In PLR 201848013, the IRS ruled that amounts received by a real estate investment trust (REIT) from tenants that are determined with reference to electricity cost savings from systems installed at rental properties do not "depend in whole or in part on the income or profits derived by any person from the leased property" within the meaning of Section 856(d)(2)(A). Accordingly, the amounts received by the REIT will not fail to constitute qualifying rents from real property by reason of Section 856(d)(2)(A).

Facts

Taxpayer, a corporation that has elected to be taxed as a REIT, conducts its activities primarily through an operating partnership (OP). OP leases certain facilities (Facilities) to tenants.

As part of a new program, OP intends to enter into agreements with its existing tenants of Facilities to install systems (Systems) in place of fixtures in the Facilities (the Agreements). Metering devices will also be installed to track energy usage. OP intends to enter into similar arrangements with any new tenants, except that the arrangements will be integrated in the new tenant's lease. The OP will bear costs related to the installation of Systems and the metering devices.

Under the Agreements, tenants will pay OP a monthly fee (the Charge) for tenant's use of Systems. The Charge is in addition to the other payments (e.g., base rents and charges for operating expenses) tenants must make under the tenant's existing lease agreements.

The Charge is calculated based on the tenant's energy cost savings from using Systems. Systems use fewer kilowatt hours (kWh) than the fixtures did. Therefore, the use of Systems results in a net reduction in electricity costs at Facilities. The Charge is calculated by multiplying a fixed rate per kWh by the amount of kWh saved by using Systems. The amount of kWh saved is the difference between the actual kWh used as determined by the metering device and either the amount of kWh that was historically used under the old system or a stipulated amount. Tenants are directly responsible for amounts paid to the utilities provider for electricity.

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 PLR 201848013, the IRS (1) noted that the Charge is a fee for the use of Systems and is based on the electricity cost savings provided by Systems, and (2) determined that the Charge does not depend on the income or profits derived by any person from Facilities 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 non-qualifying income. For example, if a REIT leases space to a retailer and collects fixed base rents plus 3% of the retailer's "net" profits derived at the leased space, all of the rents and other amounts collected from the tenant are treated as non-qualifying income for the tax year.

In PLR 201848013, the taxpayer was concerned that Section 856(d)(2)(A) could potentially apply in connection with the additional "charge" to the tenants that is determined with reference to electricity cost savings, which would affect the qualification of all rents received from tenants. The IRS reached the correct conclusion in this ruling. The ruling, however, serves as a reminder to REITs and advisors to be watchful for potential applications of Section 856(d)(2)(A). See PLRs 201722016 (Tax Alert 2017-1102) and 201301007 (Tax Alert 2013-0092), addressing somewhat similar matters in connection with the pass-through of certain amounts to tenants.

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