rr-03-86.pdf

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Part I

Section 856.–Definition of Real Estate Investment Trust

26 CFR 1.856-4: Rents from Real Property

Rev. Rul. 2003-86

ISSUE

If a joint venture partnership between a taxable REIT subsidiary (TRS) of
a real estate investment trust (REIT) and a corporation that qualifies as an
independent contractor of the REIT under § 856(d)(3)(B) of the Internal Revenue
Code provides noncustomary services to tenants of the REIT in the situation
described below, will rents paid by the tenants to the REIT fail to qualify as rents
from real property under § 856(d)?
FACTS

R is a corporation that has elected and qualifies to be treated as a REIT
under subchapter M of Chapter 1 of the Code. R owns and operates rental
apartment properties in several major metropolitan areas. In 2002, R formed a
wholly owned corporation, T, to provide services to tenants of its properties. R
and T filed Form 8875 to jointly elect for T to be treated as a TRS of R effective
as of the date of T’s formation. The services provided to tenants by T are
services that are not customarily provided to tenants of rental apartment
properties in the metropolitan areas in which R’s properties are located.

X is a corporation unrelated, either directly or indirectly, to either R or T. X
qualifies as an independent contractor under § 856(d)(3)(B). X provides various
services to R’s tenants and tenants of other rental apartments in the areas where
R’s properties are located. The services provided by X are noncustomary in the
areas where R’s properties are located and are primarily for the convenience of
tenants.

X and T formed P, which is treated as a partnership for federal income tax
purposes, to provide the noncustomary services that formerly were separately
provided to R’s tenants by either X or T. X and T made equal capital
contributions to P. X and T share in all items of P’s income, gain, loss, and
deduction in proportion to their capital contributions. R’s tenants contract directly
with P for services. R does not receive any payments related to the services
from P, X or tenants. R receives quarterly dividends from T.
LAW AND ANALYSIS

To qualify as a REIT, an entity must derive at least 95 percent of its gross
income from sources listed in § 856(c)(2) and at least 75 percent of its gross
income from sources listed in § 856(c)(3). “Rents from real property” are among
the sources listed in both of those sections. Section 856(d)(1) defines rents from
real property to include rents from interests in real property, charges for services
customarily rendered in connection with the rental of real property, and rent
attributable to certain leased personal property. However, § 856(d)(2)(C)
excludes “impermissible tenant service income” from the definition of rents from
real property.

Section 856(d)(7)(A) defines “impermissible tenant service income” to
include, with respect to any real or personal property, any amount received or
accrued directly or indirectly by a REIT for services furnished or rendered by the
REIT to tenants of the property. Section 856(d)(7)(B) provides that if
impermissible tenant service income from a property for any tax year exceeds 1
percent of all amounts received or accrued directly or indirectly by the REIT
during the tax year from the property, the impermissible tenant service income
from the property shall include all amounts received or accrued from the property
for the tax year. Section 856(d)(7)(C)(i) provides that services furnished or
rendered through a TRS or an independent contractor from whom the REIT does
not derive or receive any income are not treated as furnished, rendered, or
provided by the REIT for purposes of § 856(d)(7)(A). Thus, services rendered by
a TRS do not give rise to impermissible tenant service income, and services
rendered by an independent contractor do not give rise to impermissible tenant
service income if the REIT does not receive or derive income from the
independent contractor.

R’s tenants contract directly with P to perform noncustomary services.
Thus, R does not receive directly any payments related to the services from P.
Also, R does not directly or indirectly receive income from X, an independent
contractor. T is entitled to its share of income from the performance of services
in proportion to its interest in P, and R may indirectly receive this income in the
form of dividends from T. Under § 856(d)(7)(A) amounts received directly or
indirectly by a REIT for services furnished or rendered to tenants constitute
impermissible tenant service income.

However, § 856(d)(7)(C)(i) provides an exception for services furnished or
rendered through a TRS. R’s only interest in P is through T, which is a TRS.
Accordingly, the services provided by P are treated as provided by T to the
extent of T’s interest in P. Therefore, R will not be treated as providing
impermissible tenant services to its tenants.

HOLDING

Under the circumstances described above, a joint venture partnership
between a TRS of a REIT and a corporation that qualifies as an independent

contractor of the REIT under § 856(d)(3)(B) may provide noncustomary services
to tenants of the REIT without causing the rents paid by the tenants to the REIT
to fail to qualify as rents from real property under § 856(d).

DRAFTING INFORMATION

The principal author of this revenue ruling is Jonathan D. Silver of the
Office of Associate Chief Counsel (Financial Institutions & Products). For further
information regarding this revenue ruling contact Mr. Silver on (202) 622-3920
(not a toll-free call).