 tons and placed in the atrium of an office building could be deemed to be real property, if the building floor was constructed specifically to hold the sculpture.
In another example of a creative use of the REIT structure, Thompson Coburn recently assisted a client, the Los Angeles based Inception Companies, in creating a REIT (the “Inception REIT”) to provide capital solutions for the difficulties faced by legal cannabis-centered businesses in financing their operations. Inception REIT will operate as a hybrid REIT that both owns and leases industrial and warehouse facilities operating as greenhouses for the cultivation of cannabis by state licensed operators, and also provide loans to such operators secured by the underlying real property.
A significant benefit of operating as a REIT is the favorable tax treatment afforded under the Code, including the ability to deduct the amount of dividends it pays to its shareholders from its income. In addition, REIT shareholders have the added benefit of a 20% deduction for dividend payments they receive from the REIT under Section 199A of the Code, implemented in The Tax Cuts and Jobs Act that became law on December 22, 2017. Due to a variety of uncertainties concerning the ability of private equity funds to take full advantage of Section 199A, many private equity funds—particularly funds that make investments in the form of loans—are exploring the feasibility of converting to REIT structures.
The IRS’ recent guidance for determining whether particular assets qualify as “real property,” coupled with the favorable tax attributes of REITs, should encourage businesses to think out of the box and explore creative ways to utilize a REIT structure to improve their access to sources of capital and further their business goals.
Brad Markoff is a Partner with Thompson Coburn LLP. For more information, visit thompsoncoburn.com
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