In PLR 202012012, the IRS ruled that certain lease rights owned by a real estate investment trust (REIT) constitute real property under Treas. Reg. Section 1.856-10(f) and thus are qualifying real estate assets for purposes of the REIT asset tests of IRC Section 856(c)(4).

The IRS also ruled that the REIT's "percentage rent" from certain tenants leasing sites for billboards, which is based on a percentage of the tenants' gross revenues from the billboards reduced by certain agency fees and continuity discounts, does not depend in whole or in part on the tenant's income or profits from the billboard sites. Thus, the rents received by the REIT from these tenants are not precluded under IRC Section 856(d)(2)(A) from qualifying as "rents from real property" for purposes of the 95% and 75% income tests of IRC Sections 856(c)(2) and (3).

Facts, law, and analysis

Ruling 1: Lease rights are qualifying real estate assets

Taxpayer is a privately held corporation that has elected to be taxed as a REIT. Taxpayer earns revenues from owning rights in leases of land, building rooftops, and other assets (Lease Rights) that constitute real property under Treas. Reg. Section 1.856-10.

The Lease Rights arose when the fee owner of certain sites leased, as landlord, sites to third-party tenants. Subsequently, during the term of the lease, Taxpayer purchased the fee owner's right, title, and interest in the lease under an agreement conveying the Lease Rights. In some cases, Taxpayer acquired the Lease Rights from a person who had previously purchased the Lease Rights from a fee owner.

The agreement conveying the Lease Rights runs with the land. Taxpayer may pledge, assign, mortgage, and hold title policies for the Lease Rights. In addition, the Lease Rights agreements may be recorded with applicable local jurisdictions. Taxpayer also has or has an option to enter a successor lease that requires Taxpayer, upon termination or expiration of the lease, to automatically become the tenant on that site (with no obligation to pay any rent to the lessor) until the termination date specified in the Lease Rights agreement. Thus, Taxpayer may enter into a replacement lease with a new tenant.

The IRS determined that the Lease Rights satisfy the three requirements under Treas. Reg. Section 1.856-10(f)(1) for an intangible asset to be treated as real property: they (i) "derive their value from the underlying [site] or lease thereon"; (ii) "are not separable from the underlying [site] and lease"; and (iii) "only contribute to the production of rental income for use of the [site] and thus do not contribute to the production of income other than consideration for the use or occupancy of space." In addition, the IRS noted that the Lease Rights are "in the nature" of a leasehold interest in real property, give the Taxpayer "an interest in rights under a lease with respect to real property," and "may be converted into a traditional lease" under the successor lease provision.

Accordingly, the IRS ruled that the Lease Rights constitute real property under Treas. Reg. Section 1.856-10(f) and thus are real estate assets for purposes of IRC Section 856(c)(4).

Ruling 2: Percentage rent does not depend on tenants' income or profits

Under certain leases of sites used by tenants for billboards, Taxpayer receives percentage rent equal to a specified percentage of the tenant's gross revenue from the billboards reduced by agency fees and continuity discounts.

Agency fees are amounts paid by a tenant to an advertising agency for locating billboard customers for the tenant. To recoup the agency fee, the tenant adds the fee to the rent charged to its customers for using advertising space on the billboards.

Continuity discounts are amounts that are paid by a tenant to a billboard customer, in lieu of a rent reduction for the customer, and generally result from the customer meeting certain thresholds for extended uses of billboard space.

Under IRC Section 856(d)(2)(A), "rents from real property" does not include amounts "received or accrued, directly or indirectly" from real or personal property when their determination depends wholly or partially on another person's income or profits from the same property. "Rents from real property" does, however, include amounts from real or personal property that are "based on a fixed percentage or percentages of receipts or sales."

The IRS concluded that adjusting a tenant's percentage rent for a billboard site by agency fees and continuity discounts "more accurately reflects the third-party tenant's gross receipts" and does not cause the rent received by Taxpayer to be based on the income or profits of the tenant (or any other person) within the meaning of IRC Section 856(d)(2)(A). The IRS noted that the agency fees are transaction fees akin to sales taxes or credit card fees in a retail business. "Unlike general costs of doing business," the IRS explained, "these types of fees are specific to each transaction … and the tenant adds the agency fees to the rent paid by the billboard customer so that the fees are [borne] by the specific customer."

As for the continuity discounts paid to the billboard customer, the IRS determined that they "effectively [reduce] the rent paid by the customer to the tenant." "[If] the gross receipts of the third-party tenant were not reduced by the continuity discount," the IRS added, "the gross receipts would overstate the amount of rent received by the third-party tenant from its customer."

Implications

PLR 202012012 is the first private letter ruling to conclude that certain lease rights constitute real property since the issuance of Treas. Reg. Section 1.856-10 in August 2016, which provides detailed rules addressing the definition of "real property." Prior to issuance of the regulations, the IRS had ruled in PLR 200831020 that certain lease rights constitute real property and that income associated with the lease rights constitutes rents from real property. PLR 202012012 does not rule on whether the revenues received by Taxpayer from the Lease Rights constitute rents; the ruling implies, however, that the IRS and Taxpayer believe that the revenues were rents (for example, see Ruling 2). These two private letter rulings address very specific facts pertaining to the lease rights and thus should not be read broadly. Moreover, the acquisition of lease rights from a landlord is not a common occurrence.

PLR 202012012 also offers some insight into how the IRS views certain "reductions" to a tenant's gross receipts under a percentage rent formula for purposes of assessing whether the rent is determined with reference to tenants' income or profits, which is impermissible under the rent-exception rule of IRC Section 856(d)(2)(A).

———————————————