Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 64-50

1964-1 C.B. 231

Sec. 856

IRS Headnote

Amounts received by a real estate investment trust under the terms of a lease which has an `escalator provision' will qualify as `rents from real property' under the provisions of section 1.856-4(a) of the Income Tax Regulations where the arrangement conforms with normal business practices and is not, in reality, used as a means of basing the rent on income or profits.

Full Text

Rev. Rul. 64-50

Advice has been requested whether both the basic rental and the additional rent, if any, received by a real estate investment trust under an `escalator provision' in a lease constitute `rents from real property' under the provisions of section 856(d) of the Internal Revenue Code of 1954 and section 1.856-4 of the Income Tax Regulations.

The leases presently existing between the tenants and the real estate investment trust contain provisions which require the trust to furnish certain services to the tenants, such as heat, water, window cleaning and repairs through an independent contractor. The services furnished to the tenants are of the type usually or customarily furnished or rendered in connection with the rental of real property of the type with which we are concerned, as provided by section 1.856-4(b)(3)(i)(b) of the regulations.

The trust, in the process of negotiating new leases with the tenants, now plans to incorporate `escalator provisions' in the leases under which the tenants, in addition to the basic rental, would be subject to the payment of additional rent to the extent of their proportionate share of any increase in the cost of furnishing the services. Thus, in the event of an increase in the cost of services, the basic rental would be adjusted accordingly.

The purpose of the `escalator provisions' is to protect the trust against increases caused by inflation or other circumstances and to insure it a fair return on its investment.

Under the provisions of section 1.856-4(a) of the regulations, the term `rents from real property' means, generally, the gross amounts received for the use of, or the right to use, real property of a real estate investment trust.

However, section 1.856-4(b) of the regulations illustrates circumstances in which amounts received would not be includible as `rents from real property.' Thus, section 1.856-4(b)(1) provides, in pertinent part, that 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 the lessee's income or profits in excess of a specific amount (usually determined before deducting the fixed rental and sometimes called `overage rents'), 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.' 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 practices but is in reality used as a means of basing the rent on income or profits.

On the basis of the facts presented in this case, it is concluded that both the basic rental and the additional rent, if any, received by the real estate investment trust under the terms of the `escalator provisions' described above, do not depend, in whole or in part on the income or profits derived by the lessee and thus qualify as `rents from real property' under the provisions of section 1.856-4(a) of the regulations.