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In PLRs 201225008 and 201225009, the Service addressed two REITs that intended to become partners in a partnership which owned a hotel that would then be leased to a newly formed partnership in which a TRS (of each REIT) would be a partner. The Service ruled that the leasing arrangement qualifies for the related-party rent exception of Section 856(d)(8)(B), and thus, rents received by the REIT (through the lessor-partnership) will constitute qualifying income for purposes of the 95% and 75% income tests of Sections 856(c)(2) and (3).

Facts

Taxpayer 1 and Taxpayer 2 are LLCs that have elected to be treated as corporations for federal income purposes, and will elect to be treated as real estate investment trusts (REITs) under Section 856. Taxpayer 1 and Taxpayer 2 will each make capital contributions to LLC 2, a disregarded entity owned by LP 3. LLC 2 will become a partnership for federal income tax purposes upon such contributions.

LLC 2 owns, through a disregarded entity, a hotel (Hotel). Taxpayer 1 and Taxpayer 2 (along with certain shareholders of Taxpayer 1 and Taxpayer 2) will form Hotel TRS, an LLC which will elect to be treated as a corporation. Taxpayer 1 and Taxpayer 2 will each make a joint election with Hotel TRS to treat Hotel TRS as a taxable REIT subsidiary as defined in Section 856(l) with respect to each of Taxpayer 1 and Taxpayer 2. Hotel TRS and LP 3 will form Hotel Lessee LLC, an LLC that will be treated as a partnership for federal tax purposes. LLC 2 will lease Hotel to Hotel Lessee LLC. Hotel will be managed and operated on behalf of Hotel Lessee LLC by either the existing manager or another third-party manager (collectively, "Manager").

The taxpayers represented that: (i) Manager will be an "independent contractor" that will be actively engaged in the trade or business of operating qualified lodging facilities, within the meaning of Section 856(d)(9)(A), for entities unrelated to Taxpayer, LLC 1, or Hotel TRS; and (ii) Manager will be owned by persons unrelated to Taxpayer 1, Taxpayer 2 and Hotel TRS for purposes of Section 856(d)(8) and Sections 52(a) and (b).

Analysis and ruling

Section 856(d)(2)(B) provides that the term "rents from real property" does not include, except as stated in Section 856(d)(8), any amount received or accrued directly or indirectly from any person if the REIT owns, directly or indirectly: (i) in the case of any person which is a corporation, stock of such person possessing 10% or more of the total combined voting power of all classes of stock entitled to vote, or 10% or more of the total value 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% or more in the assets or net profits of such person.

Section 856(d)(8)(B) provides that amounts paid to a REIT by a TRS shall not be excluded from "rents from real property" by reason of Section 856(d)(2)(B) when a REIT leases a qualified lodging facility or qualified health care property to a TRS, and the property is operated on behalf of the TRS by a person who is an eligible independent contractor.

Section 856(d)(9)(A) defines the term "eligible independent contractor", with respect to any qualified lodging facility or qualified health care property, any independent contractor if, at the time such contractor enters into a management agreement or other similar service contract with the taxable REIT subsidiary to operate the 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 real estate investment trust or the taxable REIT subsidiary.

Based on the representations made, the Service ruled that (i) Manager will be treated as an eligible independent contractor with respect to the management and operation of Hotel for purposes of Section 856(d)(9)(A); (ii) Manager will be treated as managing and operating Hotel on behalf of Hotel TRS for purposes of Section 856(d)(8)(B), and Hotel TRS will not be treated as operating or managing a lodging facility in violation of Section 856(l)(3)(A); and (iii) rent paid by Hotel Lessee LLC to LLC 3 will be qualifying income to Taxpayer 1 and Taxpayer 2 for purposes of the REIT gross income tests under Sections 856(c)(2) and (c)(3).

Implications

REITs that own hotels or health care properties are allowed to lease the properties to a TRS under the special rule of Section 856(d)(8)(B), which exempts the rents received by the REIT from the related-party rent rule of Section 856(d)(2)(B), as long as the TRS hires an entity that qualifies as an eligible independent contractor to operate the property.

In PLRs 201225009 and 201225008, the taxpayers appear to have provided representations with respect to satisfaction of most of the technical requirements of the Section 856(d)(8)(B) exception. However, it seems that one issue where the taxpayers may have been seeking comfort was that the hotel was not leased directly to the TRS, but instead was leased to a partnership in which the TRS was a partner. Accordingly, these rulings should be viewed as favorably addressing this matter. While, no detailed analysis of the matter was provided in the rulings, it should be noted that the Service previously concluded in Revenue Procedure 2003-66 that a REIT can satisfy the related-party rent exception of Section 856(d)(8)(A) (relating to leasing up to 10% of the space in a non-hotel/health care property to a TRS) in a situation where the space is leased to a partnership in which the TRS is a partner. It also appears that the Service approved of a lease to a TRS-partnership in PLR 201104023.

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