In PLR 201722016, the IRS ruled that payments to a real estate investment trust (REIT) by tenants for the allocable portions of a charge from a provider for managing electricity costs at a rental property do not depend in whole or in part on the income or profits derived by any person from the property within the meaning of Section 856(d)(2)(A). Accordingly, the charges (and thus other amounts) received from the tenants will not fail to qualify as rents from real property by reason of Section 856(d)(2)(A).

Taxpayer is a corporation that will elect to be taxed as a REIT. Taxpayer purchased Property that is subject to an agreement with Provider, under which Provider installed on Property five large systems that store electricity. The systems use and collect electricity from the utility grid during off-peak hours when the cost of electricity is cheaper, and provide electricity to Taxpayer and its tenants during peak hours in lieu of Taxpayer purchasing electricity from the utility grid during peak hours. Therefore, the use of the equipment results in a net reduction in electricity costs at Property.

The systems are and will continue to be owned and maintained by Provider. Under the agreement with Provider, Taxpayer pays Provider a monthly fee (Charge) for its and its tenants' use of electricity from the systems. The charge is 50% of Taxpayer's energy cost savings from Provider's operation of the systems at Property.

Under Taxpayer's leases to tenants at Property, utility charges are submetered. Taxpayer passes submetered utility usage costs through to tenants, and thus collects an additional charge from the tenants for the provision of electricity at Property. The utility costs passed through to tenants includes an allocable portion of the utility grid costs and an allocable portion of Charges paid to Provider.

Law and analysis

Section 856 imposes certain limitations on REITs. 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.

Section 856(d)(2)(A) states 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 determination of such amount depends on the income or profits derived by any person from such property."

In its analysis, the IRS noted that charges for electricity at Property include those from the utility and Provider's Charge. Provider Charge's is a fee for the use of electricity, just as the charges from the utility grid are fees for the use of electricity. The Charge is based on the cost savings provided by systems, which result from using electricity from the utility grid during off-peak hours rather than peak hours. The IRS concluded that neither the charges for electricity from the utility grid nor the Charge depend on the income or profits derived by any person from Property.

Accordingly, the IRS ruled that tenant payments to Taxpayer for the allocable portions of Provider's Charge do not depend in whole or in part on the income or profits derived by any person from Property within the meaning of Section 856(d)(2)(A).

Implications

Section 856(d)(2)(A) contains an especially harsh rule for REITs. In general, if a REIT receives or accrues rents (or any other amounts) based on the "net" income or profits derived by the tenant (or any other person) from the leased property, then all amounts received by the REIT from the tenant for the tax year are treated as nonqualifying income. For example, if a REIT leases space to a clothing retailer and collects fixed base rents plus 3% of the retailers "net" profits derived at the leased space, then all of the rents collected from the tenant are treated as nonqualifying income for the tax year.

In PLR 201722016, the taxpayer was concerned that Section 856(d)(2)(A) could potentially apply in connection with the pass-through of the "charge" to the tenants, which would affect the qualification of all rents received from tenants. The IRS reached the correct conclusion in this ruling, and the issuance of the ruling in just over four months suggests that this was not a controversial ruling. The ruling, however, serves as a reminder to REITs and advisors to be watchful for potential applications of Section 856(d)(2)(A). Also, see PLR 201301007 (Tax Alert 2013-92) addressing a somewhat similar matter in connection with the pass-through of certain amounts to tenants.

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