IRS Changes Tack on Rents Paid Under Escalation Clause as REIT Qualifying Income

Many REIT leases have percentage or contingent rent clauses, and the analysis of their tax treatment is highly fact specific. In light of the apparent change in IRS policy, REITs that treat rents under such provisions as qualifying “rents from real property” may want to take a fresh look at their leases.

Rents from Real Property

To qualify as a REIT, an entity must satisfy two gross income tests annually. First, under IRC section 856(c)(2), at least 95% of a REIT’s annual gross income must be derived from certain types of passive income, including rents from real property. Second, under IRC section 856(c)(3), at least 75% of a REIT’s annual gross income must be derived from certain real-estate related sources, including rents from real property.

In general, “rents from real property” are the gross amounts received for the use of, or the right to use, real property of the REIT. Adjustable rents based on a fixed percentage of receipts or sales are considered “rents from real property,” but those based in whole or in part on income or profits from the property are disqualified as rents for REIT purposes.

Failure to satisfy the gross income tests could result in the loss of REIT status unless the failure is due to reasonable cause and certain other requirements are met.

The Ruling

In Private Letter Ruling 202205001, issued February 4, 2022 (the 2022 PLR), the IRS partially revoked a favorable PLR issued in 2013 (the 2013 PLR). The 2013 PLR allowed qualifying income treatment for rents paid under a formulaic rent escalation clause. In revoking the 2013 PLR, the IRS states that the conclusion of the 2013 PLR that the rent escalation formula is based on “receipts or sales” — and therefore “rents from real property” under IRC sections 856(c)(2) and 856(c)(3) — is no longer “in accord with the current views of the Service.” Instead, the IRS believes the adjustable rent clause is a measure of income or profits of the tenant.

The leases at issue in the 2022 PLR provided a rent escalation provision that increased the base rent each year by the lesser of:

• a fixed percentage of the prior year’s base rent; and
• an amount (but not less than zero) that, when added to prior year’s base rent, would result in a specified ratio of “Adjusted Revenue” to the total rent payable for such prior year.

Each of these leases defined “Adjusted Revenue” to mean the net revenue of the lessee minus expenses other than (i) interest expense, (ii) income tax expense, (iii) depreciation and amortization expense, (iv) rent expense, and (v) certain other expenses.

When re-evaluating this provision, the IRS explained that “Adjusted Revenue is not equivalent to receipts or sales and is instead a measure of the income or profits derived by the lessee from the operation of the property.” Therefore, the IRS concluded that the amounts received or accrued under the leases do not qualify as “rents from real property” under section 856(d)(2)(A).

Implications

This ruling demonstrates the IRS is limiting its views on the types of rental formulas in leases that will generate qualifying income as “rents from real property” for REIT purposes. Because the definition of “rents from real property” for REIT purposes also applies in determining whether rental income is qualifying for MLPs, this ruling also impacts MLPs. In addition, because rulings that interpret the REIT definition of “rents from real property” often serve as guidance as to whether a payment to a tax-exempt entity comes within the definition of rents for unrelated business taxable income purposes, this ruling may also impact tax-exempt entities.

REITs, MLPs and tax-exempt entities with leases will need to consult with their tax advisors and carefully review lease agreements to make sure that amounts derived under leases are not based on income or profits in order to avoid a potential tax controversy.

V&E’s Tax group has substantial experience in drafting and reviewing lease agreements for REIT, MLP and tax-exempt clients. For assistance in reviewing your lease agreements in light of this recent ruling, please contact Jim Meyer, Chris Mangin, Paige Anderson, Maddie Brown or any other member of the group.