IRS Ruling Affecting REITs, Tax-Exempt EntitiesFebruary 11, 2022
On February 4th, the IRS issued PLR 202205001 (the “New Ruling”), which potentially has important implications for REITs and tax-exempt entities. The New Ruling partially revoked PLR 201137007 (the “Old Ruling”).
As described in the Old Ruling, the taxpayer, a REIT, leased properties to an affiliate in an OpCo/PropCo structure. The leases included a rent escalation provision under which base rent increased each year but was limited to the lesser of (a) a fixed percentage or (b) an amount that when added to base rent payable for the prior year resulted in a specified ratio of “Adjusted Revenue” to total rent payable. Adjusted Revenue was earnings before interest, taxes, depreciation/amortization, and rent expense.
The Old Ruling reached the conclusion that, notwithstanding the provisions governing rent increases, the rent qualified as good rent for purposes of the annual REIT tests. In the New Ruling, the IRS determined that Adjusted Revenue was not equivalent to sales or receipts but was instead a measure of the tenant’s income or profits. Even though Adjusted Revenue did not directly determine the amount of annual rent increases and could only limit the increase in the case of a downturn in the lessee’s business, the IRS concluded that base rent depended in part on the income derived by the lessee from the property. Accordingly, the IRS found that none of the rent qualified as good rent for purposes of the annual REIT tests.
The New Ruling is an aggressive change of position by the IRS. Arguably, the way “Adjusted Revenue” was used in the lease did not amount to the REIT’s participation in the upside of an active business that the REIT rules are intended to prevent. While the ruling applies only to the limited facts in question, which do not appear to be very common, we recommend review of any lease arrangements that include non-standard rent adjustment provisions. The New Ruling raises questions about what other types of provisions the IRS will now treat as rent based on profits or net income, for both REIT purposes and Unrelated Business Income Tax purposes.
If you have any questions, please contact a member of the Tax Department.
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