[Code of Federal Regulations]
[Title 26, Volume 9]
[Revised as of April 1, 2002]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.856-4]

[Page 56-61]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1--INCOME TAXES--Table of Contents
 
Sec. 1.856-4  Rents from real property.

    (a) In general. Subject to the exceptions of section 856(d) and 
paragraph (b) of this section, the term ``rents from real property'' 
means, generally, the gross amounts received for the use of, or the 
right to use, real property of the real estate investment trust.
    (b) Amounts specifically included or excluded--(1) Charges for 
customary services. For taxable years beginning after October 4, 1976, 
the term ``rents from real property'', for purposes of paragraphs (2) 
and (3) of section 856(c), includes charges for services customarily 
furnished or rendered in connection with the rental of real property, 
whether or not the charges are separately stated. Services furnished to 
the tenants of a particular building will be considered as customary if, 
in the geographic market in which the building is located, tenants in 
buildings which are of a similar class (such as luxury apartment 
buildings) are customarily provided with the service. The furnishing of 
water, heat, light, and air-conditioning, the cleaning of windows, 
public entrances, exits, and lobbies, the performance of general 
maintenance and of janitorial and cleaning services, the collection of 
trash, and the furnishing of elevator services, telephone answering 
services, incidental storage space, laundry equipment, watchman or guard 
services, parking facilities, and swimming pool facilities are examples 
of services which are customarily furnished to the tenants of a 
particular

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class of buildings in many geographic marketing areas. Where it is 
customary, in a particular geographic marketing area, to furnish 
electricity or other utilities to tenants in buildings of a particular 
class, the submetering of such utilities to tenants in such buildings 
will be considered a customary service. To qualify as a service 
customarily furnished, the service must be furnished or rendered to the 
tenants of the real estate investment trust or, primarily for the 
convenience or benefit of the tenant, to the guests, customers, or 
subtenants of the tenant. The service must be furnished through an 
independent contractor from whom the trust does not derive or receive 
any income. See paragraph (b)(5) of this section. For taxable years 
beginning before October 5, 1976, the rules in paragraph (b)(3) of 26 
CFR 1.856-4 (revised as of April 1, 1977), relating to the furnishing of 
services, shall continue to apply.
    (2) Amounts received with respect to certain personal property--(i) 
In general. In the case of taxable years beginning after October 4, 
1976, rent attributable to personal property that is leased under, or in 
connection with, the lease of real property is treated under section 
856(d)(1)(C) as ``rents from real property'' (and thus qualified for 
purposes of the income source requirements) if the rent attributable to 
the personal property is not more than 15 percent of the total rent 
received or accrued under the lease for the taxable year. If, however, 
the rent attributable to personal property is greater than 15 percent of 
the total rent received or accrued under the lease for the taxable year, 
then the portion of the rent from the lease that is attributable to 
personal property will not qualify as ``rents from real property''.
    (ii) Application. In general, the 15-percent test in section 
856(d)(1)(C) is applied separately to each lease of real property. 
However, where the real estate investment trust rents all (or a portion 
of all) the units in a multiple unit project under substantially similar 
leases (such as the leasing of apartments in an apartment building or 
complex to individual tenants), the 15-percent test may be applied with 
respect to the aggregate rent received or accrued for the taxable year 
under the similar leases of the property, by using the average of the 
trust's aggregate adjusted bases of all of the personal property subject 
to such leases, and the average of the trust's aggregate adjusted bases 
of all real and personal property subject to such leases. A lease of a 
furnished apartment is not considered to be substantially similar to a 
lease of an unfurnished apartment (including an apartment where the 
trust provides only personal property, such as major appliances, that is 
commonly provided by a landlord in connection with the rental of 
unfurnished living quarters).
    (iii) Taxable years beginning before October 5, 1976. In the case of 
taxable years beginning before October 5, 1976, any amount of rent that 
is attributable to personal property does not qualify as rent from real 
property.
    (3) Disqualification of rent which depends on income or profits of 
any person. Except as provided in paragraph (b)(6)(ii) of this section, 
no amount received or accrued, directly or indirectly, with respect to 
any real property (or personal property leased under, or in connection 
with, real property) qualifies as ``rents from real property'' where the 
determination of the amount depends in whole or in part on the income or 
profits derived by any person from the property. However, any amount so 
accured or received 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 (whether or not receipts or sales are 
adjusted for returned merchandise, or Federal, State, or local sales 
taxes). Thus, for example, ``rents from real property'' would include 
rents where the lease provides for differing percentages or receipts or 
sales from different departments or from separate floors of a retail 
store so long as each percentage is fixed at the time of entering into 
the lease and a change in such percentage is not renegotiated during the 
term of the lease (including any renewal periods of the lease, in a 
manner which has the effect of basing the rent on income of profits. See 
paragraph (b)(6) of this section for rules relating to certain amounts 
received or accrued by a trust which are considered to be based

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on the income or profits of a sublessee of the prime tenant. The amount 
received or accrued as rent for the taxable year which is based on a 
fixed percentage or percentages of the lessee's receipts or sales 
reduced by escalation receipts (including those determined under a 
formula clause) will qualify as ``rents from real property''. Escalation 
receipts include amounts received by a prime tenant from subtenants by 
reason of an agreement that rent shall be increased to reflect all or a 
portion of an increase in real estate taxes, property insurance, 
operating costs of the prime tenant, or similar items customarily 
included in lease escalation clauses. Where in accordance with the terms 
of an agreement an amount received or accrued as rent for the taxable 
year includes both a fixed rental and a percentage of all or a portion 
of the lessee's income or profits, neither the fixed rental nor the 
additional amount will qualify as ``rents from real property''. However, 
where the amount received or accrued for the taxable year under such an 
agreement includes only the fixed rental, the determination of which 
does not depend in whole or in part on the income or profits derived by 
the lessee, such amount may qualify as ``rents from real property''. An 
amount received or accrued as rent for the taxable year which consists, 
in whole or in part, of one or more percentages of the lessee's receipts 
or sales in excess of determinable dollar amounts may qualify as ``rents 
from real property'', but only if two conditions exist. First, the 
determinable amounts must not depend in whole or in part on the income 
or profits of the lessee. Second, the percentages and, in the case of 
leases entered into after July 7, 1978, the determinable amounts, must 
be fixed at the time the lease is entered into and a change in 
percentages and determinable amounts is not renegotiated during the term 
of the lease (including any renewal periods of the lease) in a manner 
which has the effect of basing rent on income or profits. In any event, 
an amount will not qualify as ``rents from real property'' if, 
considering the lease and all the surrounding circumstances, the 
arrangement does not conform with normal business practice but is in 
reality used as a means of basing the rent on income or profits. The 
provisions of this subparagraph may be illustrated by the following 
example:

    Example. A real estate investment trust owns land underlying an 
office building. On January 1, 1975, the trust leases the land for 50 
years to a prime tenant for an annual rental of $100x plus 20 percent of 
the prime tenant's annual gross receipts from the office building in 
excess of a fixed base amount of $5,000x and 10 percent of such gross 
receipts in excess of $10,000x. For this purpose the lease defines gross 
receipts as all amounts received by the prime tenant from occupancy 
tenants pursuant to leases of space in the office building reduced by 
the amount by which real estate taxes, property insurance, and operating 
costs related to the office building for a particular year exceed the 
amount of such items for 1974. The exclusion from gross receipts of 
increases since 1974 in real estate taxes, property insurance, and other 
expenses relating to the office building reflects the fact that the 
prime tenant passes on to occupancy tenants by way of a customary lease 
escalation provision the risk that such expenses might increase during 
the term of an occupancy lease. The exclusion from gross receipts of 
these expense escalation items will not cause the rental received by the 
real estate investment trust from the prime tenant to fail to qualify as 
``rents from real property'' for purposes of section 856(c).
    (4) Disqualification of amounts received from persons owned in whole 
or in part by the trust. ``Rents from real property'' does not include 
any amount received or accrued, directly or indirectly, from any person 
in which the real estate investment trust owns, at any time during the 
taxable year, the specified percentage or number of shares of stock (or 
interest in the assets or net profits) of that person. Any amount 
received from such person will not qualify as ``rents from real 
property'' if such person is a corporation and the trust owns 10 percent 
or more of the total combined voting power of all classes of its stock 
entitled to vote or 10 percent or more of the total number of shares of 
all classes of its outstanding stock, or if such person is not a 
corporation and the trust owns a 10-percent-or-more interest in its 
assets or net profits. For example, a trust leases an office building to 
a tenant for which it receives rent of $100,000 for the taxable year 
1962. The lessee of the building subleases space to various subtenants 
for

[[Page 59]]

which it receives gross rent of $500,000 for the year 1962. The trust 
owns 15 percent of the total assets of an unincorporated subtenant. The 
rent paid by this subtenant for the taxable year is $50,000. Therefore, 
$10,000 (50,000/500,000x$100,000) of the rent paid to the trust does not 
qualify as ``rents from real property''. Where the real estate 
investment trust receives, directly or indirectly, any amount of rent 
from any person in which it owns any proprietary interest, the trust 
shall submit, at the time it files its return for the taxable year (or 
before June 1, 1962, whichever is later), a schedule setting forth--
    (i) The name and address of such person and the amount received as 
rent from such person; and
    (ii) If such person is a corporation, the highest percentage of the 
total combined voting power of all classes of its stock entitled to 
vote, and the highest percentage of the total number of shares of all 
classes of its outstanding stock, owned by the trust at any time during 
the trust's taxable year; or
    (iii) If such person is not a corporation, the highest percentage of 
the trust's interest in the assets or net profits of such person, owned 
by the trust at any time during its taxable year.
    (5) Furnishing of services or management of property must be through 
an independent contractor--(i) In general. No amount received or 
accrued, directly or indirectly, with respect to any real property (or 
any personal property leased under, or in connection with, the real 
property) qualifies as ``rents from real property'' if the real estate 
investment trust furnishes or renders services to the tenants of the 
property or manages or operates the property, other than through an 
independent contractor from whom the trust itself does not derive or 
receive any income. The prohibition against the trust deriving or 
receiving any income from the independent contractor applies regardless 
of the source from which the income was derived by the independent 
contractor. Thus, for example, the trust may not receive any dividends 
from the independent contractor. The requirement that the trust not 
receive any income from an independent contractor requires that the 
relationship between the two be an arm's-length relationship. The 
independent contractor must be adequately compensated for any services 
which are performed for the trust. Compensation to an independent 
contractor determined by reference to an unadjusted percentage of gross 
rents will generally be considered to be adequate where the percentage 
is reasonable taking into account the going rate of compensation for 
managing similar property in the same locality, the services rendered, 
and other relevant factors. The independent contractor must not be an 
employee of the trust (i.e., the manner in which he carries out his 
duties as independent contractor must not be subject to the control of 
the trust). Although the cost of services which are customarily rendered 
or furnished in connection with the rental of real property may be borne 
by the trust, the services must be furnished or rendered through an 
independent contractor. Furthermore, the facilities through which the 
services are furnished must be maintained and operated by an independent 
contractor. For example, if a heating plant is located in the building, 
it must be maintained and operated by an independent contractor. To the 
extent that services (other than those customarily furnished or rendered 
in connection with the rental of real property) are rendered to the 
tenants of the property by the independent contractor, the cost of the 
services must be borne by the independent contractor, a separate charge 
must be made for the services, the amount of the separate charge must be 
received and retained by the independent contractor, and the independent 
contractor must be adequately compensated for the services.
    (ii) Trustee or director functions. The trustees or directors of the 
real estate investment trust are not required to delegate or contract 
out their fiduciary duty to manage the trust itself, as distinguished 
from rendering or furnishing services to the tenants of its property or 
managing or operating the property. Thus, the trustees or directors may 
do all those things necessary, in their fiduciary capacities, to manage 
and conduct the affairs of the trust

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itself. For example, the trustees or directors may establish rental 
terms, choose tenants, enter into and renew leases, and deal with taxes, 
interest, and insurance, relating to the trust's property. The trustees 
or directors may also make capital expenditures with respect to the 
trust's property (as defined in section 263) and may make decisions as 
to repairs of the trust's property (of the type which would be 
deductible under section 162), the cost of which may be borne by the 
trust.
    (iii) Independent contractor defined. The term ``independent 
contractor'' means--
    (a) A person who does not own, directly or indirectly, at any time 
during the trust's taxable year more than 35 percent of the shares in 
the real estate investment trust, or
    (b) A person--
    (1) If a corporation, not more than 35 percent of the total combined 
voting power of whose stock (or 35 percent of the total shares of all 
classes of whose stock), or
    (2) If not a corporation, not more than 35 percent of the interest 
in whose assets or net profits is owned, directly or indirectly, at any 
time during the trust's taxable year by one or more persons owning at 
any time during such taxable year 35 percent or more of the shares in 
the trust.
    (iv) Information required. The real estate investment trust shall 
submit with its return for the taxable year (or before June 1, 1962, 
whichever is later) a statement setting forth the name and address of 
each independent contractor; and
    (a) The highest percentage of the outstanding shares in the trust 
owned at any time during its taxable year by such independent contractor 
and by any person owning at any time during such taxable year any shares 
of stock or interest in the independent contractor.
    (b) If the independent contractor is a corporation such statement 
shall set forth the highest percentage of the total combined voting 
power of its stock and the highest percentage of the total number of 
shares of all classes of its stock owned at any time during its taxable 
year by any person owning shares in the trust at any time during such 
taxable year.
    (c) If the independent contractor is not a corporation such 
statement shall set forth the highest percentage of any interest in its 
assets or net profits owned at any time during its taxable year by any 
person owning shares in the trust at any time during such taxable year.
    (6) Amounts based on income or profits of subtenants. (i) Except as 
provided in paragraph (b)(6)(ii) of this section, if a trust leases real 
property to a tenant under terms other than solely on a fixed sum rental 
(for example, a percentage of the tenant's gross receipts), and the 
tenant subleases all or a part of such property under an agreement which 
provides for a rental based in whole or in part on the income or profits 
of the sublessee, the entire amount of the rent received by the trust 
from the prime tenant with respect to such property is disqualified as 
``rents from real property''.
    (ii) Exception. For taxable years beginning after October 4, 1976, 
section 856(d)(4) provides an exception to the general rule that amounts 
received or accrued, directly or indirectly, by a real estate investment 
trust do not qualify as rents from real property if the determination of 
the amount depends in whole or in part on the income or profits derived 
by any person from the property. This exception applies where the trust 
rents property to a tenant (the prime tenant) for a rental which is 
based, in whole or in part, on a fixed percentage or percentages of the 
receipts or sales of the prime tenant, and the rent which the trust 
receives or accrues from the prime tenant pursuant to the lease would 
not qualify as ``rents from real property'' solely because the prime 
tenant receives or accrues from subtenants (including concessionaires) 
rents or other amounts based on the income or profits derived by a 
person from the property. Under the exception, only a proportionate part 
of the rent received or accrued by the trust does not qualify as ``rents 
from real property''. The proportionate part of the rent received or 
accrued by the trust which is non-qualified is the lesser of the 
following two amounts:

[[Page 61]]

    (A) The rent received or accrued by the trust from the prime tenant 
pursuant to the lease, that is based on a fixed percentage or 
percentages of receipts or sales, or
    (B) The product determined by multiplying the total rent which the 
trust receives or accrues from the prime tenant pursuant to the lease by 
a fraction, the numerator of which is the rent or other amount received 
by the prime tenant that is based, in whole or in part, on the income or 
profits derived by any person from the property, and the denominator of 
which is the total rent or other amount received by the prime tenant 
from the property. For example, assume that a real estate investment 
trust owns land underlying a shopping center. The trust rents the land 
to the owner of the shopping center for an annual rent of $10x plus 2 
percent of the gross receipts which the prime tenant receives from 
subtenants who lease space in the shopping center. Assume further that, 
for the year in question, the prime tenant derives total rent from the 
shopping center of $100x and, of that amount, $25x is received from 
subtenants whose rent is based, in whole or in part, on the income or 
profits derived from the property. Accordingly, the trust will receive a 
total rent of $12x, of which $2x is based on a percentage of the gross 
receipts of the prime tenant. The portion of the rent which is 
disqualified is the lesser of $2x (the rent received by the trust which 
is based on a percentage of gross receipts), or $3x, ($12x multiplied by 
$25x/$100x). Accordingly, $10x of the rent received by the trust 
qualifies as ``rents from real property'' and $2x does not qualify.
    (7) Attribution rules. Paragraphs (2) and (3) of section 856(d) 
relate to direct or indirect ownership of stock, assets, or net profits 
by the persons described therein. For purposes of determining such 
direct or indirect ownership, the rules prescribed by section 318(a) 
(for determining the ownership of stock) shall apply except that ``10 
percent'' shall be substituted for ``50 percent'' in section 318(a) 
(2)(C) and (3)(C).

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 6598, 27 FR 4085, Apr. 28, 1962, as amended by T.D. 6969, 33 FR 
12000, Aug. 23, 1968; T.D. 7767, 46 FR 11266, Feb. 6, 1981]