On August 30, 2016, the IRS issued final regulations that clarify and expand the definition of "real property" for purposes of qualifying as a real estate investment trust (REIT). The final regulations substantially follow the proposed regulations issued by the U.S. Department of the Treasury on May 9, 2014.
To qualify as a REIT, a corporation, trust, or association is required, among other things, to meet the "asset test," which requires that at least 75 percent of the value of the corporation, trust, or association's total assets consist of real estate assets, cash and cash items, and government securities at the close of each quarter of their taxable year.
Recognizing the need for guidance with respect to what constitutes real property that is considered a real estate asset for purposes of the asset test, the final regulations define real property for REIT-qualification purposes as: (a) buildings; (b) other inherently permanent structures that serve a passive function; and (c) structural components that are distinct assets that constitute a part of—and are integrated into—an inherently permanent structure, serve the inherently permanent structure in a passive function, and do not produce or contribute to the production of income. As such, only assets that are passive—meaning property that is used to shelter, support, cover, or protect—are qualifying REIT assets, and improvements or structures that serve an active function, "such as to manufacture, create, produce, convert, or transport," are not qualifying REIT assets.
The final regulations contain two examples of solar property that constitute real property and thus are real estate assets for REIT-qualification purposes.
The first example breaks down the assets of a solar energy site into four components: land, PV modules, mounts, and exit wire. In addition to the land, for which the status as real property was never in doubt, the mounts—which are designed and constructed to remain in place indefinitely, are permanently affixed to the land, and have a passive function of supporting the PV modules—are real property. The exit wire—designed to remain permanently in place and permanently affixed to an inherently permanent structure (i.e., the electric grid)—is also real property. However, the PV modules, which perform an active function of converting solar photons into electricity, are not real property for REIT purposes.
The second example addresses whether all of the assets in a solar energy site (including the PV modules) are real property for REIT purposes where the solar energy site assets are on land adjacent to an office building that is owned by a REIT and leased, along with the solar energy assets, to a single tenant and where the REIT does not operate either the office building or the solar energy assets. The example states that the solar energy assets are intended to produce electricity only to serve the office building, although excess electricity produced by these assets is occasionally transferred to a utility company. The example concludes that in this circumstance, all of the solar energy assets, including the PV modules, are structural components of the building and hence real property for REIT purposes, relying on the following factors: (a) they are expensive and time consuming to install and remove; (b) they are designed specifically for the office building; (c) they would be damaged if removed; (d) they serve a utility-like function for the office building; (e) they serve the office building in its passive functions of containing, sheltering, and protecting the tenant and the tenant's assets; (f) they produce income from consideration for the use or occupancy of space within the office building; and (g) they will remain in place when the tenant vacates. The example then identifies two factors that weigh against the characterization of the solar energy assets as structural components of the building, to wit: that they can be removed without causing material damage to the building and they were not constructed when the building was constructed. However, the regulations conclude that these factors do not outweigh the factors supporting the conclusion that they are structural components. The example also concludes that solar shingles that are used as the roof of a building owned by a REIT and leased to a single tenant would also qualify as structural components of the real property.
These examples are fact-specific, and while they are comforting in some respects, they leave a number of unanswered questions. For example, what constitutes an occasional transfer to a local utility? Would the answer in the second example change if, for example, (a) a substantial amount of the solar assets could be removed without being materially damaged; (b) some of the solar assets, such as the PV modules, are intended to be removed if the tenant vacates the premises; or (c) the solar energy site was designed to produce some excess electricity?
The final regulations apply to taxable years that begin after August 31, 2016.
For further information, please contact Greg Broome (gbroome@wsgr.com; 415-947-2139) or any member of the tax or energy and infrastructure practices at Wilson Sonsini.
