February 9, 2022
IRS rules payments to REIT based on lessee's adjusted revenue are not rents from real property, partially revoking earlier ruling
In PLR 202205001, the IRS ruled that payments to a real estate investment trust (REIT) for the use of real property that are based on the lessee's adjusted revenue are not "rents from real property" for purposes of IRC Section 856(c)(2) and 856(c)(3).
In doing so, the IRS partially revoked one of the rulings in PLR 201337007, which addressed a casino spin-off transaction and concluded that an escalation provision and other adjustments to payments under a lease would not "cause any amounts received or accrued under [the lease] to be treated as other than 'rents from real property'" under the REIT gross income tests. In revoking this portion of the prior ruling, the IRS stated that it was "not in accord with the current views" of the IRS.
A corporation that has elected to be treated as a REIT leases real property under leases that provide, in part, for fixed base rent, subject to an escalation provision and other adjustments.
Specifically, each lease provides for an annual increase to base rent limited to the lesser of (1) a fixed percentage of the prior year's base rent or (2) an amount (not less than zero) that, when added to the prior year's base rent, would result in a specified ratio of the lessee's adjusted revenue to the total of the prior year's rent (the escalation provisions). When a property is removed from a lease covering multiple properties, some leases reduce rent by an amount based on the relative adjusted revenue generated by the removed property as compared to the total adjusted revenue generated by all the properties subject to such lease (the other adjustment provisions).
The leases define adjusted revenue as the lessee's net revenue minus expenses other than interest expense, income tax expense, depreciation and amortization expense, rent expense and certain other expenses (effectively EBITDAR).
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.
Under IRC Section 856(d)(2)(A), the term "rents from real property" generally does not include amounts that depend, in whole or in part, on the income or profits derived by any person from the property. No amount, however, is excluded from rents from real property solely because it is based on a fixed percentage of receipts or sales.
In the ruling, the IRS concluded that amounts determined under the escalation provisions and other adjustment provisions depend in part on the lessee's adjusted revenue, which is a measure of the income or profits from operating the property and not equivalent to receipts or sales. Accordingly, amounts received or accrued under the leases do not qualify as rents from real property and are, therefore, not considered qualifying income for purposes of the 95% and 75% REIT gross income tests.
The ruling does not apply retroactively to the REIT's current leases (including during any current or remaining renewal periods that are exercisable at the lessee's sole discretion) but will apply if the leases are modified to change (1) the amount of the base rent or (2) the manner in which the base rent is calculated. The IRS clarified that the following modifications generally will not cause a lease to be modified in a way that would subject it to the revocation: (1) an amendment or modification that indirectly affects the base rent solely by causing an increase or decrease to adjusted revenue; (2) a capital improvement that is funded by the lessee or lessor and is not subject to an escalation provision; (3) an addition of a facility to a lease; or (4) the removal of one or more facilities (or a portion of a facility) from (i) a lease or (ii) the base rent, the escalation provision and/or the calculation of adjusted revenue.
The leases addressed in PLR 202205001 and PLR 201337007 provide for both base rent and percentage rent. PLR 202205001 revokes only the part of the PLR 201337007 ruling dealing with adjustments to base rent; it does not modify the part of the ruling concluding that the REIT's receipt of percentage rent payments "will not cause any amounts received under [the lease] to be treated as other than rents from real property" under IRC Sections 856(c)(2) and 856(c)(3). PLR 201337007 specified that percentage rent is based on a percentage of "net revenues" from the leased property. While net revenues are adjusted under the applicable lease for the retail value of certain services and other adjustments are made for certain subtenants, the PLR noted that taxes and expenses were not deducted in calculating net revenues for this purpose (unlike "adjusted revenue" as described in PLR 202205001, which is relevant to the determination of base rent).
The base rent escalation provisions in PLR 202205001 mitigate annual rent increases that would otherwise have been payable under a fixed-percentage increase provision and could be viewed as a rent concession by the REIT. Nevertheless, the IRS appears to have viewed the adjustment formula as effectively basing rents on the income or profits of the lessees because the formula could take into account the lessee's adjusted revenue from the prior year. It is unclear from the ruling if the IRS would view any reset formula referencing the tenant's past revenues (on other than a gross basis) as based on income or profits.
The ruling serves as a reminder that certain rent concessions, as well as base rent and percentage rent formulas, should be evaluated in light of the prohibition on rent based on income or profits. In addition, REITs should carefully consider lease provisions that adjust rent upon the removal of an asset from a portfolio when entering into portfolio leases. The ruling also serves as a reminder that the IRS's views on qualifying rental income continue to evolve, and the IRS may revoke or modify a letter ruling that it later finds to be in error or not in accordance with its current views.