REITs & UPREIT Partnerships: Current Planning and Structuring Issues

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REITs & UPREIT Partnerships: Current Planning and Structuring Issues

by Lary S. Wolf

Published: November 15, 1995

Source: NYU 53rd Institute on Federal Taxation

REITs Today -- New Concepts -- New Uses -- New Issues

Statistical data evidences an overwhelming interest in real estate investment trusts ("REITs"). During the first eight months of 1994 thirty-seven REIT IPOs raised more than $6 billion and during the last nine months more than twelve new real estate funds have been initiated to invest in REITs. .⁽¹⁾

In early September, Bankers Trust revealed that it is developing a derivative financial product based on an index of publicly traded REITs. The objective is to isolate the real estate element in REIT shares from the stock market element through a technique that involves buying a broad portfolio of REIT shares and taking a short position on a broad range of non-real estate stocks having similar capitalizations. The result is a derivative product that should trace the real estate market but stand independent of stock market trends. This product would, among other things, give investors the opportunity to better diversify their portfolios and give a boost to the REIT market by expanding its investor base. While fascinating for its nontax implications, this derivative concept is beyond the scope of this article.

At the forefront of the REIT ground swell is an innovation called the umbrella partnership real estate investment trust ("UPREIT"). In the classic REIT format, the REIT owns real property directly. While this format has the advantage of simplicity, under Section 351(e)⁽²⁾ sponsors cannot avoid recognition of gain when appreciated property is contributed to the REIT. The UPREIT was developed as a response to this problem. Under the UPREIT format, instead of contributing properties directly to a REIT, the sponsors contribute properties and the REIT contributes cash to an umbrella partnership in exchange for partnership interests. The REIT's cash is used to pay down debt, make improvements, acquire properties, and/or provide working capital.

Under Section 721, and subject to the discussion in Section 11.03 below, the sponsors do not realize gain upon contribution of properties to the UPREIT.⁽³⁾ However, the sponsors have the right to convert their partnership interests into REIT shares, at which time any built in gain may be realized. After formation, the umbrella partnership may acquire additional properties on an ongoing basis without causing gain recognition to the owner by having the owner contribute the property to the umbrella partnership in return for a partnership interest.

Review of Reit Rules

UPREIT's involve many interesting partnership tax issues as well as all of the usual REIT issues. The following is a brief summary of the basics about REITs.

Tax Characterization of REITs

A REIT is a domestic corporation (or a trust or association taxable as a domestic corporation) which meets specified requirements regarding organizational structure and ownership, sources of income, types of assets, distributions, and miscellaneous other items.⁽⁴⁾ Entities which qualify as REITs are exempt from the regular corporate income tax⁽⁵⁾ but are subject to tax at regular corporate tax rates on a separate income base defined in Section 857(b)(2) and (3). Under these provisions, this tax base -- "real estate investment trust taxable income" -- is defined as, in general, the REIT's taxable income with certain adjustments, of which the most important is the allowance of a deduction for dividends paid. This deduction effectively eliminates the corporate level tax.

Organizational Structure and Ownership

The shares or certificates of beneficial interest issued by any corporation, trust, or association intended to qualify as a REIT must be transferable and must be held by 100 or more persons during at least 335 days of a 12-month taxable year (or a proportionate part of any shorter taxable year).⁽⁶⁾ In addition, the entity cannot be closely held, i.e., have more than 50 percent of its stock (by value) owned, directly or indirectly, actually or constructively, by five or fewer individuals at any time in the last half of its taxable year.⁽⁷⁾

Sources of Income

Under Section 856(c), at least 75 percent of a REIT's gross income (exclusive of certain gains from the sale of property held primarily for sale to customers in the ordinary course of its trade or business, other than "foreclosure property" (see subparagraph [vi] below)), must be derived from the sources described in subparagraphs [i] through [ix], below, and at least 95 percent of a REIT's gross income (with the same exclusion as above) must be derived from the sources described in subparagraphs [i] through [xi]:

[i] rents from real property;

[ii] interest on obligations secured by mortgages on real property;

[iii] gain from the sale or disposition of real property that is not held primarily for sale to customers in the ordinary course of business;

[iv] dividends or other distributions on shares of qualified REITs; and gains from the sale of shares of qualified REITs, which shares are not held primarily for sale to customers in the ordinary course of business;

[v] abatements and refunds of real property taxes;

[vi] income and gain derived from "foreclosure property" (in general, real property acquired through foreclosure or otherwise, following a default on a mortgage or lease);

[vii] certain commitment fees;

[viii] gain from the sale or disposition of a real estate asset that qualifies for an exclusion from "prohibited transactions" under Section 857(b)(6);

[ix] "qualified temporary investment income;"

[x] dividends and interest not described above (qualified for 95 percent test only); and

[xi] gains from the sale or disposition of stock and securities not held primarily for sale to customers in the ordinary course of business (qualified for 95 percent test only).

Rents from real property: As defined for purposes of the 75 percent and 95 percent tests, rents from real property do not include rents (i) received from related persons (generally 10 percent or more overlapping ownership),⁽⁸⁾ (ii) which are dependent on the income of a tenant or any other person, or (iii) with respect to which the REIT has rendered services otherwise than through an "independent contractor" (as defined in Section 856(d)(3)), other than services which may be rendered in connection with rents excludable from "unrelated business taxable income" under Section 512(b)(3). Thus, amounts received for services "usually or customarily rendered in connection with the rental of rooms or other space for occupancy only"⁽⁹⁾ are to be treated as rents from real property, even if the services are not rendered through an independent contractor. These customary services include, for example, the furnishing of heat and light, the cleaning of public areas, and the collection of trash.⁽¹⁰⁾

Rents based on gross receipts: The exclusion of rents based on the income of a tenant or any other person does not apply to amounts based on gross receipts or sales.⁽¹¹⁾

Failure to meet income source tests: If a REIT fails to satisfy the foregoing income source tests, but otherwise satisfies the requirements for taxation as a REIT, it will continue to qualify if the failure is due "to reasonable cause and not . . . willful neglect"⁽¹²⁾ and if other requirements regarding reporting and the absence of fraud are met.⁽¹³⁾ In such a case, however, the REIT will be subject to a 100 percent tax on the excess unqualified income reduced by an allocable part of the expenses of the REIT.⁽¹⁴⁾

The 30 percent test: In addition to the tests described above, less than 30 percent of the REIT's gross income during any taxable year may be derived from the sale or disposition of (i) stock or securities held for less than one year; (ii) property held primarily for sale to customers in the ordinary course of business (other than foreclosure property), unless an exception to "prohibited transaction" treatment applies; and (iii) real property (including interests in mortgages on real property) held for less than four years (other than foreclosure property and gains arising from involuntary conversions).⁽¹⁵⁾ Gains recognized by a REIT in the year of its complete liquidation from the sale, exchange, or distribution of property after the adoption of a plan of liquidation will not be taken into account for purposes of the 30 percent income test.⁽¹⁶⁾ Failure to meet this test will result in disqualification even if due to reasonable cause, since the relief provided in certain situations by Section 856(c)(7) is not available with respect to the 30 percent test.

Asset Tests

At the end of each calendar quarter, at least 75 percent of the value of a REIT's total assets must consist of real estate assets (real property, interests in real property, interests in mortgages on real property, shares in qualified REITs, and (generally) interests in REMICs), cash and cash items (including receivables), and Government securities.⁽¹⁷⁾ However, a REIT has 30 days after the end of a calendar quarter within which to correct any violation of the asset tests resulting from an acquisition in such quarter.⁽¹⁸⁾ Real estate assets also include stock or debt instruments which are not otherwise real estate assets but which are attributable to the temporary investment of "new capital" in the one-year period beginning with the date of receipt of such capital (i.e., investments which yield qualified temporary investment income).⁽¹⁹⁾

With respect to securities other than those described in the preceding paragraph, a REIT cannot, at the end of any calendar quarter, own (i) securities representing more than 10 percent of the outstanding voting securities of any one issuer or (ii) securities of any one issuer having a value exceeding 5 percent of the value of the REIT's total assets.⁽²⁰⁾ This requirement does not necessarily require REITs to be diversified in the ordinary sense of the term. For example, most or all of the value of a REIT's assets may be represented by a single real estate asset; alternatively, a REIT which finds near the end of a calendar quarter that securities of a single issuer represent more than 5 percent of its total assets may comply with the asset tests (without selling those securities or raising new capital) by making a leveraged purchase of GNMAs or similar certificates to increase the total-assets denominator of the percentage.⁽²¹⁾

Issues

Formation Issues

Formation of an UPREIT usually involves converting one or more partnerships which own real property into one of the structures pictured in Exhibits A-D. Structuring in this area is designed in large part to avoid current taxation; thus, the various formation issues must be carefully examined in this light.

Impact of Section 752

Section 752 provides that the assumption of a share of partnership debt by a partner is a deemed contribution by such partner and the release of a partner from some or all of his share of partnership debt is a deemed distribution to that partner. Section 722 provides that a partner's basis in his partnership interest is increased by his contributions and decreased by distributions made to him. Section 731 provides that to the extent that a distribution to a partner exceeds his basis he recognizes gain.

The formation of the umbrella partnership ("UP") from the existing partnerships ("EPs") involves deemed distributions consisting of each sponsor's being relieved of his share of EP debt and deemed contributions consisting of the assumption by each sponsor of a share of UP liabilities. Due to dilution and debt paydown, the sponsors invariably have smaller debt shares in the UP than they had in the EPs. This results in a net deemed distribution to each sponsor which results in gain to the extent that it exceeds his adjusted bases in his UP units.

To calculate this gain (for each sponsor for each EP), one needs the sponsor's basis in the EP ("Old Basis") (in general, tax capital + debt share), the sponsor's debt share in the EP ("Old Debt Share") and the sponsor's debt share in the UP ("New Debt Share"). The difference between Old Debt Share and New Debt Share is the deemed distribution. The deemed distribution is subtracted from the Old Basis. To the extent that the result is negative the sponsor recognizes gain; to the extent that the result is positive the sponsor has a positive basis in his UP units.

Formation Transaction

There are two basic methods of forming an UPREIT from existing partnerships:

First, the EPs contribute their properties to the UP in exchange for units in the UP. The EPs then either remain in place or distribute the UP units in a liquidating distribution to their partners who take a basis in those units equal to their respective bases in the EPs. The Sponsors' bases in their UP units (or in their EP interests if they stay in place) are adjusted by Section 752 and deemed distributions and contributions (discussed in [a] above).

Second, the sponsors contribute their interests in the EPs to the UP for UP units in which they take a carryover basis adjusted by Section 752. If 100 percent of the interests in an EP are contributed the EP dissolves by operation of law.

These two formats reach the same result with the following significant differences:

Netting

Where a sponsor contributes multiple properties to the UP in a single transaction, he should be allowed to aggregate the bases of the contributed properties to offset any gain resulting from the shifting of liabilities in the same transaction, since each sponsor has a single basis in his UP interest. However, if two separate entities contribute properties to the UP, the entities (e.g., two EPs) will not be able to offset any excess deemed distribution in one entity against the positive basis remaining in another.

State and Local Tax

State and local taxes must also be considered. For example, under the new York gains and transfer taxes, when 50 percent or more of an entity holding real property is transferred there is a taxable transfer. Moreover, several noncontemporaneous transfers may be aggregated to make up the 50 percent (even a previously taxed transfer). If partnership interests are contributed, the contributions may be aggregated with future transfers to cause a taxable transaction when a sponsor converts his UP units into REIT shares. It may be possible to avoid aggregation issues if the property, rather than a partnership interest, is transferred.

Financing Terms

The financing terms relating to the property must be examined. Contributing the property may violate some of the financing terms as may contributing partnership interests. Careful attention must be paid to "change of control" clauses.

Depreciation

If partnership interests are transferred, partnerships may terminate under Section 708. Section 708(b)(1)(B) provides that a partnership is considered terminated if "within a 12-month period there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits." When a termination occurs under Section 708(b)(1)(B), the following is deemed to occur: The partnership distributes its properties to the purchaser and the other remaining partners in proportion to their respective interests in the partnership properties and, immediately thereafter, the purchaser and the other remaining partners contribute the properties to a new partnership.⁽²²⁾

After a termination under Section 708(b)(1)(B), the partnership must begin depreciating its property as if it were newly acquired.⁽²³⁾ In the case of commercial rental real estate this will result in a 39-year write-off of the bases in the properties. In contrast, if the properties are contributed, no termination will occur and the bases would be written off over the remaining years on the properties' current depreciation schedules.⁽²⁴⁾

At-Risk Rules

In 1986 the at-risk rules were extended to include real estate activities. These rules are often overlooked, but can have drastic effects unless carefully considered. When the sponsors contribute interests in properties which are subject to the at-risk rules they must examine the effect of the reduction in their share of qualified nonrecourse financing. Future deductions may be limited under Section 465(a) and prior deductions may be recaptured under Section 465(e).

In general, Section 465 limits deductions relating to a given activity to the "at-risk" amount. The at-risk amount for an activity is defined as the sum of amounts contributed by the taxpayer to such activity and amounts borrowed by the taxpayer with respect to such activity.⁽²⁵⁾ For an activity involving the holding of real property, amounts borrowed include only certain types of nonrecourse debt (i.e., qualified nonrecourse financing).⁽²⁶⁾ The at-risk amount is reduced by losses allowed in previous years and distributions made and increased by undistributed income.⁽²⁷⁾ Section 465(e) provides that to the extent that the at-risk amount is less than zero at the end of a taxable year the taxpayer recognizes income, in an amount not to exceed the aggregate losses taken by the taxpayer with respect to the activity reduced by the deductions previously recaptured by the taxpayer.

For sponsors who contribute interests in more than one property there is an issue as to whether they can aggregate their at-risk amounts for each property. Aggregation of at-risk amounts is the equivalent of netting in the Section 752 context described above.

Example: A, a sponsor, contributes his interest in two partnerships to an UP. In partnership 1, A has an at-risk amount of $100 and a qualified-nonrecourse-debt share of $200. As a result of the formation transaction and debt paydown, A's share of debt with respect to partnership 1 goes down to $50. (See Section 11.03[1][a] above.) In the course of A's ownership of an interest in partnership 1, A has taken net losses of $200. In partnership 2, A has an at-risk amount of $100 and no debt share. Does A have income under Section 465(e)? The answer depends on whether A can aggregate his at-risk amounts with respect to properties 1 and 2.

Partnership 1
Before Contribution	After Contribution
100	100 cash
200	50 QNF
300	150 At risk
(200)	(200) Losses
100	(50) At risk

Sections 465(c)(3)(B) and (C) state as follows:

(B) Aggregation of activities where taxpayer actively participates in management of trade or business. -- Except as provided in subparagraph (C), for purposes of this section, activities . . . which constitute a trade or business shall be treated as one activity if --

(i) the taxpayer actively participates in the management of such trade or business; or

(ii) such trade or business is carried on by a partnership or an S corporation and 65 percent or more of the losses for the taxable year is allocable to persons who actively participate in the management of the trade or business.

(C) Aggregation or separation of activities under regulations. -- The Secretary shall prescribe regulations under which activities . . . shall be aggregated or treated as separate activities.

Note that a prerequisite to aggregation under Section 465(C)(3)(B) is that the activities form a single trade or business. The regulations under Section 465 referred to in (C) do not address the aggregation of real estate activities, thus one is left with the rule of (B) that either the taxpayer must actively participate in management or 65 percent of the losses must be allocated to active participants. This last requirement is probably satisfied in most UPREITs since the REIT is usually the managing partner of the UP, owning a large percentage of the UP, and the REIT is usually allocated most or all of the depreciation losses due to Section 704(c).

The legislative history of Section 465 states as follows:

The present law at-risk aggregation rules (Section 465(c)(3)(B)) generally apply to the activity of holding real property. Under these rules, it is intended that if a taxpayer actively participates in the management of several partnerships each engaged in the real estate business, the real estate activities of the various partnerships may be aggregated and treated as one activity with respect to that partner for purposes of the at-risk rules.⁽²⁸⁾

Here also, however, there is an active participation requirement.

Nevertheless, active participation under Section 465(c)(3)(B) is only required to aggregate separate activities. One could argue that an UP interest constitutes a single activity without resort to Section 465(c)(3)(B).

The determination of what constitutes a single activity and what constitutes a single trade or business may depend upon the structure of the UPREIT. Exhibits A, B and C represent the three common formats through which an UP may hold its properties. In Exhibit A, the UP holds the property directly, in Exhibit B, through a wholly-owned partnership, and in Exhibit C, along with other partners in a lower tier partnership. Although there is little guidance regarding whether the different properties held by the UP form a single trade or business or a single activity, clearly, of these three structures Exhibit A poses the strongest case for aggregation and Exhibit C the weakest.

Section 704(c) Issues

Regulations recently issued under Section 704(c) provide that a partnership may choose one of three methods of applying Section 704(c): the traditional method, the traditional method with curative allocations and the remedial method.⁽²⁹⁾ The three methods, which are essentially three ways of dealing with the "ceiling rule," can have a substantial effect on the partners involved. In the UP context, if the traditional method is used where the EP's basis is a smaller percentage of fair market value than the REIT's percentage in the UP, the REIT will get all of the depreciation but not as much as it would have received had the UP held the properties with a fair market value basis. The other methods generally cure this problem by allocating income to the contributing partners in the amount of the deficit caused by the ceiling rule.

Example: A contributes a property with an adjusted basis of $40 and a fair market value of $100 to the UP. The REIT contributes $100 of cash. The property has ten years remaining on its depreciation schedule at the time of contribution. A and the REIT each own a 50 percent interest in the UP.

Traditional Method

Under the traditional method the REIT and A are each entitled to $5 of book depreciation for year 1([$100 ÷ 10] x 50%) and the REIT is allocated all of the $4 ($40 ÷ 10) of tax depreciation. The ceiling rule prevents the REIT from deducting the full $5 of its book depreciation.

The Traditional Method With Curative Allocations

Under the traditional method with curative allocations, the allocation of book and tax depreciation are exactly the same as under the traditional method. However, the $1 ceiling problem may be curable. If the partnership has "an item which the partners anticipate will have substantially the same effect on their tax liabilities as the tax item limited by the ceiling rule," the partnership can make a curative allocation.⁽³⁰⁾ For example, if the UP has income which qualifies under this standard the UP can allocate $1 of such income, which for book purposes goes to the REIT, to A for tax purposes. However, if the partnership has no such item the ceiling problem remains.

The Remedial Method

There are two major differences between the traditional method with curative allocations and the remedial method: First, the remedial method involves a recalculation of the book depreciation and second, curative allocations depend upon the UP's having an equivalent tax item while remedial allocations allocate synthetic tax items rather than reallocate actual tax items and are therefore not subject to the same limitation.

Thus, under the remedial method, the book depreciation for year 1 is $5.54 ($4 [$40 tax basis ÷ the 10 year recovery period] + $1.54 [$60 of excess book value over basis ÷ the new 39 year recovery period]). The book depreciation is divided 50-50, therefore, both A and the REIT have $2.77 of book depreciation. The REIT is allocated $2.77 of tax depreciation and A gets the remaining $1.33 of tax depreciation. Therefore, in this example, after year 1 the remedial method benefits the sponsor even more than the traditional method does. After the end of 10 years, however, when there is no more tax depreciation to allocate, the REIT will have $.77 of book tax depreciation each year (until the 39th year) and the regulations dictate that an allocation of a $.77 synthetic loss be made to the REIT and an offsetting $.77 allocation of synthetic gain be made to A.

In sum, as between the traditional method and the traditional method with curative allocations, the former will favor the sponsors and the latter will favor the REIT. However, as between the remedial method and the other methods, who is favored depends upon a variety of factors.

Disguised Sale Rules

Another hurdle to tax-free treatment on formation is the disguised sale rules. Section 707(a)(2)(B) provides that where a partner transfers money or property to a partnership and there is a related transfer of money or property by the partnership to such partner, if these transfers when viewed together are properly characterized as a sale, then they are treated as a sale. The regulations under Section 707(a)(2)(B) reserve the section on disguised sales of partnership interests. In the UPREIT context, Section 707(a)(2)(B) may come into play when some of the offering proceeds which are contributed by the REIT to the UP are then distributed to the sponsors (e.g., to pay income taxes incurred due to formation).

Regulation Section 1.707-5 deals with the treatment of liabilities under the disguised sales rules. In general, a partnership's assuming a qualified liability⁽³¹⁾ of a partner is not treated as a transfer of consideration to the partner. However, if section 707(a)(2)(B) applies independent of the qualified liabilities assumed, then the "drag along" rule of Regulation 1.707-5 applies. This rule treats as a transfer of consideration the lesser of (i) the liability assumed by the partnership and the partner's share of that liability after contribution and (ii) the product of the liability and the partner's "net equity percentage."⁽³²⁾ The net equity percentage is defined as the transferor's disguised sale proceeds other than those relating to qualified liabilities divided by the net value of the property subject to the qualified liability.

The effect of the application of the disguised sales rules is to treat a portion of an otherwise tax-free contribution to the UP as a taxable sale.

Operating Issues

At the heart of REIT tax planning lies the income tests. Passing these tests is vital, since they are necessary for qualification as a REIT (and the dividends paid deduction which that entails); however, the planning involved is difficult, requiring the "always painful" modification of business procedures to conform to a nebulous and changing standard.

All of the REIT qualification issues apply in the UPREIT context. Regulation Section 1.856-3(g) provides:

(g) Partnership interest. In the case of a real estate investment trust which is a partner in a partnership, as defined in section 7701(a)(2) and the regulations thereunder, the trust will be deemed to own its proportionate share of each of the assets of the partnership and will be deemed to be entitled to the income of the partnership attributable to such share. For purposes of section 856, the interest of a partner in the partnership's assets shall be determined in accordance with his capital interest in the partnership. The character of the various assets in the hands of the partnership and items of gross income of the partnership shall retain the same character in the hands of the partners for all purposes of section 856.

This regulation has come under much criticism, in part for creating a system of allocations for purposes of the REIT gross income tests which differs from that of the partnership rules. Regardless of how income items are allocated between the REIT and its partners, in an UPREIT structure the regulations subject the REIT's share of UP items to the same test they would need to meet if the REIT received its income directly. The same is true of the REIT's share of income derived from partnerships in which the UP has an interest. A recent private letter ruling⁽³³⁾ confirms that it is necessary to look through tiers of partnerships. Assets of a partnership in which a REIT is a partner also include that partnership's proportionate share (based on its capital interest) of the assets of a lower-tier partnership. (See Exhibits B and C).

Regulation Section 1.856-3(g) does not specifically say whether partnerships are to be disregarded for purposes of the gross income tests of section 856; this unresolved issue spawns many dependent issues. The above regulation does make clear, however, that generally in an UPREIT structure all of the rules and issues which normally apply to a REIT's income apply to the UP's income.

95 percent of a REIT's income must come from rents from real property, dividends and interest. Non-qualifying income ("bad income") must be carefully monitored so as not to approach the dangerous 5 percent threshold. Many practitioners prefer to keep this 5 percent basket intact as a cushion against unforeseeable events and errors. This goal, however, is often at odds with operational efficiency and competitiveness.

Umbrella Partnership (or REIT) Management for Other Partners

Amounts earned by a REIT for managing property for third parties are bad income. As described in Exhibit C, in some UPREITs the UP is itself a partner in a lower tier property-owning partnership ("Property Partnership"), along with one or more third-party partners. If in such a structure the UP manages the property for a fee paid to it by the Property Partnership, the portion of the fee attributable to the third party partner's interest can be viewed as the equivalent of a fee for managing third party property, which is nonqualifying income. Prior to Private Letter Rulings 9343027 and 9428018 it was thought that if the fee were cast as a guaranteed payment it would constitute "rents from real property" since the underlying partnership income would consist only of "rents from real property."

Private Letter Ruling 9343027 dealt with a REIT which was a partner directly in property-owning partnerships together with third party partners. Under the proposed transaction the REIT was to assume the management duties for the property-owning partnerships in return for a fee. The issue is whether the fee income qualified under the REIT income tests. Private Letter Ruling 9428018 dealt with the same scenario in an UPREIT structure (see Exhibit C).

In Private Letter Rulings 9343027 and 9428018 the Service held, based on Regulation Section 1.856-3(g), that the portion of the fee attributable to the third-party partners was nonqualifying income and the remainder was disregarded "since it was already reflected as qualifying rental income pursuant to Section 1.856-3(g) of the regulations."⁽³⁴⁾ In PLR 9431005, a property owning partnership was owned by the UP and a qualified REIT subsidiary and the UP managed the property for a fee. The Service held that the entire fee is not to be treated as an item of gross income and, therefore, is to be disregarded. These rulings do not actually say that they are disregarding the partnership for purposes of section 856, however, this appears to be the only way to justify the result.

Related Lessee

A similar issue arises in connection with rents from related lessees. Section 856(d)(2)(B) provides that the term "rents from real property" does not include --

(B) any amount received or accrued directly or indirectly from any person if the real estate investment trust owns, directly or indirectly

(i) in the case of any person which is a corporation, stock of such person 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 number of shares of all classes of stock of such person; or

(ii) in the case of any person which is not a corporation, an interest of 10 percent or more in the assets or net profits of such person[.]

As applied to a related lessee which is a partnership, there is some tension between the above Code provision and Private letter Rulings 9343027, 9428018 and 9431005 discussed above. If a REIT owned 50 percent of a partnership the other 50 percent of which was owned by unrelated parties and this partnership rented space from the REIT, the principles of these private letter rulings would dictate that the partnership be ignored and, therefore, the 50 percent of the rents which are allocable to the third-party partners are "rents from real property" and the 50 percent which are allocable to the REIT should be ignored as self-charged. Section 856(d)(2)(B), however, provides that none of the rent paid by the partnership to the REIT qualifies as "rents from real property."

The statute does leave room for the position that 50 percent of the rent is not gross income at all (and therefore not disqualified income) since it is self-charged and has already been accounted for in the gross income of the partnership which is attributed to the REIT by Regulation Section 1.856-3(g). This position, however, yields the ironic result that the portion of the rent which is really third-party rent is treated worse than the related party portion.

Services

The provision of services requires especially careful planning as it is full of pitfalls in this area; as mentioned above, the rules that generally apply to the REIT will apply to the UP by virtue of Regulation Section 1.856-3(g). Section 856(d)(2)(C) provides that the term rents from real property does not include:

any amount received or accrued, directly or indirectly, with respect to any real or personal property if the real estate investment trust furnishes or renders services to the tenants of such property, or manages or operates such property, other than through an independent contractor from whom the trust itself does not derive or receive any income.

Subparagraph (C) shall not apply with respect to any amount if such amount would be excluded from unrelated business taxable income under section 512(b)(3) if received by an organization described in section 511(a)(2).

This provision creates a "tainting" problem that goes far beyond the mere generation of bad income from the prohibited service. If certain services are provided with respect to a property, no amounts received with respect to such property qualify as rents from real property. Thus if one "bad service" is provided, rents from the entire building might be tainted and overflow the 5 percent basket. The Internal Revenue Service has yet to rule in a case where bad services are provided to only one of many tenants in a given property. In such a case, is the rent from the entire property tainted or only the rent from the space under the lease pursuant to which the service was provided?

The Internal Revenue Service has addressed a similar issue in a situation involving percentage rents.⁽³⁵⁾ A REIT leased space to ten different tenants under ten separate leases, with nine of the tenants paying a fixed sum rental. The lease with the remaining tenant provided for a rental based on a percentage of the tenant's net profits. The Service concluded that only the rent from the tenant whose rent was based on net profits did not qualify as rents from real property; the rent from the other tenants in the building was not tainted by the bad lease.

It is hoped that the Service will apply the lease-by-lease analysis in the services situation so that only the rent received from the tenant who receives bad services will not qualify as rent from real property.

Before 1986, Section 856(d)(2)(C) prevented REITs from furnishing or rendering services to tenants or managing or operating property, other than through an independent contractor.⁽³⁶⁾ In 1986 Congress added the last sentence of Section 856(d)(2)(C); this sentence provides that a service will not taint rents from a property if it would not have caused the rents from the property to be unrelated business income under Section 512(b)(3). Any service which meets this standard can be performed directly by the REIT or UP without tainting the rent from the property. Services which do not meet this standard must be performed by an independent contractor from whom the REIT or UP does not "derive or receive any income."

There are thus two categories of bad services: (i) services which generate income which does not qualify for either the 95 percent test or the 75 percent test and (ii) services which, in addition to generating non-qualifying income, taint income which would otherwise be qualifying income.

Income from services which falls into the first category uses up the 5 percent basket. To convert this income into dividend income (which can comprise up to 25 percent of a REIT's gross income), the business producing such income is often put into a "service subsidiary" which is a C corporation the nonvoting preferred stock of which (representing most of the economic value) is owned by the UP or the REIT but the voting stock of which is owned by a third party (since the REIT cannot own more than 10 percent of the voting stock of any issuer). This structure is illustrated in Exhibit D. The nonqualifying income is thus converted into dividend income which can comprise up to 25 percent of the REIT's gross income; however, the price is a double tax on the income.

The chart below summarizes the ramifications of the different ways of structuring different types of services.

	Customary Tenant Services/Management	Noncustomary Tenant Services
1) REIT performs for itself	Good income under all income tests	a) Such income will use up 5%basket. b) Taints all rent derived from such property, so it too uses up 5% basket. Sec. 856(d)(2)(C).
2) REIT performs for third parties	Does not matter whether services are customary. a) If performed directly income derived therefrom uses up 5% basket. b) If performed by C Corporation subsidiary: i) double tax, and ii) the dividend income uses up 25% basket.
3) Independent contractor performs and REIT gets no income from independent contractor	No tainting of rent

The determination of which services are customary is crucial to a REIT's qualification; unfortunately this determination is often extremely difficult to make. Most of the guidance in this area consists of some general statements in the regulations, legislative history and the large array of private letter rulings on the subject. Part of the problem arises from the fact that the determination of which services are good is in part a determination of fact; however as will be described below the standards by which these facts are measured are also unclear.

As noted above, Section 856(d)(2) provides:

Regulation Section 1.512(b)-1(c)(5) provides in relevant part:

(5) Rendering of services. For purposes of this paragraph, payments for the use or occupancy of rooms and other space where services are also rendered to the occupant, such as for the use or occupancy of rooms or other quarters in hotels, boarding houses, or apartment houses furnishing hotel services, or in tourist camps or tourist homes, motor courts or motels, or for the use or occupancy of space in parking lots, warehouses, or storage garages, do not constitute rent from real property. Generally, services are considered rendered to the occupant if they are primarily for his convenience and are other than those usually or customarily rendered in connection with the rental of rooms or other space for occupancy only. The supplying of maid service, for example, constitutes such service; whereas the furnishing of heat and light, the cleaning of public entrances, exits, stairways, and lobbies, the collection of trash, etc., are not considered services rendered to the occupant. (Emphasis added.)

Although there seems to be some confusion on this point, the regulation clearly states that services will disqualify the rent from the property only if those services are (i) primarily for the tenant's convenience and (ii) are not customarily rendered. Thus, any service which is customarily rendered will not taint rental income regardless of one's interpretation of "primarily for his convenience."

Against what background is the determination of "customarily rendered" made? Clearly, office buildings involve different customary services than do apartment buildings. Different geographic areas and qualities of buildings produce a similar fragmentation of custom. Does the "customary" test take into account the specific landlord/tenant relationship, or the specific needs (or capabilities) of a given tenant?

Does customarily rendered mean that the landlord actually performs the service himself or merely that the landlord provides access to the service? If tenants in a certain type of building must go through the landlord to obtain a certain service, does that mean that the service is "customary?"

The activities of a partnership in which a REIT or an UP is a partner can adversely affect the REIT's qualification. Therefore, it is imperative for a REIT or an UP not only to review carefully the existing leases and operations of any partnerships in which it is acquiring an interest, but also to have control or consent rights with respect to future leases and operations of such partnerships.

The Next Generation?

An innovative approach has recently been unveiled in the prospectus for Security Capital Industrial Trust. The new concept, referred to as a "mirror partnership," is designed to secure the benefits of tax-free property acquisition (currently enjoyed only by UPREITs) for REITs which hold some of their properties directly.

As discussed above, UPREITs are able to acquire properties, either upon formation or subsequently, in a transaction which is tax-free to the sellers by having the sellers contribute the property to the UP in return for which they receive UP units. Since in the UPREIT structure the REIT owns all of its property through the UP, an interest in the UP is the economic equivalent of an interest in the REIT.

In the mirror partnership format (illustrated in Exhibit E), the REIT can acquire properties in a tax-free transaction by having the seller contribute the property to a limited partnership called a mirror partnership in return for mirror partnership units ("MPUs"). The REIT is the managing general partner of the mirror partnership and the MPUs represent limited partnership interests. The partnership agreement of the mirror partnership provides that the limited partners receive distributions for each MPU equal to the REIT's per share distribution. If the mirror partnership does not generate enough cash flow to make this distribution, the distribution accumulates (possibly with interest). Any excess cash flow after payment of distributions to the limited partners is paid to the REIT general partner. Thus, although the REIT holds properties outside of the mirror partnerships and may have more than one mirror partnership, the MPUs represent the same economic interest as REIT shares.

The Security Capital Industrial Trust prospectus describes two different mirror partnerships. Among the differences between the two, is that in partnership 1, if partnership properties are sold the limited partners receive a pro rata share of the proceeds, while in partnership 2 the REIT general partner receives all of the proceeds. As a result, in Partnership 1 the economic interest of the limited partners diverges from those of the REIT shareholders with regard to the appreciation of properties, while partnership 2's MPUs mirror the REIT shares in this respect also.

No mirror partnership variation can erase all of the tax distinctions between the REIT shareholders and the MPU holders. For example, if the REIT issues a capital gain dividend, the MPU holders receive a matching distribution; however, if the Mirror Partnership only produced ordinary income such would be the character of the income generated by the MPUs. It still remains to be seen how large a factor these Mirror Partnerships will become in the currently UPREIT dominated market.

Conclusion

The economic benefits of securitizing real estate are great and REITs, particularly UPREITs, are the most practical means of doing so. As noted above, care must be taken to avoid income recognition upon formation and to ensure that operations result in ongoing qualification.

FOOTNOTES_____________________

1. Mr. Wolf greatly appreciates the assistance of Ezra Dyckman in the preparation of this article.

2. Except as otherwise indicated, section references are to sections of the Internal Revenue Code of 1986 ("I.R.C."), and references to "Reg. Search7RH" are to the regulations promulgated under the 1986 Code and the 1954 Code.

3. Example 4 of the partnership anti-abuse regulations issued on December 29, 1994 (Treas. Reg. Search7RH 1.701-2) confirms that the UPREIT structure is nonabusive and that the partnership structure will be respected.

4. See I.R.C. Search7RH856(a).

5. I.R.C. Search7RH 11(c)(3).

6. I.R.C. Search7RH 856(a)(2), (a)(5), (b).

7. I.R.C. Search7RH856(a)(6), (h)(1).

8. See I.R.C. Search7RH 8569d)(2)(B), (d)(5).

9. See Treas. Reg. Search7RH 1.512(b)-1(c)(5).

10. Id.; see also H.R. Rep. No. 841, 99th Cong., 2d Sess. II-220 (1986) (the "1986 Act Conference Report") (regarding parking facilities).

11. I.R.C. Search7RH 856(d)(2)(A).

12. I.R.C. Search7RH856(c)(7).

13. See Treas. Reg. Search7RH 1.856-7.

14. I.R.C. Search7RH 857(b)(5).

15. I.R.C. Search7RH 856(c)(4).

16. I.R.C. Search7RH 856(c)(8).

17. I.R.C. Search7RH 856(c)(5).

18. Id.

19. I.R.C. Search7RH 856(6)(B), (D).

20. I.R.C. Search7RH 856(c)(5).

21. See, e.g., Rev. Rul. 70-544, 1970-2 C.B. 6.

22. Treas. Reg. Search7RH 1.708-1(b)(1)

23. I.R.C. Search7RH 168(i)(7).

24. Id.

25. I.R.C. Search7RH 465(b)(2).

26. I.R.C. Search7RH 465(b)(6).

27. I.R.C. Search7RH465(b)(5).

28. S. Rep. No. 313, 99th Cong., 2d Sess. (1986).

29. Final regulations authorizing the traditional method and the traditional method with curative allocations, Treas. Reg. Search7RH 1.704-3(a)(c), (e), were promulgated on December 21, 1993 and final regulations authorizing the remedial method, Treas. Reg. Search7RH 1.704-3(d), were promulgated on December 27, 1994.

30. Search7RH 1.704-3(c).

31. The term "qualified liability" is defined in Treas. Reg. Search7RH1.707-5(a)(6). Generally the term includes: liabilities more than two years old, liabilities not incurred in anticipation of the transfer, liabilities allocable to capital expenditures with respect to the property transferred and liabilities incurred in the ordinary course of the trade or business in which the transferred property was used.

32. Treas. Reg. Search7RH 1.707-5(a)(5).

33. PLR 9428018.

34. PLR 9343027

35. Rev. Rul. 72-353, 1972-2 C.B. 413

36. However, Treas. Reg. Search7RH 1.856-4(b)(5)(ii) provides:

Trustee or director functions. The trustees or directors of the real estate investment trust are not required to delegate or contract out their fiduciary duty to manage the trust itself, as distinguished from rendering or furnishing services to the tenants of its property or managing or operating the property. Thus, the trustees or directors may do all those things necessary, in their fiduciary capacities, to manage and conduct the affairs of the trust itself. For example, the trustees or directors may establish rental terms, choose tenants, enter into and renew leases, and deal with taxes, interest, and insurance, relating to the trust's property. The trustees or directors may also make capital expenditures with respect to the trust's property (as defined in section 263) and may make decisions as to repairs of the trust's property (of the type which would be deductible under section 162), the cost of which may be borne by the trust.

Lary S. Wolf

Real Estate Taxation