The Evolution of a REIT Rule: Impermissible Tenant Service Income Akin Gump Strauss Hauer & Feld LLP

Of course, this assumes the corporation is not otherwise disqualified (for reasons previously discussed). The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting or tax advice or opinion provided by Ernst & Young LLP to the reader. The reader also is cautioned that this material may not be applicable to, or suitable for, the reader’s specific circumstances or needs, and may require consideration of non-tax and other tax factors if any action is to be contemplated. The reader should contact his or her Ernst & Young LLP or other tax professional prior to taking any action based upon this information. Ernst & Young LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein. While the 100 shareholder test can be easily administered, the 5/50 test requires a significant diversification of ownership that often deters owners that own a majority stake in real estate.

  1. Accordingly, the IRS ruled that Taxpayer’s provision of the Listed Services will not cause otherwise qualifying amounts received by Taxpayer to be excluded from rents from real property under IRC Section 856(d).
  2. This way the REIT has a better understanding of the type of income being generated and can plan a cure by year-end so there is enough qualifying income to pass the income tests.
  3. All of the real estate income from the 75 percent test qualifies for the 95 percent test.
  4. Stradley Ronon represented Bristol, PA-based United Packaging, a leading distributor of high-quality packaging, shipping, safety and janitorial supplies in its acquisition by Envoy Solutions.
  5. What might be considered a customary service in Los Angeles might not be considered customary in Chicago.

At least 75 percent of a REIT’s gross income must be derived from rents from real property, interest on obligations secured by mortgages on real property, dividends from other REITs, and gain from the sale or other disposition of real property. Rents from real property is defined to include rents; charges for services customarily furnished in connection with rental of real property; and generally rent attributable to personal property which is leased in connection with a lease of real property. Impermissible tenant service income is excluded from rents from real property. A taxable REIT subsidiary (TRS) is primarily used to allow the REIT to provide otherwise non-qualifying services. Under IRC Section 856(d)(2)(C), ITSI is excluded from the definition of « rents from real property. » IRC Section 856(d)(7)(A) defines ITSI as any amount received or accrued by a REIT for services furnished or rendered to tenants or for managing or operating the property. ITSI does not include (1) payments for services, management or operation provided through an IK or a TRS or (2) any amount that would be excluded from unrelated business taxable income (UBTI) under IRC Section 512(b)(3) if received by an organization described in IRC Section 511(a)(2) (IRC Section 856(d)(7)(C)).

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Extensions may be granted if the TRS entity acted reasonably and in good faith, but the related process can be costly and time consuming and should only be considered as a last result. Furthermore, if a TRS acquires more than 35%, by vote or value, of the stock of another corporation, the acquired corporation is also considered a TRS and the REIT and existing TRS should file an updated copy of Form 8875 to include the new subsidiary TRS. The TRS election is generally irrevocable unless written consent is provided by both the REIT and TRS via the filing of a “revocation” Form 8875.

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Section 1.512(b)-1(c)(5), payments for the use or occupancy of rooms and other spaces where services are rendered to the occupant, such as in hotels, boarding houses, tourist camps, parking lots, warehouses, storage garages, etc., do not constitute rent from real property. Services are generally considered rendered to an occupant if they are primarily for the occupant’s convenience and are not usually or customarily rendered in connection with renting rooms or other spaces for occupancy only. IRC Section 856(c)(2) requires a REIT to derive at least 95% of its gross income from specified sources of passive income, including rents from real property.

By way of background, the TRS was introduced by the Tax Relief Extension Act of 1999 to provide REITs with additional flexibility. Since a REITs income must be primarily from passive real estate investments, the TRS was created to perform activities that cannot be performed directly by the REIT without jeopardizing REIT status. Almost two decades after the introduction of the TRS, these corporations are now commonly embedded in REIT structures. The second question is aimed at determining if the service is so specialized that it is outside the scope of basic services that need to be provided as part of an operational building. Of course, each building needs to provide basic services to its tenants such as electricity, water, HVAC, telecom, trash collection, etc.

By Service

The REIT’s ownership (which must be proven by transferable shares or by transferable certificates of beneficial interest) must be held by at least 100 shareholders for at least 335 days of a 365-day calendar year (or equivalent thereof for a short tax year) for the second taxable year and beyond. While REITs differentiate themselves through various characteristics, all REITs must follow the same regulations under federal tax law. Excellent lawyers who also understand your business, anticipate developments in your industry, help you manage your budget and staffing needs, connect you with business opportunities, partner with you on community outreach and giving, and assist in educating your staff are a considerably rarer breed. Stradley Ronon represented Customers Bank, the primary subsidiary of Customers Bancorp, Inc.

On March 31, 2021, President Biden introduced The American Jobs Plan (the Jobs Plan) which proposes raising the corporate tax rate to 28%. IKs will offer certain services (Third-Party Services) directly to tenants at certain Properties, and tenants will directly compensate the IKs. Specifically, a bicycle attendant will assist tenants with minor repairs and maintenance of their bicycles in the Designated Storage Areas, and IKs at staffed Fitness Centers may offer additional services, such as personal training or massages, for additional fees. Clients receive concierge service because every client is important in a firm our size.

Related Services

Taxpayer represented that the Listed Services are customarily furnished or arranged by landlords in connection with leasing space in Class A office buildings in the city in which the Properties are located and are not personal services rendered to any particular tenant. A user must pay for a specified minimum volume commitment per month even if it uses less than its entire reserved capacity. For each agreement, the https://turbo-tax.org/ rent for the leased personal property (e.g., pumps, compressors, meters) is 15% or less of the total rent for the real and personal property leased under that agreement. The first question is a two part question that depends on what is considered a customary service and what is considered the geographic region. What might be considered a customary service in Los Angeles might not be considered customary in Chicago.

As noted earlier, REITs are required to distribute at least 90 percent of their taxable income to shareholders. REITs simplify state tax reporting for individuals since the state income tax consequences and filing requirements of multistate real estate portfolios do not pass through the REIT to the investor. The shareholders simply recognize dividend income impermissible tenant service income and pay tax in their state of residence. Rents derived from a related party or impermissible tenant services (described below) are also excluded. A tenant is considered a related party if the REIT owns 10 percent or more of the assets or net profits (for non-corporate entities) or 10 percent or more of the voting power or value (for a corporation).

All of the real estate income from the 75 percent test qualifies for the 95 percent test. This can most often be seen in retail properties when a portion of a tenant’s rent is fixed, and the other portion varies based on the net profits of the store that occupies the space. Conversely, the sharing of gross profits between tenants and the REIT is acceptable. Similar rules regarding fixed and variable rate mortgages also apply to interest income for mortgage REITs. For purposes of this limited rental exception, the IRS ruled that the relevant « property » with regard to Taxpayer’s fiber optic cable is the continuously connected fiber optic cable within the geographic boundaries of the applicable Area. With the increasing popularity of REITs and based on the increasingly service-oriented nature of the real estate assets, a TRS can be an effective structuring option to ensure a REIT maintains its REIT status.

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In its analysis, the IRS first noted that, when determining if impermissible tenant service income exists, only the income that is attributable to a provision of a service is analyzed. Although services may be provided in the Facilities, the IRS explained that the Facilities themselves are not services. Thus, income that is attributable to making the Facilities available to all tenants at no additional cost is not income from the provision of a service and is therefore not impermissible tenant service income. Any services that are provided in or with respect to the Facilities, however, are analyzed as any other service provided to tenants.

Property managers are typically the best source of market information, as typical and customary services vary not only across regions but across property types. Under Section 856(c)(2), a REIT must derive at least 95% of its gross income from certain categories of income, including rents from real property. Under Section 856(c)(3), a REIT must derive at least 75% of its gross income from certain sources, including rents from real property.

A customary service for an office building might not be considered a customary service in a residential setting. Additionally, the geographic region in New York City may be a few blocks versus a geographic region in Texas of a few square miles. After making these determinations, if the service is not customary in the geographic region, the service must be provided through a 3rd party independent contractor or TRS. If the service is customary in the geographic region, move on to the second question. By nature, a Real Estate Investment Trust, or REIT, is meant to hold a passive investment in real estate and receive rental income.

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