Rev. Rul. 73-194

Advice has been requested whether, under the circumstances described below, income received by a real estate investment trust from a partnership qualifies as "rents from real property" under section 856(d) of the Internal Revenue Code of 1954.

The trust entered into a partnership with X corporation for the purpose of constructing and holding for investment a number of apartment buildings. The trust contributed 10 acres of land to the partnership as its original capital contribution. Under the terms of the partnership agreement, X corporation was responsible for (1) supervising, financing, developing and constructing the apartment buildings, (2) obtaining construction and permanent financing for such development and construction, (3) obtaining necessary permits for construction and operation of the property, (4) procuring of bids and letting of construction to subcontractors and material men, and (5) the bookkeeping and payment of bills during construction.

Though X corporation had the responsibility for the construction of the apartment buildings, the trust had the right to review and approve or disapprove all financing arrangements, construction plans, specifications, and costs before construction commenced. In addition, it had the right to review and approve or disapprove any and all changes in financing arrangements, construction plans, specifications, and costs after construction began.

The partnership agreement between the trust and X corporation stated that the partners agreed to enter into a management agreement with another corporation (management company) whereunder the management company would manage an apartment building that was to be constructed and held as an investment by the partnership. The management company was employed in an arm's length transaction, and was paid a fee for its services equal to the going rate charged by other management companies in the area for comparable services. The agreement between the partnership and the management company could be terminated by either party at the end of a term of two years.

The trust did not own any shares of the capital stock of X corporation or of the management company, and neither X corporation nor the management company, nor any of the shareholders of those two corporations owned shares of beneficial interest of the trust. However, X corporation was a wholly owned subsidiary of Y corporation which owned a substantial percentage of the stock of the management company.

The partnership's gross income consists almost entirely of rents from the apartment buildings.

Section 856(d)(3) of the Code provides, in part, that the term "rents from real property" does not include "any amount received or accrued, directly or indirectly, with respect to any real property, if the real estate investment trust furnishes or renders services to the tenants of such property, or manages or operates such property, other than through an independent contractor from whom the trust itself does not derive or receive any income." An independent contractor is defined as:

(A) A person who does not own, directly or indirectly, more than 35 percent of the shares, or certificates of beneficial interest, or

(B) a person, 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, if not a corporation, not more than 35 percent of the interest in whose assets or net assets is owned, directly or indirectly, by one or more persons owning 35 percent or more of the shares or certificates of beneficial interest in the trust.

In House Report No. 2020, Eighty-sixth Congress, 1960-2 C.B. 819, 825, it is stated that the restrictions contained in section 856(d) of the Code are designed to prevent income from active business operations from being included as qualifying real estate investment trust income. Further, in discussing the limitation of section 856(d)(3) of the Code, the Committee stated that "the requirement that the trust not receive any income from the independent contractor requires that the relationship between the two be an arm's length relationship."

In the instant case, the management company meets the "independent contractor" definition, stated above, as to the trust. Further, the management company was employed in an arm's length transaction and was paid a fee equal to the going rate charged by other management companies for such services.

Accordingly, in the instant case, the income received by the trust from the partnership will not be disqualified as "rents from real property" under section 856(d)(3) of the Code due to the relationship between X corporation, Y corporation, and the management company.