March 22, 2022
IRS rules payments to REIT for waiver of liability shield for property damage are rents from real property
The IRS ruled in PLR 202211002 that rents from real property under IRC Section 856(d) include a tenant's payments to its landlord for a limited waiver of a lease provision that shields the landlord from liability for personal property damage.
Taxpayer, a corporation that intends to elect to be taxed as a REIT, conducts its activities through a partnership that owns and operates certain facilities. Tenants lease space in the facilities under leases that include a liability shield (the Liability Shield). The Liability Shield protects the landlord and its agents and employees from liability for damage sustained by tenants' property in the leased space, including damages resulting from "active or passive acts or omissions or negligence" by the landlord, its agents or employees. This provision is consistent with standard leases in Taxpayer's industry.
A tenant has two options when entering into a lease: (1) present proof of adequate third-party insurance coverage or (2) make a monthly payment to the landlord in exchange for a limited waiver of the Liability Shield (the Coverage Product). Landlords require tenants to satisfy one of these two options to limit landlord's exposure from operating a facility and to ensure there is a clear process to address tenant claims that might otherwise become the subject of lawsuits.
Tenants choosing the Coverage Product must enter into a lease addendum with the landlord (the Agreement) permitting the tenant to bring a claim against the landlord for damages if the landlord would be liable under landlord-tenant law absent the Liability Shield. The claim amount is capped, although a tenant can pay more, in some cases, for a higher cap on the landlord's potential liability. The Agreement specifies that the monthly payment for the Coverage Product is "additional rent" or "additional monthly rent," and that the Coverage Product is not insurance.
The Coverage Product is currently provided by Taxpayer's taxable REIT subsidiaries. Upon receipt of the ruling, Taxpayer intends for the partnership through which Taxpayer invests (or the partnership's direct or indirect subsidiaries) to provide the Coverage Product to tenants.
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)(1), "rents from real property" generally includes: "(A) rents from interests in real property; (B) charges for services customarily furnished or rendered in connection with the rental of real property, whether or not such charges are separately stated; and (C) 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 taxable 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. 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, real property of the REIT.
The IRS ruled that the payments for the Coverage Product qualify as rents from real property for purposes of the 75% and 95% gross income tests under IRC Sections 856(c)(2) and 856(c)(3). In support of its ruling, the IRS noted that the tenant's right to make a claim against the landlord arises out of the landlord-tenant relationship and the tenant's right to use the real property space. "In this case, paying a separate fee for this right does not change this analysis," the IRS said.
The IRS noted that the payments for the Coverage Product are similar to those addressed by Revenue Ruling 75-226, which concluded that rents from real property included a payment received by a REIT for subordinating its fee interest in leased land to a mortgage loan obtained by the tenant and secured by the tenant's interest in improvements constructed on the leased land. As with the payments to the REIT in the revenue ruling, the payments for the Coverage Product are additional consideration for a right (in this case, the right to make a claim against the landlord for damage to personal property located in the leased space) that is so closely connected with the tenant's occupation, possession and enjoyment of the real property that it constitutes rents from real property under IRC Section 856(d)(1)(A).
PLR 202211002 was not issued under the IRS's discretionary authority under IRC Section 856(c)(5)(J), which allows the IRS to treat an item of income or gain that does not otherwise qualify under IRC Sections 856(c)(2) or (c)(3) as either qualifying income or excludable from gross income for purposes of the REIT gross income tests. While private letter rulings do not have precedential authority, the fact that the IRS did not conclude that the payments for the Coverage Product were otherwise non-qualifying under IRC Sections 856(c)(2) or (c)(3) may be helpful to taxpayers and their advisors considering how the IRS may view similar payments.
While PLR 202211002 appears to involve storage arrangements, REITs in many sectors similarly require tenants either to provide proof of insurance coverage or to purchase some form of minimal protection with respect to their personal property located within leased space. PLR 202211002 provides a framework for considering when payments for such coverage may be viewed as so inextricably linked to tenants' rights under a lease that the payments qualify as rents from real property for purposes of IRC Sections 856(c)(2) and (c)(3). Because the Agreement states that the Coverage Product is not insurance, and merely permits potential claims that the tenant would otherwise have had against the landlord under applicable law absent the Liability Shield, this raises the question of whether the IRS would view a similar product differently if it were labeled as insurance.
Rather than offering an insurance-like product that allows a tenant to bring a claim against the landlord, many leases allow the landlord to charge a tenant for failure to provide proof of insurance. PLR 202211002 may provide some support for considering such payments as qualifying rents from real property for purposes of IRC Sections 856(c)(2) and (c)(3).