Novel Approach Offers More Tax Efficiencies

By James Brennan, Exchange Solutions Group L.L.C.

In the last 12 months, creative REIT executives were provided a map to improve taxation for their business.

In the last 12 months, creative REIT executives were offered a map to create more tax efficiencies for their businesses. Hunt Power, along with institutional co-investors, acquired a Private Letter ruling from the IRS delineating what assets are eligible real property for a real estate investment trust. While most commercial property executives may rely on standard apartment buildings and strip malls, the definition is actually much more welcoming.

Hunt Power’s private letter ruling came to us via the energy industry, not exactly through the standard real estate industry channels. Hunt’s energy infrastructure REIT navigates the IRS’ requirements on what type of properties are eligible for REIT status. Hunt’s format raises issues not only on formation, but continually, with income thresholds required to keep REIT status.

Historically REITS have invested in clear-cut real estate such as malls and office towers. You do see some like Weyerhauser REIT that invest in timber rights and other related property interests. This new REIT seeks to only own key electrical and natural-gas assets such as local distribution companies and power lines.

Hunt Power came up with the concept of placing a REIT structure on energy infrastructure as far back as 2006. The company spent some time refining the concept and applied to the Internal Revenue Service for a private letter ruling to obtain their view that electricity transfer assets were eligible for REIT structures. Hunt Power received IRS approval in 2007.

In its request for a private-letter ruling from the Internal Revenue Service, Hunt discussed a PropCo-OpCo structure embraced by real estate private equity in the past. The PropCo-OpCo structure was embraced in the 2005-2008 timeframe for a reason: financing. Real estate-heavy operating companies, like casinos and fast food joints, were enhanced with stellar company credit ratings.

The PropCo-OpCo structure is essentially a sale-leaseback with another entity you control, where a company conveys a real estate asset to an affiliate company, and leases it back for a defined period. This allows the firm to cash in its equity in any real property; it can also guarantee an investor long-term income.

In Hunt’s strategy, the PropCo would own systems under the PLR. This would include interests in or rights to occupy land, towers and poles affixed to the ground; lines or wires attached to the poles; substations and transformers affixed to the ground; and even electric meters affixed to buildings.

With the question lingering whether these assets constitute real property, the law in question provides that 75 percent of REIT’s assets must be cash, government securities and real estate. It further provides that interests in real property include land or improvements thereon…but does not include mineral, oil or gas interests. The PLR analogized the passive “system” components to railway components in Rev. Ruling 69-94 that are passive assets that are interdependent components that are affixed to the land.

With a view to maintaining REIT status, the second looming question is how does 95 percent of the REIT’s gross income come from rents from real property? Section 856(d)(2) describes “rents from real property” to essentially includes rental income from leased property. In the energy REIT scenario, OpCo basically leases the system via triple net lease into the PropCo. Thus the PropCo cleanly receives primarily rent from OpCo for use of the systems.

Creative REIT C-level executives can use both the self-imposed REIT structure and the use of non-traditional real property assets in expanding what property is eligible to be “REIT ‘D’”. While the energy industry established this novel ruling, the real estate industry really benefits for years to come.