United States: Final Regulations Define "Real Property" For REITs

On August 31, 2016, the Internal Revenue Service (IRS) and US Department of the Treasury issued final regulations (Final Regulations) under section 856 of the Internal Revenue Code to clarify the definition of "real property" for purposes of sections 856 through 859 relating to real estate investment trusts (REITs). The Final Regulations largely follow proposed regulations issued in 2014 (Proposed Regulations) by providing a safe harbor list of assets and establishing facts and circumstances tests to analyze other assets.


Section 856 sets forth the requirements for a taxpayer to qualify as a REIT for federal income tax purposes. One of the requirements is that at the close of each quarter of the taxable year, at least 75 percent of the value of the REIT's assets must be represented by real estate assets, cash and cash items (including receivables) and government securities.

Section 856 defines "real estate assets" to include real property and interests in real property. Treasury Regulations section 1.856-3(d), promulgated in 1962, defined real property as "land or improvements thereon, such as buildings or other inherently permanent structures thereon (including items which are structural components of such buildings or structures)," and also included "interests in real property."

Between 1969 and 1975, the IRS issued various revenue rulings addressing whether certain assets qualify as real property for purposes of section 856. Since then, REITs have sought to invest in a variety of other types of assets that are not directly addressed by those revenue rulings, and have sought and received private letter rulings from the IRS with respect to assets such as a data center and related infrastructure, boat slips and end ties in a marina and outdoor advertising signs. Given that private letter rulings are limited to their particular facts and may not be relied upon by other taxpayers, the IRS and Treasury recognized the need to provide updated published guidance on the definition of real property under sections 856 through 859.

On May 14, 2014, the IRS and Treasury published in the Federal Register a notice of proposed rulemaking to define "real property" solely for purposes of sections 856 through 859 and provisions that reference the definition of real property in section 856 and the regulations thereunder.

Click here for a detailed summary of the Proposed Regulations.

Final Regulations

The Final Regulations follow the Proposed Regulations in defining "real property" to include land and improvements to land—i.e., inherently permanent structures (IPSs) and their structural components. The Final Regulations also follow the Proposed Regulations by providing safe harbor lists of assets and establishing facts and circumstances tests to analyze other assets. 

The Final Regulations apply only in determining whether the assets held by a REIT qualify as real property, and provide neither explicit nor implicit guidance regarding whether income derived from such assets is "good" REIT income under sections 856(c)(2) and (3). 


Land is treated as real property and includes water and air space superjacent to land, as well as natural products and deposits that are unsevered from the land. The preamble to the Final Regulations clarifies that air space and water space superjacent to land each qualify as land even if the REIT owns only the air space or water space and does not own an interest in the underlying land.

IPSs include permanently affixed buildings and other inherently permanent structures (OIPSs). The Proposed Regulations stated that to qualify as an IPS, a distinct asset must be permanently affixed, and that if the affixation is reasonably expected to last indefinitely based on all the facts and circumstances, the affixation is considered permanent. The Final Regulations retain this requirement, with the preamble clarifying that the IRS and Treasury do not intend the term "indefinitely" to mean "forever."

The Final Regulations add motels, enclosed stadiums and arenas and enclosed shopping malls to the "safe harbor" list of assets that are treated as buildings. The IRS and Treasury declined to add outdoor sports stadiums, amphitheaters and unenclosed parking garages to this list; however, the preamble notes that many of these structures would satisfy the definition of an OIPS under the Final Regulations. No additions were made to the safe harbor lists of OIPSs and structural components set forth in the Proposed Regulations. 

The Proposed Regulations contained a requirement that an OIPS must serve a passive function, such as to contain, support, shelter, cover or protect, and must not serve an active function, such as to manufacture, create, produce, convert or transport. The Final Regulations retain this requirement and add "provide a conduit or a route" to the list of permitted passive functions. The preamble clarifies that the IRS and Treasury intend the term "transport" to mean to cause to move, rather than to provide a conduit (such as in the case of a pipeline or electrical wire) or route (as in the case of a road or railroad track). The preamble to the Final Regulations also clarifies that the passive function requirement neither prohibits a tenant from using a passive asset, such as an office building, in the tenant's active business nor limits a REIT's ability to perform either the permitted services under section 856(d)(7)(C)(ii) or the permitted trustee/director functions under Treasury Regulations section 1.856-4(b)(5)(ii). The IRS and Treasury further state in the preamble that machinery and equipment that may serve both passive and active functions are excluded from the definition of an IPS.  

Structural Components

A structural component means any distinct asset that (1) is a constituent part of and integrated into an IPS; (2) serves the IPS in its passive function; and (3) even if capable of producing income other than consideration for the use or occupancy of space, does not produce or contribute to the production of such income. 

The Proposed Regulations stated that a structural component would not qualify as real property unless the REIT's interest in the structural component is included with an "equivalent interest" held by the REIT in the IPS to which the structural component is functionally related. The preamble to the Final Regulations states that the IRS and Treasury intended that the "equivalent interest" requirement in the Proposed Regulations ensure that an asset did not qualify as a structural component unless that asset served real property in which the REIT also had an interest. Under the Final Regulations, the REIT is no longer required to hold an "equivalent interest" in the IPS. However, an interest in the IPS is still required. Specifically, the REIT must hold its interest in the structural component together with a real property interest with respect to the space in the IPS that the structural component serves. As such, differing interests (e.g., an ownership interest in the structural component and a leasehold interest in the IPS) are permissible under the Final Regulations.   

Distinct Asset

The Final Regulations retain the language in the Proposed Regulations regarding "distinct assets." To determine whether an asset is land, an IPS or a structural component, it is necessary to test first whether the item of property is a "distinct asset" based on all the facts and circumstances. The IRS and Treasury clarify in the preamble to the Final Regulations that for a distinct asset to be treated as a structural component, a REIT must hold a legally enforceable real property interest in the space in the IPS that the structural component serves, and that a leasehold interest is permissible.


The Proposed Regulations provided that an intangible asset is real property or an interest in real property if the asset derives its value from real property or an interest in real property, is inseparable from that real property or interest in real property, and does not produce or contribute to the production of income other than consideration for the use or occupancy of space. The IRS and Treasury state in the preamble that intangible assets that are separable from real property or an interest in real property should not qualify as real property. Therefore, the Final Regulations clarify that intangible assets that are related to services and that are separable from the real property do not qualify as real property. The Final Regulations also clarify that an intangible asset, such as a lease, may include an asset that is, in part, an interest in real property and, in part, an asset other than an interest in real property. The Final Regulations include a new example illustrating the application of these rules to an in-place above-market lease that produces income that qualifies as rents from real property under section 856(d)(1) and other non-qualifying income.


The examples in the Final Regulations illustrate the application of the rules to various types of assets, including an indoor sculpture, bus shelters, a cold storage warehouse, a data center, partitions, a solar energy site, a solar-powered building, a pipeline transmission system, a land use permit and a license to operate a business. 

The Final Regulations retain and revise 12 of the 13 examples included in the Proposed Regulations. The excluded example (Example 11 of the Proposed Regulations) addressed whether goodwill established under GAAP as a result of the acquisition of stock of a corporation that owned a hotel qualifies as real property for purposes of sections 856 through 859. The example concluded that such goodwill is real property to the acquiring REIT when it acquires the stock of the corporation. The Final Regulations remove this example, because depreciated replacement cost is no longer the standard under GAAP for valuing property such as the hotel. In its place, the Final Regulations add a new Example 11, which involves an in-place above-market lease that is treated as an intangible asset under GAAP. The value of the above-market lease is partly attributable to rents from real property and partly attributable to income that does not qualify as rents from real property. The example concludes that the above-market lease can be treated as, in part, an interest in real property (with respect to the portion of the value that is attributable to rents from real property) and, in part, an asset other than an interest in real property (with respect to the portion of the value that is attributable to income that does not qualify as rents from real property). 

Several examples in the Proposed Regulations involved a REIT that enters into long-term, triple-net leases of property. The Final Regulations revise these examples to refer generally to "leases" (rather than long-term, triple-net leases) and to provide that the REIT neither operates the property nor provides services to the lessee. 

The Final Regulations are generally consistent with the Proposed Regulations in their treatment of renewable energy assets: smaller-scale renewable energy systems that primarily serve buildings are generally REIT-eligible assets, whereas larger, utility-scale assets effectively are not eligible. The Final Regulations are also consistent with the Proposed Regulations in their treatment of transmission systems: despite the fact that a transmission system may serve an active function (e.g., transporting natural gas), distinct assets within the system may nevertheless be an IPS if that asset does not perform an active function. 

Effective/Applicability Date 

The Final Regulations apply for taxable years beginning after August 31, 2016, although taxpayers may rely on them for quarters that end before that date. In addition, the preamble clarifies that to the extent a previously issued letter ruling is inconsistent with the Final Regulations, the letter ruling is revoked prospectively from the applicability date of the Final Regulations (i.e., August 31, 2016).

Final Regulations Define "Real Property" For REITs

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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