Final Regulations Define “Real Property” for REITs: Considerations for Renewable Energy and Transmission Assets

Overview


The recently released final regulations are generally consistent with the 2014 proposed regulations in their treatment of renewable energy and transmission assets, with several useful clarifications provided.

In Depth


On August 31, 2016, the Internal Revenue Service (IRS) and US Department of the Treasury issued final regulations (Final Regulations) under section 856 of the Internal Revenue Code to clarify the definition of “real property” for purposes of sections 856 through 859 relating to real estate investment trusts (REITs). The Final Regulations largely follow proposed regulations issued in 2014 (Proposed Regulations) by providing a safe harbor list of assets and establishing facts and circumstances tests to analyze other assets.

The Final Regulations are generally consistent with the Proposed Regulations in their treatment of renewable energy assets: smaller-scale renewable energy systems that primarily serve buildings are generally REIT-eligible assets, whereas larger, utility-scale assets are effectively not eligible. The Final Regulations also clarify that until additional guidance is issued, the REIT-eligibility of renewable energy assets will not be affected if such assets generate excess electricity sold to utilities under net metering programs, with the income derived from such assets still qualifying as “good” REIT income for purposes of section 856(c)(2) and (3).

The Final Regulations are also consistent with the Proposed Regulations in their treatment of transmission systems: although a transmission system may serve an active function (e.g., transporting natural gas), distinct assets within the system, such as pipelines, isolation valves and vents, may nevertheless be REIT-eligible assets.

Background

Section 856 sets forth the requirements for a taxpayer to qualify as a REIT for federal income tax purposes. One of the requirements is that at the close of each quarter of the taxable year, at least 75 percent of the value of the REIT’s assets must be represented by real estate assets, cash and cash items (including receivables), and government securities.

Section 856 defines “real estate assets” to include real property and interests in real property. Treas. Reg. section 1.856-3(d), promulgated in 1962, 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),” and also included “interests in real property.”

Between 1969 and 1975, the IRS issued various revenue rulings addressing whether certain assets qualify as real property for purposes of section 856. Since then, REITs have sought to invest in a variety of other types of assets that are not directly addressed by those revenue rulings, and have sought and received private letter rulings from the IRS with respect to these assets. See, e.g., Private Letter Ruling 201314002 (Oct. 9, 2012) (data center and infrastructure); Private Letter Ruling 201310020 (Dec. 5, 2012) (boat slips and end ties in a marina); Private Letter Ruling 201204006 (Oct. 24, 2011) (outdoor advertising signs). Given that private letter rulings are limited to their particular facts and may not be relied upon by other taxpayers, the IRS and Treasury recognized the need to provide updated published guidance on the definition of real property under sections 856 through 859.

On May 14, 2014, the IRS and Treasury published in the Federal Register a notice of proposed rulemaking (NPRM) to define “real property” solely for purposes of sections 856 through 859 and provisions that reference the definition of real property in section 856 and the regulations thereunder. Comments responding to the NPRM were received, and a public hearing on the Proposed Regulations was held on September 18, 2014.

Final Regulations

The Final Regulations follow the Proposed Regulations in defining “real property” to include land and improvements to land—i.e., inherently permanent structures (IPSs) and their structural components. The Final Regulations also follow the Proposed Regulations by providing safe harbor lists of assets and establishing facts and circumstances tests to analyze other assets.

The Final Regulations apply only in determining whether the assets held by a REIT qualify as real property, and provide neither explicit nor implicit guidance regarding whether income derived from such assets is “good” REIT income under sections 856(c)(2) and (3).

Land

Land is treated as real property and includes water and air space superjacent to land, as well as natural products and deposits that are unsevered from the land. The preamble to the Final Regulations clarifies that air space and water space superjacent to land each qualify as land even if the REIT owns only the air space or water space and does not own an interest in the underlying land.

Inherently Permanent Structures

IPSs include permanently affixed buildings and other inherently permanent structures (OIPSs). The Proposed Regulations stated that to qualify as an IPS, a distinct asset must be permanently affixed, and that if the affixation is reasonably expected to last indefinitely based on all the facts and circumstances, the affixation is considered permanent. The Final Regulations retain this requirement, with the preamble clarifying that the IRS and Treasury do not intend the term “indefinitely” to mean “forever.”

The Final Regulations add motels, enclosed stadiums and arenas, and enclosed shopping malls to the “safe harbor” list of assets that are treated as buildings. The IRS and Treasury declined to add outdoor sports stadiums, amphitheaters and unenclosed parking garages to this list; however, the preamble notes that many of these structures would satisfy the definition of an OIPS under the Final Regulations. No additions were made to the safe harbor lists of OIPSs and structural components set forth in the Proposed Regulations.

The Proposed Regulations contained a requirement that an OIPS must serve a passive function, such as to contain, support, shelter, cover or protect, and must not serve an active function, such as to manufacture, create, produce, convert or transport. The Final Regulations retain this requirement and add “provide a conduit or a route” to the list of permitted passive functions. The preamble clarifies that the IRS and Treasury intend the term “transport” to mean to cause to move, rather than to provide a conduit (such as in the case of a pipeline or electrical wire) or route (as in the case of a road or railroad track). The preamble to the Final Regulations also clarifies that the passive function requirement neither prohibits a tenant from using a passive asset, such as an office building, in the tenant’s active business nor limits a REIT’s ability to perform either the permitted services under section 856(d)(7)(C)(ii) or the permitted trustee/director functions under Treas. Reg. section 1.856-4(b)(5)(ii). The IRS and Treasury further state in the preamble that machinery and equipment that may serve both passive and active functions are excluded from the definition of an IPS.

Structural Components

A structural component means any distinct asset that (i) is a constituent part of and integrated into an IPS; (ii) serves the IPS in its passive function; and (iii), 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.

The Proposed Regulations stated that a structural component would not qualify as real property unless the REIT’s interest in the structural component is included with an “equivalent interest” held by the REIT in the IPS to which the structural component is functionally related. The preamble to the Final Regulations states that the IRS and Treasury intended that the “equivalent interest” requirement in the Proposed Regulations ensure that an asset did not qualify as a structural component unless that asset served real property in which the REIT also had an interest. Under the Final Regulations, the REIT is no longer required to hold an “equivalent interest” in the IPS. However, an interest in the IPS is still required. Specifically, the REIT must hold its interest in the structural component together with a real property interest with respect to the space in the IPS that the structural component serves. As such, differing interests (e.g., an ownership interest in the structural component and a leasehold interest in the IPS) are permissible under the Final Regulations.

Distinct Asset

The Final Regulations retain the language in the Proposed Regulations regarding “distinct assets.” To determine whether an asset is land, an IPS or a structural component, it is necessary to test first whether the item of property is a “distinct asset” based on all the facts and circumstances. The IRS and Treasury clarify in the preamble to the Final Regulations that for a distinct asset to be treated as a structural component, a REIT must hold a legally enforceable real property interest in the space in the IPS that the structural component serves, and that a leasehold interest is permissible.

Intangibles

The Proposed Regulations provided that an intangible asset is real property or an interest in real property if the asset 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 IRS and Treasury state in the preamble that intangible assets that are separable from real property or an interest in real property should not qualify as real property. Therefore, the Final Regulations clarify that intangible assets that are related to services and that are separable from the real property do not qualify as real property. The Final Regulations also clarify that an intangible asset, such as a lease, may include an asset that is, in part, an interest in real property and, in part, an asset other than an interest in real property. The Final Regulations include a new example illustrating the application of these rules to an in-place above-market lease that produces income that qualifies as rents from real property under section 856(d)(1) and other non-qualifying income. This example is discussed further below.

Examples

Several examples in the Proposed Regulations involved a REIT that enters into long-term, triple-net leases of property. The Final Regulations revise these examples to refer generally to “leases” (rather than long-term, triple-net leases) and to provide that the REIT neither operates the property nor provides services to the lessee.

Changes to Examples 8, 9 and 10 are particularly relevant to renewable energy and transmission assets and are discussed further below.

Example 11 of the Proposed Regulations addressed whether goodwill established under GAAP as a result of the acquisition of stock of a corporation that owned a hotel qualifies as real property for purposes of sections 856 through 859. The example concluded that such goodwill is real property to the acquiring REIT when it acquires the stock of the corporation. The Final Regulations remove this example, as depreciated replacement cost is no longer the standard under GAAP for valuing property such as the hotel. In its place, the Final Regulations add a new Example 11, which concludes that an in-place above-market lease can be treated as, in part, an interest in real property and, in part, an asset other than an interest in real property.

Effective/Applicability Date

The Final Regulations apply for taxable years beginning after August 31, 2016, although taxpayers may rely on them for quarters that end before this date. In addition, the preamble clarifies that to the extent a previously issued letter ruling is inconsistent with the Final Regulations, the letter ruling is revoked prospectively from the applicability date of the Final Regulations.

Considerations for Renewable Energy and Transmission Assets

Renewable Energy Assets

The Final Regulations are generally consistent with the Proposed Regulations in their treatment of renewable energy assets: smaller-scale renewable energy systems that primarily serve buildings are generally REIT-eligible assets, whereas larger, utility-scale assets are effectively not eligible.

The Final Regulations retain Examples 8 and 9 of the Proposed Regulations, each of which describes solar energy sites.

Example 8 analyzes a solar energy site that includes land, photovoltaic modules (PV modules), mounts and an exit wire. In the example, electricity produced by the PV modules is transmitted to an electrical power grid through which the electricity is distributed for sale to third parties. The example concludes that the exit wire and mounts are both treated as IPSs, but that the PV modules serve an active function (converting solar energy into electricity) and therefore do not qualify as IPSs. Commenters recommended that the example also analyze the treatment of inverters. The IRS and Treasury declined to include such analysis but state in the preamble to the Final Regulations that inverters also perform an active function and do not qualify as IPSs.

Example 9 analyzes a similar solar energy site, except that the solar energy site is mounted on land adjacent to an office building owned by the REIT. The example assumes that although the tenant “occasionally transfers” excess electricity produced by the solar energy site assets to a utility company, the solar energy site assets are designed and intended to produce electricity only to serve the office building. The example concludes that the solar energy site assets are a structural component of the office building, and that this conclusion would not change if, instead of the solar energy site assets, solar shingles were used as the roof of the office building.

A commenter recommended revisions to the facts in Example 9, as most materials used for solar rooftop and other smaller-scale installations are mass-produced and standardized, and can be removed and reinstalled without major complications or damage. Example 9 of the Proposed Regulations stated that the solar energy site assets were designed and constructed specifically for the office building and were intended to remain permanently in place. The Final Regulations revise Example 9 to state that the size and other specifications of the solar energy system were established to serve the needs of the office building and that no facts indicate that the solar energy system will not remain in place indefinitely.

Commenters also requested clarification of the terms “occasionally transfers” and “only serve the office building” in Example 9, given that building-integrated solar assets may generate excess electricity that is fed back into the electric grid and sold to the utility under net energy metering programs. In the preamble to the Final Regulations, the IRS and Treasury state that they are considering whether additional guidance is necessary, but until such additional guidance is issued, the IRS (i) will not treat the transfer of excess electricity as affecting qualification as a structural component; (ii) will treat income resulting from the transfer of such excess electricity as not constituting gross income for purposes of section 856(c)(2) and (3); and (iii) will not treat any net income resulting from the transfer of such excess electricity as constituting net income derived from a prohibited transaction. The IRS and Treasury also state that income earned by a tenant from the sale of renewable energy credits (RECs) would not affect the qualification of the solar energy site as a structural component.

Additional Comments

The IRS and Treasury rejected other comments relevant to renewable energy projects, including the following:

  • Replacing the passive function requirement with a test that focuses on the asset’s human factor, which the commenter defined as whether, and the extent to which, human involvement is needed for an asset to function. The commenter mentioned wind turbines as assets that, when compared to conventional power plants, have a “vastly reduced need for human personnel.” Treasury and the IRS rejected the comment and stated that machinery will not qualify as real property, even if it functions with little or no human involvement.
  • Qualification of “dual use” machinery or equipment, such as solar panels that serve a passive function (to protect buildings and other structures from solar radiation) and an active function (to convert energy for sale to third parties), as an IPS or as a structural component to an IPS. As noted above, Treasury and the IRS believe that such dual-use machinery or equipment does not qualify as an IPS.
  • A safe harbor for structural components that provide utility-like functions. Treasury and the IRS note that several utility-like systems are already included in the safe harbor, but state that they may add other systems to the structural components list through future guidance.
  • Inclusion of the following assets in the safe harbor lists: car charging stations, electrical distribution and redundancy systems, energy storage components, solar PV panels, related wiring and functionally related transformers, power conditioning equipment, electrical power inverters and related wiring, solar energy generating and heating systems and related energy storage equipment, and concentrating solar power systems and associated assets (for example, a parabolic trough system).
  • Treatment of RECs as real property.
  • Treatment of sunlight and wind rights as interests in land.
  • Modification of Example 9 to address wind facilities rather than solar facilities. In the preamble, the IRS and Treasury state that the components of wind facilities may similarly be analyzed as structural components under the relevant facts and circumstances test in the Final Regulations.

The application of the definition of real property under the Final Regulations is limited to sections 856 through 859. As such, tax benefits available to renewable energy projects under other sections of the Code, such as the investment tax credit under section 48 and accelerated depreciation, should not be affected.

Transmission Assets

The Final Regulations are also consistent with the Proposed Regulations in their treatment of transmission systems: although a transmission system may serve an active function (e.g., transporting natural gas), distinct assets within the system, such as pipelines, isolation valves and vents, may nevertheless be REIT-eligible assets.

The Final Regulations retain Example 10 of the Proposed Regulations, which addressed the application of the Proposed Regulations to a pipeline transmission system. The example stated that the pipeline transmission system serves a passive function (containing oil) and an active function (transporting oil). The example further stated that, even though the pipeline transmission system serves an active function, a distinct asset within the system may nevertheless be an IPS if that asset does not perform an active function.

One commenter noted that because the pipeline transmission system is composed of distinct assets, the discussion about whether the entire system performs an active function is not relevant to the analysis in Example 10. In the preamble, Treasury and the IRS state that this discussion is helpful because it demonstrates that a distinct asset within a system may still qualify as an IPS, or a structural component thereof, even though the system serves an active function.

The Final Regulations follow the Proposed Regulations in their inclusion of pipelines in the list of safe harbor assets that are treated as OIPSs. The Final Regulations clarify that the pipelines perform the passive function of providing a conduit, consistent with the addition of “provide a conduit or a route” to the list of permitted passive functions.

The Final Regulations also modify Example 10 so that the pipeline transmission system transports natural gas, rather than oil. One commenter noted that because oil is transported within a pipeline in a liquid state, it is not susceptible to being compressed or vented; as such, the facts of Example 10 in the Proposed Regulations more accurately described a natural gas pipeline transmission system. The Final Regulations incorporate the commenter’s suggestions and change “vents and valves” to isolation valves and vents, pressure control valves, relief valves and pressure regulating stations. Consistent with the Proposed Regulations, the Final Regulations treat these assets as structural components of the pipelines and, therefore, real property.

The Proposed Regulations stated that meters and compressors were not structural components, as they do not serve tanks or pipelines in their passive function of containing oil and are used in connection with the production of income from the sale of transportation of oil, rather than as consideration for the use or occupancy of space within the tanks or pipeline. The Final Regulations modify the example to address a natural gas pipeline transmission system, but otherwise retain the language and conclusion of the Proposed Regulations. Treasury and the IRS clarify in the preamble that the compressors are not structural components because they do not serve the pipelines in their passive function of providing a conduit, but rather cause the natural gas to move through the conduit, which is an active function. Treasury and the IRS also rejected several comments that argued that compressors should be treated as structural components because they (i) are analogous to elevators or escalators that facilitate movement within an IPS, (ii) may be viewed as performing a propelling function and (iii) enable the efficient use of a pipeline.

One commenter suggested that the Final Regulations include an example addressing an electric transmissions and distribution system. Treasury and the IRS rejected the comment, stating in the preamble that the distinct assets of an electric transmission and distribution system are similar in many respects to the distinct assets of the solar energy site addressed in Example 8 and may be analyzed using the standards set forth in the Final Regulations.