PLR 1033022: IRS approved a REIT's foreclosure-property election and lodging-facility rent treatment

Plain-English summary

The IRS ruled that a real estate investment trust could treat a resort property acquired after a tenant defaulted as foreclosure property. The REIT's acquisition or lease of related resort property and acquisition of associated personal property would not count as construction that ended the foreclosure-property status. The IRS also ruled that the resort, including customary amenities, was a qualified lodging facility. Because a taxable REIT subsidiary would lease and operate the combined resort through an eligible independent contractor, the rents paid to the REIT would qualify as rents from real property under IRC § 856(d)(8).

Ruling snapshot

• Question: Would the REIT's related resort acquisitions affect its foreclosure-property election, and would rents from leasing the combined resort to a taxable REIT subsidiary qualify as rents from real property?
• Outcome: Approved
• Key authorities: IRC § 856(c), (d), and (e); Treas. Reg. § 1.856-6

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201033022 Third Party Communication: None
Release Date: 8/20/2010 Date of Communication: Not Applicable
Index Number: 856.05-02, 856.04-00
Person To Contact:
---------------------------------------------------- --------------------------, ID No. ----------------
--------------------------------------- -----------------
---------------------------------------- Telephone Number:
------------------------------------ ---------------------
----------------------------------------- Refer Reply To:
CC:FIP:3
PLR-150800-09
Date:
May 04, 2010

Legend:

Taxpayer = -----------------------------------------

State X = ------------

Date 1 = --------------------------

Date 2 = -------------------

Date 3 = --------------------------

Resort = -----------------------------

a = -----

b = --------

c = ---------

d = -----

e = -----

f = ----

g = --

h = -----

Tenant = ------------------------------------------------------

Tenant Affiliate = --------------------------------

Year 1 = -------

Dear -----------------:

   This is in reply to a letter dated November 13, 2009, in which Taxpayer requests

a ruling concerning an election to treat certain property owned by Taxpayer as
foreclosure property pursuant to § 856(e) of the Internal Revenue Code. In addition,
Taxpayer requests a ruling that certain property owned by Taxpayer represents an
interest in a “qualified lodging facility” as that term is defined in § 856(d)(9)(D).

Facts:

   Taxpayer is a State X Corporation that elected to be taxed as a Real Estate

Investment Trust (REIT) for its tax year ended Date 1. Taxpayer is engaged in the
business of owning and investing in a diversified portfolio of real estate investments.
Taxpayer primarily invests in ---------- properties located in the United States and abroad
and generally leases the properties on a long term basis to tenants or operators who are
significant industry leaders.

    On Date 2, Taxpayer acquired the lodging and ski areas of Resort (the Resort

Property). The Resort Property includes a four season hotel, an inn, and a lodge
(collectively, the Lodging Facilities). The Lodging Facilities provide a rooms for lodging.
Other facilities and amenities acquired as part of the Resort Property include a
freestanding b square-foot restaurant, a c square-foot ski lodge and a d-acre ski area
that includes e acres, f miles of groomed trails, and g chairlifts.

     Upon acquisition of the Resort Property, Taxpayer entered into two long-term,

triple-net leases with Tenant. Tenant engaged a resort management company to
operate the Resort Property. At the time Taxpayer acquired the Resort Property, an
entity affiliated with Tenant, Tenant Affiliate, acquired the remaining h acres of the
Resort. These h acres included two golf courses, equestrian stables, a golf
clubhouse/ski center, a sports club, utilities, and other undeveloped land (Tenant
Affiliate Resort Property). Tenant Affiliate provided guests of the Lodging Facilities with
access to all of the facilities and amenities included in the Tenant Affiliate Resort
Property. The Resort Property and Tenant Affiliate Resort Property were operated and
offered to the public as a single resort destination.

   Tenant defaulted on its lease, and on Date 3, Taxpayer terminated Tenant’s

lease and took possession of the Resort Property. In order to continue to allow guests
of the Lodging Facilities to use all of the Resort’s amenities, Taxpayer intends to either
acquire or lease the Tenant Affiliate Resort Property from Tenant Affiliate. As part of

the lease termination, Taxpayer also acquired from Tenant Affiliate the following assets,
all of which have always been used in connection with the operation of the Resort
(Tenant Affiliate Assets): 1) lease on overflow parking lot used in winter; 2) lease for
golf course clubhouse used for ski operations during winter; 3) lease on office space
used for overflow sales/marketing; 4) snowmaking ponds; 5) land and improvements;
6) equipment.

   Taxpayer intends to make an election pursuant to Treas. Reg. § 1.856-6(c), on or

before the due date of Taxpayer’s Year 1 income tax return, to treat the Resort Property
as “foreclosure property” under § 856(e). Taxpayer does not intend to consider any
income derived from the Tenant Affiliate Resort Property or from the Tenant Affiliate
Assets as income derived from foreclosure property for purposes of § 856(e).

   Taxpayer further intends to form a new taxable REIT subsidiary (“TRS”) and will

lease the Resort Property and Tenant Affiliate Resort Property to the TRS. The TRS
will engage an eligible independent contractor to operate and manage both the Resort
Property and Tenant Affiliate Resort Property, so that the Resort can continue to
operate as a single unified property.

   Taxpayer represents that the amenities included in both the Resort Property and

Tenant Affiliate Resort Property are customary amenities for other properties of a similar
size and class.

Law and Analysis:

Issue 1:

  Section 856(c)(2) provides that at least 95 percent of a REIT's gross income

must be derived from, among other sources, rents from real property.

  Section 856(c)(3) provides that at least 75 percent of a REIT's gross income

must be derived from, among other sources, rents from real property.

   Section 856(e) provides that the term “foreclosure property” means any real

property (including interests in real property), and any personal property incident to such
real property, acquired by the REIT as the result of such trust having bid on such
property at foreclosure, or having otherwise reduced such property to ownership or
possession by agreement or process of law, after there was a default (or default was
imminent) on a lease of such property or on an indebtedness which such property
secured.

 Under section 856(e)(5), property is treated as foreclosure property only if a REIT

makes an election to treat it as such prior to the due date for the REIT’s tax return for

the taxable year in which it acquires such property upon default or as a result of the
imminence of default.

   Section 856(e)(4)(B) provides that any foreclosure property shall cease to be

such on the first day (occurring on or after the day on which the REIT acquired the
property) on which any construction takes place on such property (other than
completion of a building, or completion of any other improvement, where more than 10
percent of the construction of such building or other improvement was completed before
default became imminent).

  Section 1.856-6(b)(1) provides that foreclosure property which a REIT owned

and leased to another is acquired for purposes of § 856(e) on the date on which the
REIT acquires possession of the property from its lessee.

   Section 1.856-6(b)(2) provides that personal property (including personal

property not subject to a mortgage or lease of the real property) will be considered
incident to a particular item of real property if the personal property is used in a trade or
business conducted on the property or the use of the personal property is otherwise an
ordinary and necessary corollary of the use to which the real property is put.

   Section 1.856-6(e)(1) provides that under § 856(e)(4)(B), all real property (and

any incidental personal property) for which a particular election has been made shall
cease to be foreclosure property on the first day (occurring on or after the day on which
the trust acquired the property) on which any construction takes place on the property,
other than completion of a building (or completion of any other improvement) where
more than 10 percent of the construction of the building (or other improvement) was
completed before default became imminent.

   Section 1.856-6(e)(2) notes that construction includes the renovation of a

building, such as the remodeling of apartments, or the conversion of apartments into
condominiums. Direct costs of construction include amounts paid for labor and for
building materials and supplies consumed. Section 1.856-6(e)(5) provides that
construction does not include repair and maintenance of a building or other
improvement. Architect’s fees, administrative costs of the developer or builder, lawyers’
fees and expenses incurred in connection with obtaining zoning approval or building
permits are not direct costs of construction.

    The legislative history of § 856(e) reflects a concern to provide relief for situations

where a REIT inadvertently acquires property on foreclosure and risks becoming
disqualified involuntarily or taking action which is not economically sensible to remain
qualified. S. Rep. No. 93-1357, at 11 (1974). Under the foreclosure rules, a REIT will
be able to complete construction of a project where there has been so much
construction that it would be difficult to dispose of the property unless the project is

completed. Id. at 14. This is necessary for a REIT to make a project economically
viable and for the REIT to preserve its investment. Id.

   Although the term “construction” is not expressly defined in either § 856(e) or the

regulations thereunder, the terminology used in the regulations indicates that the term
should be given its ordinary meaning. In the instant case, Taxpayer is not performing
any construction within the ordinary meaning of the term. For example, Taxpayer has
not incurred expenses for building materials or supplies, nor has Taxpayer engaged in
building remodeling or renovations.

    In this case, Taxpayer is merely acquiring or leasing additional real property or

acquiring personal property incident to such real property previously used in connection
with the Resort to protect its investment. Without these acquisitions, the value of the
Resort would decrease because guests of the Lodging Facilities would be denied
access to many of the amenities customary for a resort of this size and class. This
result would be contrary to the legislative intent that led to the enactment of § 856(e).
The acquisition or lease of the Tenant Affiliate Resort Property and the acquisition of the
Tenant Affiliate Assets supplement the use of the Lodging Facilities and are necessary
for the Lodging Facilities to be utilized in the manner intended. Therefore, Taxpayer’s
acquisition or lease of the Tenant Affiliate Resort Property and the acquisition of the
Tenant Affiliate Assets do not fit within the definition of “construction” and do not affect
the status of Taxpayer’s foreclosure property election.

Issue 2:

  Section 856(c)(2) provides that at least 95 percent of a REIT's gross income

must be derived from, among other sources, rents from real property.

  Section 856(c)(3) provides that at least 75 percent of a REIT's gross income

must be derived from, among other sources, rents from real property.

   Section 856(d)(2) excludes certain amounts from the definition of rents from real

property. Specifically, except as provided in § 856(d)(8), § 856(d)(2)(B) provides that
the term does not include any amount received or accrued directly or indirectly from a
corporation if the REIT owns, directly or indirectly, stock of such corporation possessing
10 percent or more of the total combined voting power of all classes of stock entitled to
vote, or 10 percent or more of the total value of shares of all classes of stock of such
corporation.

 Section 856(d)(8) provides that in certain situations, amounts paid to a REIT by a

TRS shall not be excluded from the definition of rents from real property.

  Section 856(d)(8)(B) provides that the requirements of § 856(d)(8) are met with

respect to an interest in real property which is a qualified lodging facility (as defined in

§ 856(d)(9)(D)) leased by a REIT to a TRS of the REIT if the property is operated on
behalf of such subsidiary by a person who is an eligible independent contractor.

     Section 856(d)(9)(A) provides that the term “eligible independent contractor”

means, with respect to any qualified lodging facility, any independent contractor if, at the
time such contractor enters into a management agreement or similar service contract
with the TRS to operate such qualified lodging facility, such contractor (or any related
person) is actively engaged in the trade or business of operating qualified lodging
facilities for any person who is not a related person with respect to the REIT or the TRS.

     Section 856(d)(9)(D) defines the term “qualified lodging facility” to mean any

lodging facility (unless wagering activities are conducted at or in connection with such
facility), and the term “lodging facility” means a 1) hotel, 2) motel, or 3) other
establishment more than one-half of the dwelling units in which are used on a transient
basis.

     Section 856(d)(9)(D)(iii) provides that the term “lodging facility” includes

customary amenities and facilities operated as part of, or associated with, the lodging
facility so long as such amenities and facilities are customary for other property of a
comparable size and class owned by other owners unrelated to such REIT.

     The Resort Property and the Tenant Affiliate Resort Property, comprising the

entire Resort, include the Lodging Facilities as well as supplementary amenities and
facilities that are customary for other properties of similar size and class. Therefore,
both properties together meet the definition of a qualified lodging facility.

   The Resort Property and the Tenant Affiliate Resort Property will together be

operated as the Resort by a single eligible independent contractor. Consequently, rents
paid by the TRS to Taxpayer with respect to the lease of the Resort Property and
Tenant Affiliate Resort Property qualify as rents from real property under § 856(d)(8).

   Except as specifically ruled upon above, no opinion is expressed concerning any

federal income tax consequences relating to the facts herein under any other provision of
the Code. Specifically, we do not rule whether Taxpayer otherwise qualifies as a REIT
under subchapter M of Chapter 1 of the Code. Nor do we rule on whether any party acting
as an eligible independent contractor qualifies as such for purposes of § 856(d).

  This ruling is directed only to the taxpayer requesting it. Taxpayer should attach

a copy of this ruling to each tax return to which it applies. Section 6110(k)(3) of the
Code provides that this ruling may not be used or cited as precedent.

                                 Sincerely,

                                 Alice M. Bennett___________________________
                                 Alice M. Bennett
                                 Chief, Branch 3
                                 Office of Associate Chief Counsel
                                 (Financial Institutions and Products)