August 26, 2021
IRS rules payments to REIT for use of fiber optic cable capacity are 'rents from real property,' geographic operational area can be used for limited rental exception
In two recent private letter rulings (PLR 202132002 and PLR 202133003), the IRS has ruled that payments received by a real estate investment trust (REIT) for the right to use capacity on the REIT's fiber optic cables qualify as "rents from real property" for purposes of IRC Section 856(c)(2) and 856(c)(3). The IRS also ruled that the performance of certain services and activities do not give rise to impermissible tenant service income. In addition, the IRS ruled that the REIT may apply the limited rental exception under IRC Section 856(d)(8)(A) by reference to the continuously connected fiber optic cable within the geographic boundaries of a specified operational area.
In both PLRs, Taxpayer intends to elect to be treated as a REIT under IRC Sections 856 through 859. Taxpayer is in the business of leasing the following property to Tenants: (1) systems composed of permanently affixed coaxial and fiber optic cable and the associated conduit piping; and (2) indoor and outdoor distributed antenna systems or small cell systems (DAS).
Taxpayer will typically own the equipment that receives, amplifies, converts and returns a signal originated by a Tenant, including antennas, optical converters, lasers, transponders, amplifiers and regeneration equipment. Either a taxable REIT subsidiary (TRS) or an independent contractor from whom Taxpayer does not derive or receive any income (IK) will perform all work to operate, monitor, manage, maintain and repair this equipment. Taxpayer represented that it will treat the equipment as personal property for purposes of IRC Section 856(d)(1)(C). It also represented that the fair market value of the personal property leased under, or in connection with, a lease of real property assets of a DAS installation or other fiber optic system is less than 15% of the fair market value of the real and personal property subject to the lease.
Taxpayer enters into six different types of contractual agreements with Tenants for the use of fiber optic cable capacity, all of which are described in the PLRs: (1) DAS Agreements; (2) Indefeasible Rights of Use Agreements (IRUs); (3) Capacity Leases; (4) Wave Leases; (5) Backhaul Leases; and (6) Bifurcated Leases. Under a Bifurcated Lease, Tenant's signal will travel from Tenant's premises and follow a dedicated fiber optic pathway owned by Taxpayer to equipment that will direct Tenant's signal along one of up to seven dedicated fiber optic pathways owned by Taxpayer. Where Taxpayer's fiber optic pathway ends, a TRS or IK will transfer Tenant's signal to a server owned by an unrelated third party. Signals of different Tenants are not intermingled.
Under certain circumstances, Taxpayer will also lease capacity on its fiber optic cable to a TRS, which will lease less than 10% of the leased capacity as measured within an Area, which is defined as "a specifically identified geographic region of Taxpayer's fiber network" that Taxpayer designates to facilitate the operation of its continuously connected fiber across the country.
Law and analysis
IRC Section 856(c)(2) requires a REIT to derive at least 95% of its gross income from specified sources of passive income, including rents from real property. IRC Section 856(c)(3) requires a REIT to derive at least 75% of its gross income from specified sources of real estate source income, including rents from real property.
Treas. Reg. Section 1.856-4(a) defines the term "rents from real property" generally as the gross amounts received for the use of, or the right to use, the REIT's real property. Under IRC Section 856(d)(1), the term "rents from real property" includes: (1) rents from interests in real property; (2) charges for services customarily furnished or rendered in connection with the rental of real property, whether or not such charges are separately stated; and (3) rent attributable to personal property leased under, or in connection with, a lease of real property, but only if the rent attributable to the personal property for the tax year does not exceed 15% of the total rent for the tax year attributable to both the real and personal property leased under, or in connection with, such lease. A service furnished to tenants of a particular building will be considered customary if, in the geographic market in which the building is located, the service is customarily provided to tenants in buildings of a similar class (Treas. Reg. Section 1.856-4(b)(1)).
Under IRC Section 856(d)(2)(C), impermissible tenant service income (defined by IRC Section 856(d)(7)(A) as any amount received or accrued by the REIT for services furnished or rendered to tenants or for managing or operating the property) is excluded from the definition of "rents from real property." Impermissible tenant service income does not include (1) payments received for services, management or operation provided through an IK or the REIT's TRS and (2) any payment that would be excluded from unrelated business taxable income under IRC Section 512(b)(3) if received by an organization described in IRC Section 511(a)(2) (IRC Section 856(d)(7)(C)).
The IRS ruled that amounts received by Taxpayer for the right to use or occupy space on the real property assets comprising a fiber optic system or DAS installation qualify as "rents from interests in real property" under IRC Section 856(d)(1)(A). In so ruling, the IRS noted that Taxpayer had represented that such assets are real property for purposes of IRC Section 856 and that under each of the six types of Agreements:
The IRS also ruled that the furnishing of the services described in the PLRs that will be performed by a TRS or IK and the performance of certain activities by Taxpayer do not give rise to impermissible tenant service income, and will not cause any portion of the rents received by Taxpayer from Tenants for use of Taxpayer's real property assets to fail to qualify as "rents from real property" under IRC section 856(d).
Under IRC Section 856(d)(8), payments to a REIT by its TRS for the use of space may qualify as "rents from real property," despite the related-party rent rule under IRC Section 856(d)(2)(B), if at least 90% of the leased space of a particular property is rented to persons other than the REIT's TRSs or related parties. The rents paid by the TRS to the REIT must be substantially comparable to rents paid by the other tenants of the REIT's property for comparable space.
For purposes of this limited rental exception, the IRS ruled that the relevant "property" with regard to Taxpayer's fiber optic cable is the continuously connected fiber optic cable within the geographic boundaries of the applicable Area.
Significantly, PLR 202132002 and PLR 202133003 expand the types of fiber optic arrangements that generate "rents from interests in real property" within the meaning of IRC Section 856(d)(1)(A) to include agreements for the use of fiber optic cable capacity to transmit a signal from one origination point to one of several different destination points. Previous PLRs (e.g., PLR 201901001) only addressed transmission along a fiber optic pathway from one point to a single designated endpoint.
In addition, PLR 202132002 and PLR 202133003 confirmed the position taken in certain previous PLRs (e.g., PLR 202035008) that payments received by a REIT for use of fiber-optic-cable capacity qualify as "rents from interests in real property" under IRC Section 856(d)(1)(A), where the REIT owns the associated signal equipment, such as antennas, optical converters, lasers, transponders, amplifiers and regeneration equipment (see Tax Alert 2020-2219). In other previous PLRs (e.g., PLR 201901001), the REIT represented that the TRS would both own and operate such equipment. Here, however, the REIT may own such equipment, while a TRS or IK will operate, monitor, manage, maintain and repair it.
Finally, PLR 202132002 and PLR 202133003 allow the REIT to apply the 10% limited rental exception under IRC Section 856(d)(8)(A) by reference to a specified operational area with geographic boundaries, rather than requiring the REIT to determine the application of such rule by reference to individual fibers or cables.