The IRS and Senator Warren Raise Concerns about Lodging and Health Care REITs

    I. Introduction

    On September 3, 2024, Senator Elizabeth Warren (D-MA) sent a letter to the Internal Revenue Service (the “IRS”) urging it to “increase enforcement scrutiny of REITs, especially large health and hospitality REITs that may be illegally claiming significant tax breaks while meddling in the operations of their tenants”. In the letter, Senator Warren states that:

    [T]axable REIT subsidiaries (“TRSs”) have negotiated agreements with hotel operators that give the TRS the right to exert significant control over labor terms, including vetoing collective bargaining agreements negotiated with hotel workers and participating in negotiations with hotel employee labor unions.

    I urge you to increase enforcement scrutiny of REITs, especially large health and hospitality REITs that may be illegally claiming significant tax breaks while meddling in the operations of their tenants.

    Senator Warren’s letter followed a public letter from the IRS to Senator Ron Wyden (D-OR), where the IRS states that:

    [W]e have become aware that some in the industry have advocated the view that an appropriate structure is for [a] TRS to lease [a] qualified lodging facility from [a] REIT and indirectly operate the qualified lodging facility. Any TRS that implements such an approach will lose its tax status. That may cause its REIT owner to fail one or more of its qualification requirements. That in turn would cause the REIT to lose its tax status for five years, including the ability to deduct dividends paid to shareholders, and become fully subject to the corporate tax.

    Indirect operation or management, as well as direct operation or management, of lodging facilities by a TRS violates the tax rules. The prohibition applies even when the TRS rents the facility from the REIT under the related-party rental exception and an eligible independent contractor is hired to manage and operate the facility on the TRS’s behalf. Even under this structure, the TRS remains barred from directly or indirectly operating or managing the lodging facility.

    Senator Wyden’s letter to the IRS, which was the impetus for the IRS letter, has not been released.

    TRSs that lease qualified lodging facilities and qualified health care properties from REITs and hire eligible independent contractors to manage and operate the facilities and properties often have the right to approve collective bargaining agreements entered into by the contractors with unions. We do not believe that these approval rights alone constitute the operation or management of the lodging or health care businesses. Participating in negotiations with unions on behalf of the facilities could, however, be an indicium of operation or management.

    II. Background on TRSs and the Related-Party Rental Exception

      REITs are passive vehicles that are limited in the services they can provide and the income they can earn—in exchange, if they distribute all of their taxable income, they are not subject to corporate-level income tax.  TRSs are often used by REITs to provide the services and earn the income that the REIT cannot—the tradeoff is that income earned by the TRS is subject to the usual corporate level tax. 

      Generally, rents paid by a wholly owned TRS to its REIT parent do not qualify as “rents from real property” for purposes of the REIT income tests.[1]  However, special rules apply to rents received by a REIT in respect of “qualified lodging facilities” and “qualified health care properties” leased to a TRS.[2] These rents do qualify as rents from real property if the facilities or properties are operated and managed by an eligible independent contractor[3] (an “EIK”) (the “related-party rental exception”).[4]

      Under the related-party rental exception, a TRS cannot directly or indirectly operate or manage a lodging facility or qualified health care property. [5] Neither the statute, the regulations, nor any other authority provides clear guidance on what it means to directly or indirectly operate or manage a lodging facility or qualified health care property.

      Although a lodging facility or qualified health care property must be operated and managed by an EIK, the TRS (i) may bear all of the expenses of operating the lodging facilities or health care properties pursuant to a management agreement and (ii) may receive revenues from the operation of the lodging facilities or health care properties, net of expenses for such operation and fees payable to the EIK pursuant to a management agreement.[6]Thus, it is common in these arrangements for the TRS to benefit from all gross income from the business and bear all of its operating costs, including salaries and other benefits payable to the EIK’s employees, and for the EIK to receive a fee for its services. Since the TRS bears all of the expenses incurred in the operation of the business it is also common for the TRS to have approval rights over operating budgets and other major decisions with respect to the lodging facility or health care property, including the right to approve collective bargaining agreements.

      III. The Letters

        The IRS letter is unusual. It cites industry sources without attribution, gives a vague, high-level description of certain disapproved conduct, and then asserts that a TRS that engages in that conduct violates federal tax laws. In particular, the asserted bad conduct is “indirect operation or management” of a lodging facility, which is a requirement already specified in the Code itself, although the letter also states that “as a general matter, a TRS is prohibited from managing the day-to-day operation of the lodging facility, which may include recruiting, hiring, daily supervision, and direction of the employees.” Overall, the IRS letter does not add much more information about the tax law requirements imposed on TRSs with respect to qualified lodging facilities.

        The Warren letter references a specific REIT but does not indicate any specific conduct by that REIT that violates the REIT rules. Instead, it suggests broadly that TRSs that have the right to veto collective bargaining agreements or participate in negotiations violate the REIT rules—a topic that the IRS letter did not directly address.

        IV. Conclusions

        We do not believe that it is possible to draw any firm conclusions from the letters. We believe that the mere power to approve major contracts, including a collective bargaining agreement, is not the operation or management of a qualified lodging facility or qualified health care property. Negotiating a collective bargaining agreement is normally a function of management and therefore could be viewed as evidence of operation or management that would have to be considered with other facts.


        [1] Sec. 856(d)(2)(B).

        [2] A “qualified lodging facility” is, in general, a hotel or motel without wagering facilities. Sec. 856(d)(9)(D). A “qualified health care property” is, in general, real property that is a hospital or other licensed facility that provides medical or nursing or ancillary services to patients and is operated by a provider that is eligible to participate in the Medicare program with respect to the facility. Sec. 856(e)(6).

        [3] An EIK is an independent contractor who (i) is actively engaged in the trade or business of operating lodging or health care facilities, respectively, for a person who is not related to the REIT or TRS and (ii) must have a management contract with a TRS to manage a property. Sec. 856(d)(9)(A). An independent contractor must operate more than one facility to qualify as an EIK. Sec. 856(d)(8)(B); see also P.L.R. 2008-25-034 (March 17, 2018).

        [4] Sec. 856(d)(8)(B).

        [5] We note that the IRS has held that a TRS that (i) had no employees, (ii) did not participate in the operation or management of a facility, (iii) had no control over the employment of individuals providing services at the facility, and (iv) was managed by an EIK that had exclusive authority over persons providing services at a facility, including exclusive responsibility for the “selection, hiring, employment, retention, training, control, determination of benefits and compensation, discharge, and other terms of employment of all the individuals providing services” at the facility, was not considered to be directly or indirectly operating or managing a lodging facility in violation of section 856(l)(3)(A).  P.L.R. 2015-33-006 (May 15, 2015).  However, these were representations made by the taxpayer in the ruling, and while the IRS found these facts sufficient to establish that the TRS was not directly or indirectly operating or managing a lodging facility, the IRS did not state or otherwise hold that exclusive authority over all employment matters by an EIK is required in order for the TRS to not be considered to directly or indirectly operate a lodging facility or whether a TRS’s retention of certain rights with respect to an EIK’s employees, in particular matters affecting costs associated with employees that would be borne by the TRS, would be acceptable.

        [6] Sec. 856(d)(9)(B).

        Photo of Jean Bertrand Jean Bertrand

        Jean Bertrand is a partner in the Tax Department and a member of the Private Funds Group. Jean advises clients on a broad range of domestic and international tax issues. Her practice focuses on hedge and private equity fund formation, investment structuring, cross-border…

        Jean Bertrand is a partner in the Tax Department and a member of the Private Funds Group. Jean advises clients on a broad range of domestic and international tax issues. Her practice focuses on hedge and private equity fund formation, investment structuring, cross-border lending transactions and other financings, and providing general tax advice to corporations, partnerships, high-net-worth individuals and families. In addition, Jean has significant experience in advising public charities, private foundations and other tax-exempt organizations on structural and operating matters, including obtaining tax-exempt status, managing unrelated business taxable income, complying with the excess benefit transaction rules, grant-making, fundraising, and structuring investments.

        Prior to becoming a lawyer, Jean was registered as a certified public accountant in New York and worked for several years as an auditor at a major public accounting firm. Prior to joining the Firm, Jean was a Special Counsel at Cadwalader, Wickersham and Taft LLP.

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        Richard M. Corn is a partner in the Tax Department. He focuses his practice on corporate tax structuring and planning for a wide variety of transactions, including:

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        Richard M. Corn is a partner in the Tax Department. He focuses his practice on corporate tax structuring and planning for a wide variety of transactions, including:

        • mergers and acquisitions
        • cross-border transactions
        • joint ventures
        • structured financings
        • debt and equity issuances
        • restructurings
        • bankruptcy-related transactions

        Richard advises both U.S. and international clients, including multinational financial institutions, private equity funds, hedge funds, asset managers and joint ventures. He has particular experience in the financial services and sports sectors. He also works with individuals and tax-exempt and not-for-profit organizations on their tax matters.

        Richard began his career as a clerk for the U.S. Court of Appeals for the Fourth Circuit Judge J. Michael Luttig and then went on to clerk at the U.S. Supreme Court for Associate Justice Clarence Thomas. Prior to joining Proskauer, he most recently practiced at Sullivan & Cromwell as well as Wachtell, Lipton, Rosen and Katz.

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        Robert Friedman is a partner in the Tax Department whose practice focuses on representing clients in all facets of corporate and partnership related tax matters. In particular, Robert provides tax advice on public and private mergers, acquisitions, joint ventures, divestitures, private equity fund…

        Robert Friedman is a partner in the Tax Department whose practice focuses on representing clients in all facets of corporate and partnership related tax matters. In particular, Robert provides tax advice on public and private mergers, acquisitions, joint ventures, divestitures, private equity fund formation, financial products and electric and gas utility tax issues.

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        David Miller is a partner in the Tax Department. David advises clients on a broad range of domestic and international corporate tax issues. His practice covers the taxation of financial instruments and derivatives, cross-border lending transactions and other financings, international and domestic mergers…

        David Miller is a partner in the Tax Department. David advises clients on a broad range of domestic and international corporate tax issues. His practice covers the taxation of financial instruments and derivatives, cross-border lending transactions and other financings, international and domestic mergers and acquisitions, multinational corporate groups and partnerships, private equity and hedge funds, bankruptcy and workouts, high-net-worth individuals and families, and public charities and private foundations. He advises companies in virtually all major industries, including banking, finance, private equity, health care, life sciences, real estate, technology, consumer products, entertainment and energy.

        David is strongly committed to pro bono service, and has represented more than 200 charities. In 2011, he was named as one of eight “Lawyers Who Lead by Example” by the New York Law Journal for his pro bono service. David has also been recognized for his pro bono work by The Legal Aid Society, Legal Services for New York City and New York Lawyers For The Public Interest.

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        Amanda H. Nussbaum is the chair of the Firm’s Tax Department as well as a member of the Private Funds Group. Her practice concentrates on planning for and the structuring of domestic and international private investment funds, including venture capital, buyout, real estate…

        Amanda H. Nussbaum is the chair of the Firm’s Tax Department as well as a member of the Private Funds Group. Her practice concentrates on planning for and the structuring of domestic and international private investment funds, including venture capital, buyout, real estate and hedge funds, as well as advising those funds on investment activities and operational issues. She also represents many types of investors, including tax-exempt and non-U.S. investors, with their investments in private investment funds. Business partners through our clients’ biggest challenges, Amanda is a part of the Firm’s cross-disciplinary, cross-jurisdictional Coronavirus Response Team helping to shape the guidance and next steps for clients impacted by the pandemic.

        Amanda has significant experience structuring taxable and tax-free mergers and acquisitions, real estate transactions and stock and debt offerings. She also counsels both sports teams and sports leagues with a broad range of tax issues.

        In addition, Amanda advises not-for-profit clients on matters such as applying for and maintaining exemption from federal income tax, minimizing unrelated business taxable income, structuring joint ventures and partnerships with taxable entities and using exempt and for-profit subsidiaries.

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        Photo of Rita N. Halabi Rita N. Halabi

        Rita Halabi is an associate in the Tax Department. She advises public and private companies on a variety of U.S. federal corporate, partnership and international tax matters, including private equity and investment fund transactions, tax controversy, mergers and acquisitions, and financing transactions. In…

        Rita Halabi is an associate in the Tax Department. She advises public and private companies on a variety of U.S. federal corporate, partnership and international tax matters, including private equity and investment fund transactions, tax controversy, mergers and acquisitions, and financing transactions. In addition, Rita regularly blogs about developments in federal tax law on the Proskauer Tax Talks blog.

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        Maggie Livingstone is an associate in the Tax Department and a member of the firm’s Corporate Tax and Employee Benefits & Executive Compensation practice groups. She earned her B.A. with Honors from Brown University and her J.D. from USC Gould School of Law.

        Maggie Livingstone is an associate in the Tax Department and a member of the firm’s Corporate Tax and Employee Benefits & Executive Compensation practice groups. She earned her B.A. with Honors from Brown University and her J.D. from USC Gould School of Law. In law school, she was a Senior Editor of the Southern California Law Review and a legal writing fellow.