IRS partially revokes an old REIT-rent ruling, but only going forward

Plain-English summary

A REIT collects rent under a master lease and other leases whose annual rent increases (called Escalation and Other Adjustments) are capped by a formula tied to the tenant's "Adjusted Revenue," a measure of the tenant's net income or profits. Back in 2012, an earlier private letter ruling (Ruling 47 of PLR 201337007) had blessed these adjustments as still producing "rents from real property," which is important because a REIT must draw most of its income from qualifying rents to keep its tax status. The IRS reconsidered and decided that was wrong: because the adjustments depend on the tenant's income or profits (not merely on receipts or sales), those amounts fail the rents-from-real-property test in section 856(d)(2)(A). The IRS therefore partially revoked Ruling 47. To soften the blow, it used its section 7805(b) authority to make the revocation prospective only: it applies starting with a future tax year and does not disturb the existing leases (including discretionary renewals) as they stood, unless a lease is later amended to change how the base rent is calculated. The upshot is a loss on the legal characterization but meaningful protection for the taxpayer's existing arrangements. This matters because it shows the line the IRS draws between profit-based rent (bad for REIT qualification) and receipts-based rent (acceptable), and how section 7805(b) relief can grandfather reliance on a ruling that is later withdrawn.

Ruling snapshot

• Question: Do lease rent adjustments tied to the tenant's "Adjusted Revenue" (a profit measure) still count as "rents from real property," and should revoking the prior contrary ruling apply retroactively?
• Outcome: Mixed (prior Ruling 47 partially revoked because the amounts are not rents from real property; section 7805(b) relief limits the revocation to future years and grandfathers existing leases)
• Key authorities: IRC § 856(c)(2), (c)(3), § 856(d)(2)(A); § 7805(b); Rev. Proc. 2021-1 §§ 11.04, 11.06

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202205001 Third Party Communication: None
Release Date: 2/4/2022 Date of Communication: Not Applicable
Index Number: 856.01-00, 856.04-00,
856.05-01 Person To Contact:
--------------, ID No. -----------------
-------------- Telephone Number:
------------------------------------------------------------ --------------------
---------------- Refer Reply To:
------------------------------------- CC:FIP:B03
---------------------------------------- PLR-102160-19
-------------------------------- Date:
November 04, 2021

LEGEND

Taxpayer 1 = ------------------------------------------------------------------------------------------
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Taxpayer 2 = ------------------------------------------------------------------------------------------
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State = ------------------

Date 1 = --------------------------

Date 2 = ------------------------

Date 3 = -------------------------

UPREIT LLC = -------------------------------------------------------------

UPREIT LP = --------------------------------------------------

a = ---

b = --
PLR-102160-19 2

Master Lease = ------------------------------------------------------------------------------------------
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Other Leases = ------------------------------------------------------------------------------------------
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Building Base = ------------------------------------------------------------------------------------------
Rent

Facility = ------------------------------------------------------------------------------------------
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Agreement = ------------------------------------------------------------------------------------------
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Dear ------------------------------:

    On September 28, 2012, the Internal Revenue Service (“Service”) issued PLR

201337007 (PLR-127348-11) to Taxpayer 2. PLR 201337007 includes certain rulings
with respect to the Proposed Transaction described in the PLR. The Proposed
Transaction involved Taxpayer 1 and Taxpayer 2. (Taxpayer 1 and Taxpayer 2,
collectively, “Taxpayers”).

 Ruling 47 in PLR 201337007 states: “UPREIT LP’s receipt of Percentage Rent

payments under the Master Lease and the specified adjustments to amounts payable
PLR-102160-19 3

under the Master Lease pursuant to the Escalation and the Other Adjustments will not
cause any amounts received under the Master Lease to be treated as other than ‘rents
from real property’ under § 856(c)(2)(C) and 856(c)(3)(A).” UPREIT LP is a% owned by
UPREIT LLC and b% owned by Taxpayer 1. UPREIT LLC is a single member LLC
owned by Taxpayer 1.

   On Date 2, the Service notified your authorized representatives that the Service

was reconsidering the portion of Ruling 47 that provides that the specified adjustments
to amounts payable under the Master Lease pursuant to the Escalation and the Other
Adjustments will not cause any amounts received under the Master Lease to be treated
as other than rents from real property under section 856(c)(2)(C) and 856(c)(3)(A) of the
Internal Revenue Code (“Code”).

   The Service has determined that this portion of Ruling 47 is not in accord with the

current views of the Service. Section 11.04 of Rev. Proc. 2021-1, 2021-1 I.R.B. 1,
provides that a letter ruling found to be in error or not in accordance with the current
views of the Service may be revoked or modified. Accordingly, the portion of Ruling 47
in PLR 201337007 that provides that the specified adjustments to amounts payable
under the Master Lease pursuant to the Escalation and the Other Adjustments will not
cause any amounts received under the Master Lease to be treated as other than rents
from real property under section 856(c)(2)(C) and 856(c)(3)(A) is revoked.

    Section 11.04 of Rev. Proc. 2021-1 also provides that if a letter ruling is revoked

or modified, the revocation or modification applies to all years open under the period of
limitation unless the Service uses its discretionary authority under section 7805(b) to
limit the retroactive effect of the revocation or modification. Taxpayers requested that
the retroactive effect of any revocation or modification of Ruling 47 be limited.

  The Service has decided to grant relief, as described below, under section

7805(b) to limit the effect of the partial revocation of Ruling 47.

                                      FACTS

    Taxpayer 1 is a State corporation that has elected to be treated as a real estate

investment trust (“REIT”) beginning with the taxable year ended Date 1. Taxpayer 2 is a
State corporation. Each of the lessors under the Master Lease and the Other Leases
(each a “Subject Lease” and together, the “Subject Leases”) is an entity that is
disregarded as separate from Taxpayer 1 for Federal income tax purposes, or is a
qualified REIT subsidiary (within the meaning of section 856(i)) of Taxpayer 1.
Subsidiaries of Taxpayer 2 are the lessees under several of the Subject Leases. Each
of the Subject Leases was entered into prior to Date 2. Each of the Subject Leases has
options for renewal periods that are solely within the lessee’s discretion.

   Each of the Subject Leases provides, in part, for a fixed base rent subject to

Escalation and Other Adjustments. Each of the Subject Leases provides for an annual
increase to the Building Base Rent that is limited to the lesser of (a) a fixed percentage
PLR-102160-19 4

of the prior year’s Building Base Rent or (b) an amount (but not less than zero) that,
when added to Building Base Rent for the prior year, would result in a specified ratio of
Adjusted Revenue to the total rent payable for such prior year (each such provision, the
“Escalation Provision” and collectively, the “Escalation Provisions”). Each Subject
Lease defines “Adjusted Revenue” as the net revenue of the lessee minus expenses
other than (i) interest expense, (ii) income tax expense, (iii) depreciation and
amortization expense, (iv) rent expense, and (v) certain other expenses.

   Under the Master Lease and three of the Other Leases, upon the occurrence of

certain contingencies resulting in the removal of a particular property from the properties
covered by a Subject Lease, certain rent otherwise payable will be reduced by an
amount that is based on the relative Adjusted Revenue generated at the removed
property and the Adjusted Revenue at all properties covered by the Subject Lease
(each such provision the “Other Adjustments Provision” and collectively, the “Other
Adjustments Provisions”).

                             LAW AND ANALYSIS

  Section 856(c)(2) requires that at least 95 percent of a REIT’s annual gross

income (excluding gross income from prohibited transactions) be derived from certain
sources, including rents from real property. Section 856(c)(3) requires that at least 75
percent of a REIT’s annual gross income (excluding gross income from prohibited
transactions) be derived from certain sources, including rents from real property.

   Subject to certain exceptions, section 856(d)(2)(A) provides that the term “rents

from real property” does not include any amount received or accrued, directly or
indirectly, with respect to any real or personal property, if the determination of such
amount depends in whole or in part on the income or profits derived by any person from
such property (except that any amount so received or accrued shall not be excluded
from the term rents from real property solely by reason of being based on a fixed
percentage or percentages of receipts or sales).

   The amounts determined under the Escalation Provisions and the Other

Adjustments Provisions in the Subject Leases depend in part on the lessee’s Adjusted
Revenue. Adjusted Revenue is not equivalent to receipts or sales and is instead a
measure of the income or profits derived by the lessee from the operation of the
property. Thus, amounts received or accrued under the Subject Leases do not qualify
as rents from real property under section 856(d)(2)(A).

   Accordingly, Ruling 47 in PLR 201337007 is partially revoked to read as follows:

   UPREIT LP’s receipt of Percentage Rent payments under the Master
   Lease will not cause any amounts received under the Master Lease to be
   treated as other than rents from real property under § 856(c)(2)(A) and
   856(c)(3)(A).

PLR-102160-19 5

   Section 7805(b)(8) provides that the Secretary may prescribe the extent, if any,

to which any ruling (including any judicial decision or any administrative determination
other than by regulation) relating to the internal revenue laws shall be applied without
retroactive effect.

    Under section 11.06 of Rev. Proc. 2021-1, if the revocation or modification of a

letter ruling is for reasons other than a change in facts as described in section 11.05 of
Rev. Proc. 2021-1, the revocation or modification generally will not be applied
retroactively to the taxpayer for whom the letter ruling was issued or to a taxpayer
whose tax liability was directly involved in the letter ruling provided that (1) there has
been no change in the applicable law; (2) the letter ruling was originally issued for a
proposed transaction; and (3) the taxpayer directly involved in the letter ruling acted in
good faith in relying on the letter ruling, and revoking or modifying the letter ruling
retroactively would be to the taxpayer’s detriment.

                                 CONCLUSIONS

   As discussed above, we conclude that Ruling 47 in PLR 201337007 is partially

revoked. The partial revocation of Ruling 47 will apply beginning with Taxpayer 1’s first
taxable year beginning after Date 3. The partial revocation of Ruling 47, however, will
not apply to the Escalation Provision or the Other Adjustments Provision of a Subject
Lease (including during any current or remaining renewal periods provided in such
Subject Lease, as provided by such Subject Lease on Date 2, that are exercisable at
the lessee’s sole discretion) as in effect on Date 2, unless and until an amendment or
modification to such Subject Lease has the effect of modifying (a) the amount of
Building Base Rent set forth in such Subject Lease or (b) the manner in which Building
Base Rent is calculated under such Subject Lease, including an amendment or
modification to the terms and conditions of the Escalation Provision or the Other
Adjustments Provision.

    Notwithstanding the above, the following shall not be considered to be an

amendment or modification to a Subject Lease contemplated by clause (a) or (b) of the
immediately preceding paragraph: (1) an amendment or modification to a Subject
Lease that has an indirect effect on Building Base Rent solely by causing an increase or
decrease in the amount of Adjusted Revenue; (2) a capital improvement funded by
either the lessee or lessor of a Subject Lease, provided that any rent payments
attributable to such capital improvement or such funding and added pursuant to any
corresponding amendment or modification of such Subject Lease shall not be subject to
the Escalation Provision of such Subject Lease; (3) an addition of a Facility to a Subject
Lease pursuant to the Agreement and; (4) the removal of one or more Facilities (or a
portion of a Facility) (i) from a Subject Lease or (ii) from the Building Base Rent, the
Escalation Provision and/or from the calculation of Adjusted Revenue of a Subject
Lease (and any correlative or conforming amendments to such Subject Lease
necessary to effect a removal described in clause (i) or (ii)). Clauses (1) (in the case of
a modification or amendment to the Other Adjustments Provision of a Subject Lease or
a modification or amendment to a Subject Lease that implicates the Other Adjustments
PLR-102160-19 6

Provision thereof) and (4) may be relied on with respect to a particular Subject Lease
only if the Other Adjustments Provision of such Subject Lease has been amended either
to eliminate the use of Adjusted Revenue or to modify the definition of Adjusted
Revenue to conform with applicable law. Any amendment or modification described in
this paragraph shall otherwise conform with applicable law. Any other capital
improvement or addition of a Facility to a Subject Lease not described in clause (2) or
(3) of this paragraph will be considered an amendment or modification to the Subject
Lease contemplated by clause (a) or (b) of the immediately preceding paragraph.
Notwithstanding the above, the Escalation Provision and the Other Adjustments
Provision of a Subject Lease may be amended either to eliminate the use of Adjusted
Revenue or to modify the definition of Adjusted Revenue to conform with applicable law.

    This ruling’s application is limited to the facts, representations, Code sections,

and regulations cited herein. Except as expressly provided herein, no opinion is
expressed or implied concerning the tax consequences of any aspect of any transaction
or item discussed or referenced in this letter. In particular, no opinion is expressed
concerning whether Taxpayer 1 otherwise qualifies as a REIT under Subchapter M, Part
II of Chapter 1 of the Code.

  In accordance with Forms 8821, Tax Information Authorization, submitted by

Taxpayer 1 and Taxpayer 2, this ruling is directed only to the Taxpayers. Section
6110(k)(3) of the Code provides that it may not be used or cited as precedent.

     In accordance with the Power of Attorney on file with this office, a copy of this

letter is being sent to your authorized representatives.

                                   Sincerely,


                                   ______________________________
                                   K. Scott Brown
                                   Senior Technician Reviewer, Branch 3
                                   Office of the Associate Chief Counsel
                                   (Financial Institutions & Products)

Enclosure:
Copy for section 6110 purposes

cc: