May 10, 2023 | Real Estate, The Practical Real Estate Lawyer

There is no single legal definition of a “master lease.” Such an arrangement may be used in equipment leasing as well as in the real estate space. A master lease may be an alternative to traditional bank financing or a means of credit support. It also may figure prominently in the context of tax planning, most notably for entities taxed as real estate investment trusts (REITs) under the US Internal Revenue Code of 1986, as amended (Code).1 This article will describe some of the uses of master lease structures for these purposes.2

The Use of Master Leases in Commercial Real Estate Transactions - by Jonathan Talansky presented by ALI CLE


Tenancy in common / section 1031 structures
Master leases may arise in section 1031 like-kind exchanges. Section 1031 provides for the deferral of gain or loss on the exchange of business or investment property solely for property of “like kind.”3 The rationale behind the provision is that when an investor exchanges a piece of property for like-kind property, the investor is merely continuing an ongoing investment, rather than liquidating one to obtain another.4 Thus, gain or loss is deferred until the investor’s funds are no longer tied up in the same kind of property. In order to obtain such deferral, certain requirements must be met. The replacement property must be of like-kind with respect to the relinquished property.5 It must be identified within 45 days of the transfer of the relinquished property, and generally must be received by the transferor within 180 days of the transfer of the relinquished property.6 In addition, both the relinquished property and the replacement property must be held for productive use in a trade or business or for investment and must not be stock in trade, other property held primarily for sale, stocks, securities, partnership interests, and similar intangibles.7 A “partnership” for such purposes includes any unincorporated organization through or by means of which any business, financial operation, or venture is carried on.8 Generally, and in light of the policy rationale behind section 1031, the courts have interpreted its provisions liberally in order to allow taxpayers to come within its terms.9

Real estate syndicators have created an industry offering tenancy in common (TIC) interests in professionally managed rental real estate as the like-kind replacement property required to complete a section 1031 exchange. A TIC is an undivided fractional interest in real property that is generally considered to be of like-kind with property that is wholly-owned. Syndicated TIC interests are easy to identify within the 45 day identification period and close on within the 180-day exchange period. In addition, TIC interests provide taxpayers with the opportunity to invest in rental real estate and achieve tax deferral, all without the burdens of managing the real estate. As attractive as TIC interests are, they do come with some risk. The common ownership of property has, under certain circumstances, been treated by the IRS and courts as a deemed partnership for tax purposes.10 Thus, TIC arrangements intended to qualify for section 1031 treatment must be structured carefully to prevent the interests from being treated as disqualifying interests in a partnership or other entity.

In 2002, the IRS issued a Revenue Procedure stating that the IRS “will consider a request for a ruling that an undivided fractional interest in rental real property … is not an interest in a business entity” if the arrangement meets the 15 conditions specified therein.11 Those conditions, while not technically a safe harbor, are sometimes treated as such for planning purposes. The conditions include: (i) all the tenants must hold their interests as a tenant in common under local law; (ii) there are no more than 35 TIC owners; (iii) the TIC owners must not hold themselves out as members of an entity or file any type of entity tax return; (iv) unanimous vote is required for the hiring of management and the sale, leases, or re-leases of the property or any portion of the property; and (v) the TIC owners must not engage in business activities with respect to the property other than those that are “customary activities” related to maintenance and repair.12 As a practical matter, when TIC interests are held by more than a few owners, satisfying the unanimous vote concept can become extremely onerous.

Enter the master lease. Master leases provide a solution to such restrictive conditions, and they are often used in TIC arrangements as a way to achieve compliance with the Revenue Procedure. For example, TIC owners can lease the rental real estate to a master tenant under a long-term lease, and the master tenant then subleases the property to multiple tenants. Under such a scenario, the TIC owners need only make a single unanimous decision in selecting a master tenant. The master tenant will then manage the project and make leasing decisions, relieving the TIC owners from having to reach unanimous decisions with respect to daily operations. Relegating the management of the project to the master tenant also insulates the TIC owners from being characterized as conducting business activities beyond those that are customary and thus the arrangement from being considered a disqualifying interest in a partnership or other entity.


Background on REITs

REITs provide investors with an opportunity to invest in a professionally managed pool of real estate in a tax efficient manner. In general, REITs are organizations that are treated as corporations for US federal tax purposes but receive special tax treatment under the Code that makes these vehicles more tax efficient than traditional subchapter C corporations. They also can be an extremely efficient vehicle for foreign persons to invest in US real estate while mitigating the impact of sections 897 and 1445. The special tax treatment is only available to the extent that a REIT’s income is from passive sources and the REIT does not engage in any active trade or business.13 The tax efficiency is achieved through a REIT’s ability to deduct the income distributed out to shareholders, thus eliminating the double taxation typical of corporate income and instead delivering pass-through or conduit treatment to its shareholders. The benefits of the REIT structure, however, come with the added burdens of establishing and maintaining qualification under the REIT rules for US federal income tax purposes. The REIT rules impose complex organizational and structural requirements, income and asset tests, and distribution and record keeping requirements.

In particular, each year, a REIT must satisfy two different income tests, which are designed to ensure that the income derived from the REIT is in fact passive in nature. The first test requires that for each taxable year, at least 95 percent of a REIT’s gross income must be derived from dividends, interest, rents from real property, gains on dispositions of stock, securities, and real property not held for sale to customers in the ordinary course of business, income and gain from foreclosure property, fees received for making mortgage loans and entering into purchase contracts and leases, and certain related items.14

The second test requires that, in addition to the 95 percent income test, at least 75 percent of the REIT’s income for a taxable year must be derived from real property investments including rents from real property, interest on real property mortgages, gains on dispositions of real property not held for sale to customers in the ordinary course of business, dividends from other REITs, gains on dispositions of shares of other REITs, income and gain from foreclosure property, refunds of real property taxes, and “qualified temporary investment income.”15

CLICK HERE to read the full article, which was originally published in ALI CLE’s The Practical Real Estate Lawyer.

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