PLR 1323016: REIT financing interests in structural improvements qualify as real-estate assets

Plain-English summary

The IRS considered a planned REIT that would finance permanent structural improvements to buildings and other facilities. It ruled that the REIT's interests in those improvements, secured by the improvements and the related real property, would qualify as real-estate assets under section 856. It also ruled that the financing income would qualify as interest on obligations secured by mortgages on real property for the REIT's income tests. The ruling was based on the taxpayer's representations that the improvements were permanent, functionally related to the underlying property, and not business equipment, and that the financing returns were fixed rather than tied to another person's income or profits.

Ruling snapshot

• Question: Do the REIT's interests in financed structural improvements qualify as real-estate assets, and does its related financing income qualify as mortgage interest on real property?
• Outcome: Approved, both requested rulings were granted on the stated facts.
• Key authorities: IRC §§ 856(c)(2), 856(c)(3), 856(c)(5), and 856(f); Treas. Reg. §§ 1.856-3 and 1.856-5

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201323016 Third Party Communication: None
Release Date: 6/7/2013 Date of Communication: Not Applicable
Index Number: 856.00-00
Person To Contact:
-------------------------------------------------- ---------------, ID No. ------------------
-------------------------------------------- Telephone Number:
---------------------------------- ----------------------
-------------- Refer Reply To:
-------------------------------------- CC:FIP:B01
PLR-108050-12
Date: July 30, 2012

Legend:

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

Structural = --------------------------------------------------------------

State = --------------

X = ----

Y = ----

A% = ------

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

This is in reply to a letter dated February 17, 2012, and subsequent submissions and
conversations with your representatives, requesting rulings on behalf of Company
(defined below). You have requested a ruling that (i) the Company's interests in the
Structural Improvements constitute "real estate assets" for purposes of section
856(c)(5)(B) Internal Revenue Code of 1986, as amended (the “Code”); and (ii) the
Company’s interest income from the financing of Structural Improvements qualifies as
interest on obligations secured by mortgages on real property or interests in real
property for purposes of section 856(c)(3) of the Code.

Facts:
PLR-108050-12 2

Company is a “to be formed” State corporation that will elect to be taxed as a real estate
investment trust (“REIT”) for federal income tax purposes. The Taxpayer expects the
Company to finance Structural Improvements secured by the Structural Improvements
and the underlying building or facility. The Structural Improvements are long lived
permanent improvements to buildings or facilities that are designed to improve the -------
------------------------- --- the building or facility. Some larger Structural Improvements may
be constructed as a separate structure adjacent to a building or facility and connected,
with ---------------------------------------------------. The Structural Improvements are intended
solely for the use of the building or facility and it is not the purpose of the Structural
Improvements to operate a business or ----------------or other products to a third party.
The Structural Improvements are located on the building or facility owner’s real
property, are necessary for the building or facility to function and would be included in
the mortgage and/or sale if the real property was financed or sold.

In a typical financing, the owner of a building or facility (the “Owner”) enters into a
contract (“Contract”) with a contractor (the “Contractor”) for the installation of the
Structural Improvements. The Contractor is also responsible for soliciting financing
bids. The Contract establishes a payment schedule from the Owner and a security
interest in the installed Structural Improvements for the third party financier. Upon
completion of the construction, the Owner accepts the project and takes legal title to the
Structural Improvements, subject to the security interest granted to the third party
financier.1

Currently, Taxpayer bids to provide the financing for these Contracts and, if successful,
finalizes various financing terms including interest rate, amortization schedule, security
interest and term of the financing (averaging over X years, but as long as Y years).
Taxpayer is assigned the payment stream due under the Contract. Under the terms of
the financing, the Contractor is prohibited from modifying the underlying Contract in a
way that would impact the payment stream assigned to the Taxpayer and the
Contractor is required to file any claims or appeals on behalf of the Taxpayer. The
Contract may provide a warranty on the Structural Improvements or, in some cases, a
guarantee ------------------------------. The Contractor holds Taxpayer harmless for any
warranty or guarantee claims. To date the Taxpayer’s collections on these warranty or
guarantee claims have been less than A% of total financings. In the absence of default
by the Owner under the Contract, Taxpayer’s return on any particular Contract is fixed
and determinable.

Some contracts include an ongoing obligation to operate and maintain the --------------- in
good working order for a defined period of time in exchange for a separate payment
stream. The Taxpayer does not provide any services, retain any rights to the separate
payment, or share in any of the Contractor’s profit or losses from the Contracts.

1
In some cases, the Contractor retains nominal title until the Contract payments are made.
PLR-108050-12 3

Moreover, the Taxpayer does not have any joint venture or partnership relationship with
the Contractors and all financings are conducted on an arm’s-length basis.

Taxpayer is the beneficial owner of a trust (“Trust”), which is treated as a disregarded
entity, through which most of the Taxpayer’s Contract financing activities are
undertaken. Taxpayer typically assigns all of its rights under a Contract to the Trust.
The Trust issues notes to third party investors (“Investor Notes”). There is typically a
difference on the interest rates on the financing under the Contract and the Investor
Notes, this difference is retained by the Taxpayer as owner of the Trust.

Taxpayer intends to form the Company, which will elect to be taxed as a REIT, to which
it will contribute its beneficial interest in the Trust, together with other assets. The
Taxpayer expects the Company to raise equity in the capital markets, and use the funds
raised to purchase some of the then outstanding Investor Notes and purchase other
assets. Going forward, the Company (directly or through one or more trusts or
subsidiaries) will continue the activity of providing Contract financing to the Contractors.

The Taxpayer represents that the Company (directly or through one or more trusts or
subsidiaries) will in each case have a valid security interest that, in the case of default
by the owner, provides the holder with the rights of a secured party ---------------------------
-------------------------, including the right to bring a foreclosure action with respect to the
Structural Improvements and the real property into which the Structural Improvements
have been installed.

Law and Analysis:

Issue 1 - Real Estate Assets

Section 856(c)(5)(B) of the Code defines the term “real estate assets”, in part, to mean
real property (including interests in real property and interests in mortgages on real
property) and shares (or transferable certificates of beneficial interest) in other REITs.
Section 856(c)(5)(C) of the Code provides that the term “interests in real property”
includes fee ownership and co-ownership of land or improvements thereon, leaseholds
of land or improvements thereon, options to acquire land or improvements thereon, and
options to acquire leaseholds of land or improvements thereon, but does not include
mineral, oil, or gas royalty interests.

Section 1.856-3(b)(1) of the Income Tax Regulations provides that the term “real estate
assets” means real property, interests in mortgages on real property (including interests
in mortgages on leaseholds of land or other improvements thereon), and shares in other
qualified REITs. The term “mortgages on real property” includes deeds of trust on real
property.
PLR-108050-12 4

Section 1.856-3(c) provides that the term “interests in real property” includes fee
ownership and co-ownership of land or improvements thereon, leaseholds of land or
improvements thereon, options to acquire land or improvements thereon, and options to
acquire leaseholds of land or improvements thereon.

Section 1.856-3(d) provides that the term “real property” means land or improvements
thereon, such as buildings or other inherently permanent structures thereon (including
items that are structural components of those buildings or structures). In addition, real
property includes interests in real property. Local law definitions do not control for
purposes of determining the meaning of the term real property as used in section 856 of
the Code and the regulations thereunder. The term includes, for example, the wiring of
a building, plumbing systems, central heating or central air-conditioning machinery,
pipes or ducts, elevators or escalators installed in the building, or other items that are
structural components of a building or other permanent structure. The term does not
include assets accessory to the operation of a business, such as machinery, printing
press, transportation equipment that is not a structural component of the building, office
equipment, refrigerators, individual air-conditioning units, grocery counters, furnishings
of a motel, hotel, or office building, etc., even though those items may be termed
fixtures under local law.

Rev. Rul. 75-424, 1975-2 C.B. 270, concerns whether various components of a
microwave transmission system are real estate assets for purposes of section 856 of
the Code. The system consists of transmitting and receiving towers built upon pilings or
foundations, transmitting and receiving antennae affixed to the towers, a building,
equipment within the building, and waveguides. The waveguides are transmission lines
from the receivers or transmitters to the antennae, and are metal pipes permanently
bolted or welded to the tower and never removed or replaced unless blown off by
weather. The transmitting, multiplex, and receiving equipment is housed in the building.
Prewired modular racks are installed in the building to support the equipment that is
installed upon them. The racks are completely wired in the factory and then bolted to
the floor and ceiling. They are self-supporting and do not depend upon the exterior walls
for support. The equipment provides for transmission of audio or video signals through
the waveguides to the antennae. Also installed in the building is a permanent heating
and air conditioning system. The transmission site is surrounded by chain link fencing.
The revenue ruling holds that the building, the heating and air conditioning system, the
transmitting and receiving towers, and the fence are real estate assets. The ruling holds
further that the antennae, waveguides, transmitting, receiving, and multiplex equipment,
and the prewired modular racks are assets accessory to the operation of a business
and therefore not real estate assets.

Rev. Rul. 73-425, 1973-2 C.B. 222, considers four situations where a trust owns a
mortgage interest in a total energy system. A total energy system is a self-contained
facility for the production of all the electricity, steam or hot water, and refrigeration
needs of associated commercial or industrial buildings, building complexes, shopping
PLR-108050-12 5

centers, apartment complexes, and community developments. The system may be
permanently installed in the building, attached to the building, or it may be a separate
structure nearby. The principal components consist of electric generators powered by
turbines or reciprocating engines, waste heat boilers, heat exchangers, gas-fired
boilers, and cooling units. In addition, each facility includes fuel storage tanks, control
and sensor equipment, electrical substations, and air handling equipment for heat, hot
water, and ventilation. It also includes ducts, pipes, conduits, wiring, and other
associated parts, machinery and equipment.

In situation 1, the trust made a loan for the purpose of constructing a total energy
system which is permanently installed in the building which it serves. In return, the trust
received an obligation secured by a mortgage covering the total energy system.

In situation 2, the facts are the same as in situation 1 except that the obligation received
by the trust is secured by a mortgage covering not only the total energy system, but also
the building served by the system. The terms of the mortgage interest in the facilities
are the same as the terms of the mortgage interest in the building served by the total
energy system.

In situation 3, the facts are the same as in situation 2 except that the total energy
system is housed in a separate structure apart from the building which it serves.

In situation 4, a bank advanced permanent mortgage financing covering 80 percent of
the cost of construction of a shopping center complex, including the total energy
system. The bank received a mortgage covering the entire shopping center project,
including the total energy system. The trust purchased an undivided 50 percent interest
in the mortgage note held by the bank. The terms of the mortgage interest in the total
energy system are the same in every respect as the terms of the mortgage interest in
the buildings served by the total energy system.

Rev. Rul. 73-425 held that: (1) the mortgage in situation 1 does not qualify as a real
estate asset within the meaning of section 856(c)(6)(B) of the Code since the mortgage
is secured only by the total energy system; (2) the mortgage in situations 2 and 3 qualify
as real estate assets within the meaning of section 856(c)(6)(B) of the Code; and (3) as
to the trust, the undivided 50 percent interest in the mortgage in situation 4 qualifies as
a real estate asset within the meaning of section 856(c)(6)(B) of the Code.

Similar to the properties or structural components described in Rev. Rul. 75-424 and
Rev. Rul. 73-425 that qualify as real property for purposes of section 856 of the Code,
the Structural Improvements described above are inherently permanent structures and
not assets accessory to the operation of a business like the examples set forth in
section 1.856-3(d). Therefore, the Structural Improvements that are structural
components of real property are also real property.
PLR-108050-12 6

Rev. Rul. 73-425 holds, in part, that a mortgage secured by the building and the total
energy system is a real estate asset regardless of whether the system is housed in the
building it serves or is housed in a separate structure apart from the building it serves.
This is because the interest in a structural component is included with an interest held in
a building or inherently permanent structure to which the structural component is
functionally related. In this case, the Company’s interest will be secured by the
Structural Improvements and the real property into which the Structural Improvements
have been installed.

The Taxpayer has represented that the Company will in each case have a valid security
interest that, in the case of default, provides the holder with the rights of a secured party
--------------------------------------------------, including the right to bring a foreclosure action
with respect to the Structural Improvements and the real property into which the
Structural Improvements have been installed. The security interest in the Structural
Improvements (and the building or facility in which they are installed as structural
components) are conveyed at the time of financing to secure payments under the
financing. Therefore, the Company’s interests in the Structural Improvements constitute
interests in mortgages on the Structural Improvements and the real property into which
the Structural Improvements have been installed.

Accordingly, based on the information submitted and representations made, we
conclude that the Company’s interests in the Structural Improvements constitute “real
estate assets” for purposes of section 856(c)(5)(B) of the Code.

Issue 2 - Interest on Obligations Secured by Mortgages on Real Property

Section 856(c)(2) of the Code provides that at least 95 percent of a REIT's gross
income must be derived from, among other sources, “interest.”

Section 856(c)(3) of the Code provides that at least 75 percent of a REIT's gross
income must be derived from, among other sources, “interest on obligations secured by
mortgages on real property or on interests in real property.”

Section 856(f) of the Code provides, in part, that the term “interest” excludes any
amount received or accrued, directly or indirectly, if the determination of such amount
depends in whole or in part, on the income or profits of any person except that any
amount so received or accrued will not be excluded from the term “interest” solely by
reason of being based on a fixed percentage or percentage of receipts or sales.

Section 1.856-5(c)(1) provides that where a mortgage covers both real and other
property an apportionment of the interest income must be made for purposes of the 75-
percent requirement.
PLR-108050-12 7

Section 1.856-5(c)(2) provides, in part, that the loan value of the real property is the fair
market value of the property, determined as of the date on which the commitment by the
trust to make the loan becomes binding on the trust. However, in the case of a
construction loan or other loan made for purposes of improving or developing real
property, the loan value of the real property is the fair market value of the land plus the
reasonably estimated cost of the improvements or developments (other than personal
property) which will secure the loan and which are to be constructed from the loan
proceeds of the loan. The fair market value of the land and the reasonably estimated
cost of improvements or developments shall be determined as of the date on which a
commitment to make the loan becomes binding on the trust.

Here, the Company will have a loan secured by the Structural Improvements and the
real property in which it is installed. The payments under the financing are not
contingent on any further action by the Company and are not determined by the income
or profits of any other person but rather as compensation for the use or forbearance of
money. Therefore, interest income from the financing of Structural Improvements
qualifies as interest on obligations secured by mortgages on real property or interests in
real property within the meaning of section 856(c)(3)(B) of the Code.

                                  CONCLUSION

Based on the facts as represented, we rule that:

(i) the Company's interests in the Structural Improvements constitute "real estate
assets" for purposes of Section 856(c)(5)(B) of the Code; and
(ii) the Company’s interest income from the financing of Structural Improvements
qualifies as interest on obligations secured by mortgages on real property or
interests in real property for purposes of section 856(c)(3) of the Code.

No opinion is expressed or implied as to the federal income tax consequences of this
transaction under any provision not specifically addressed herein. Specifically, no
opinion is expressed or implied whether the Structural Improvements constitute real
property under any section of the Code other than section 856. Furthermore, no opinion
is expressed concerning whether Company otherwise qualifies as a REIT under
subchapter M, part II of Chapter 1 of the Code.
PLR-108050-12 8

This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) of the
Code provides that it may not be used or cited as precedent. In accordance with the
Power of Attorney on file with this office, a copy of this letter is being sent to your
authorized representative.

                                  Sincerely,

                                  Diana Imholtz
                                  Diana Imholtz
                                  Branch Chief, Branch 1
                                  Office of Associate Chief Counsel
                                  (Financial Institutions & Products)