Tax issues

Telecommunications Services May Be Good for REITs

The rapid advancement of telecommunications technology has made it necessary for property owners, including real estate investment trusts, to upgrade their properties with voice, video, and data communications systems to help attract new tenants.

This trend particularly has been menacing for REITs from a tax standpoint. A REIT's income from providing services associated with telecommunications equipment may be deemed "bad income" pursuant to rules governing REITs contained in Sections 856 and 857 of the Internal Revenue Code. Excessive bad income from the provision of impermissible services ultimately may lead to the loss of preferential REIT status. However, in a recent private letter ruling, PLR 199914038, the Internal Revenue Service held that income that a REIT receives from a variety of telecommunications services may qualify as rent from real property pursuant to IRC Section 856(d).

"Good Income"
In general, REIT regulations provide that at least 95 percent of a REIT's gross income must be derived from rents from real property, or "good income."

For purposes of the REIT rules, good income includes:

  • rent from interests in real property;
  • charges for services customarily furnished or rendered in connection with the rental of real property; and
  • rent attributable to personal property that is leased under, or in connection with, a lease of real property — but only if the rent attributable to such personal property for the taxable year does not exceed 15 percent of the total rent for the year attributable both to the real and personal property leased under, or in connection with the lease.

Services rendered to tenants of a building are considered customary if tenants in other similar-class buildings in the area customarily are provided with the service.

However, good income does not include "impermissible tenant service income," which is any amount that a REIT receives or accrues directly or indirectly for furnishing or rendering services to its properties' tenants or for managing or operating its properties. The exception to this rule allows REITs to receive income from such services as long as they are provided through an independent contractor from whom the REIT itself does not derive or receive any income.

Good income also does not include income from providing services that are primarily for convenience.

Telecommunications Issues
The IRS' recent private letter ruling was based on the following situation. A corporation that elected to be treated as a REIT for federal income tax purposes was a fully integrated real estate company that, through an operating partnership, owned and operated commercial office buildings.

To retain tenants as well as attract new tenants, the REIT planned to improve its properties with a network of voice, video, and data communications systems. These systems would be owned by the REIT and/or by one or more third-party service provider. The service provider or the REIT could provide related equipment to the tenants in connection with providing services including telephone, e-mail, video communications, electronic research, Internet access, safety and security systems, and environmental control systems.

The REIT or the OP would derive income in connection with providing these services as follows:

Pursuant to an agreement between a third-party provider and the REIT, a provider could pay the REIT or the OP a fee expressed as a fixed dollar amount, a percentage of the provider's gross receipts, or a combination of the two.

In addition to, or in lieu of, such fees, a tenant could pay the REIT or the OP a fee expressed as a fixed dollar amount, a percentage of the tenant's payments made to any service provider, or a combination of the two.

Finally, if the REIT or the OP owned an equity interest in an entity that is treated as a partnership for federal tax purposes, the REIT or the OP could derive income in connection with the provision of telecommunications services by reason of the REIT or the OP's proportionate share of charges received by such an entity from tenants and providers in connection with the provision of telecommunications services.

The REIT represented to the IRS that the telecommunications services offered to the tenants were those usually offered or provided to tenants of similar office properties. In addition, no service provider that entered into agreements with the REIT offered any telecommunications services to tenants that it also did not offer to its customers that were not tenants. Finally, the actual telecommunications services provided to tenants were not customized to tenants.

Given these facts, the IRS reasoned that providing telecommunications services has become an essential means of communicating business information and data. The IRS also reasoned that the REIT's ability to provide telecommunications services to tenants would allow the REIT to offer services similar to those offered to tenants of similar buildings.

The IRS held that the REIT's telecommunications services would not be considered to be rendered primarily for the convenience of the tenants, and therefore, the income generated from such services would be deemed good income.

The ruling breaks new ground by allowing a REIT to provide telecommunications services to its commercial tenants, but the IRS appears to have limited a REIT's ability to customize Internet services to fit the needs of a specific tenant.

In addition, the ruling does not address whether a REIT safely can provide Internet access to residential tenants. While a private letter ruling cannot be cited as precedent in legal proceedings with the IRS, the ruling is a valuable gauge of how the IRS may rule in a similar scenario. Any REIT seeking similar treatment should consult a tax adviser.

Steven M. Friedman and Samuel H. Hoppe

Steven M. Friedman is a tax partner and Samuel H. Hoppe is a tax professional in the McLean, Va., office of Ernst & Young. Contact them at (703) 747-1000 or steve.friedman@ey.com and samuel.hoppe@ey.com.

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