In PLR 202551040, the IRS ruled that a real estate investment trust (REIT) could exclude from gross income a portion of rents for data centers received from or paid to joint ventures (JV) for purposes of IRC Sections 856(c)(2) and (c)(3) (Income Tests), finding that including the rents would result in double-counting for the Income Tests.

Facts

Taxpayer, a corporation that elected to be treated as a REIT, operates colocation data centers across the United States and internationally, primarily generating income from leasing space at its data centers to tenants. To expand its business, Taxpayer formed and intends to form JVs with unrelated capital partners to develop and lease a specific type of data center (Facility), which offers lower pricing and requires significant upfront capital. Taxpayer generally serves as the general partner of the JVs, which are classified as partnerships for federal tax purposes. Each JV will engage a taxable REIT subsidiary (TRS) of Taxpayer for construction, asset management and other services.

If a property has both colocation space and space to develop a Facility, ownership of the property will be split between Taxpayer and one or more JVs if possible. If ownership cannot be split, the property will be wholly owned by Taxpayer or a JV, and one of two approaches will be used to allow the other party to use a portion of the property:

• Tenant Approach: One or more JVs will own the property and lease a portion to Taxpayer; Taxpayer will pay arm's-length rent to the JVs (Colocation Prime Rents) and sublease the leased portion of the property to colocation tenants.
• Landlord Approach: Taxpayer will own the property and lease a portion to one or more JVs, which will pay arm's-length rent to Taxpayer (Facilities Prime Rents) and sublease the leased portion of the property to third parties for use as a Facility.

Law

IRC Section 856(c)(2) requires a REIT to derive at least 95% of its gross income from certain types of income, including rents from real property. IRC Section 856(c)(3) requires a REIT to derive at least 75% of its gross income from certain types of income, including rents from real property.

IRC Section 856(d)(2)(B) generally excludes from the definition of rents from real property any rents received from a partnership in which the REIT owns, directly or indirectly, a 10% or more interest in the partnership's assets or net profits.

Under Treas. Reg. Section 1.856-3(g), a REIT that is a partner in a partnership is deemed (1) to own its proportionate share of each of the assets of the partnership and (2) to be entitled to the partnership income attributable to that share. For purposes of IRC Section 856, the partner's interest in the partnership's assets is determined in accordance with the partner's capital interest in the partnership.

Analysis

For properties governed by the Tenant Approach, tenants pay rent to Taxpayer, who then pays Colocation Prime Rents to each relevant JV. Under Treas. Reg. Section 1.856-3(g), Taxpayer, as a partner in each JV, includes in its gross income its proportionate share of each JV's income, including the Colocation Prime Rents, based on Taxpayer's capital interest in each relevant JV. The IRS concluded that including the Colocation Prime Rents attributable to Taxpayer's capital interest in each relevant JV in Taxpayer's gross income would cause those rents to be double-counted for purposes of the Income Tests. Therefore, those rents are excluded from the Income Tests.

For properties subject to the Landlord Approach, each JV collects sublease rental income and pays Taxpayer the Facilities Prime Rents. Under Treas. Reg. Section 1.856-3(g), Taxpayer includes in its gross income its proportionate share of each JV's income, including the sublease rental income, based on Taxpayer's capital interest in each relevant JV. The IRS concluded that, because the source of the Facilities Prime Rents is amounts already included in Taxpayer's gross income (the sublease rental income), including the full Facilities Prime Rents in Taxpayer's gross income would cause those rents to be double-counted for purposes of the Income Tests. Accordingly, the IRS ruled that a portion of the Facilities Prime Rents corresponding to Taxpayer's capital interest in the JV is excluded from Taxpayer's gross income for purposes of the Income Tests.

Implications

PLR 202551040 is the most recently issued PLR addressing "self-charged" rental income and is consistent with the IRS's prior rulings on the treatment of such amounts for purposes of the Income Tests. See PLRs 201407011 (Tax Alert 2014-512), 201204006 (Tax Alert 2012-219) and 200705019 (Tax Alert 2007-129). Similar to prior private letter rulings involving a REIT receiving rent from a related-party partnership, the IRS ruled that Taxpayer may exclude from gross income, for Income Tests purposes, the portion of rent it receives from a related-party partnership based on its equal to its capital interest to prevent "double-counting. For Colocation Prime Rents paid by Taxpayer to a partnership in which it holds an interest, the IRS looked to Treas. Reg. Section 1.856-3(g) in concluding that Taxpayer's proportionate share of rents received by the JV could be excluded. PLR 202551040 provides comfort that in both scenarios the IRS's previous views on "self-charged" rental income remain unchanged.

PLR 202551040 does not mention the IRS's discretionary authority under IRC Section 856(c)(5)(J). PLR 201407011, the most recent private letter ruling addressing self-charged rental income prior to PLR 202551040, contained a recital of IRC Section 856(c)(5)(J) but did not expressly indicate that the ruling was provided under such discretionary authority.