SECTION 3. REVENUE RULING

2004-86

.01 Rev. Rul. 2004-86, 2004-2 C.B. 191, holds that a Delaware statutory trust (Trust) formed to hold real property subject to a lease under the trust agreement described in the ruling is an arrangement that is classified as a trust for Federal tax purposes under § 301.7701-4(c). Each of Trust’s owners is treated, by reason of § 677, as an owner of a pro rata portion of Trust. Because an owner of an undivided fractional interest in Trust owns for Federal tax purposes the assets of Trust attributable to that interest, each owner is considered to own for those purposes an undivided fractional interest in the rental real property held by Trust. Accordingly, under § 1031 of the Code, a taxpayer may exchange an interest in real property for an interest in Trust without recognition of gain or loss, if the other requirements of § 1031 are satisfied. .02 Under the facts of Rev. Rul. 200486, an individual borrows money from a bank and signs a 10-year note bearing adequate stated interest. On the same day, the individual uses the proceeds of the loan to purchase Blackacre, rental real property. The note is secured by Blackacre and is nonrecourse to the individual. Immediately after this purchase, the individual enters into a net lease with a tenant (Tenant) for a term of 10 years.

.03 Under the terms of the lease, Tenant must pay all taxes, assessments, fees, or other charges imposed on Blackacre by Federal, state, or local authorities. In addition, Tenant must pay all insurance, maintenance, ordinary repairs, and utilities relating to Blackacre. Tenant may sublease Blackacre. Tenant’s rent is fixed. The revenue ruling indicates that Tenant’s rent qualifies as fixed even if the lease agreement includes automatic periodic adjustments to the rent that are based on a fixed rate or on an objective index, such as

June 22, 2020 990 Bulletin No. 2020–26

an escalator clause based on the consumer price index. No adjustments are within the control of any of the parties of the lease. The amount of rent is not contingent on the tenant’s ability to lease the property, on the tenant’s gross sales, or on net profits derived from the property.

.04 On the same day that the lease was executed, the individual forms Trust and contributes Blackacre to Trust. Upon the transfer of Blackacre, Trust assumes the rights and obligations of the individual as to the note with the bank and the lease with Tenant.

.05 The terms of Trust provide for the following—

(1) A single class of trust interests, each representing an undivided interest in the assets of Trust (in this case, Blackacre, which is subject to both the lease and the note);

(2) Authorization for the trustee to establish a reasonable reserve for expenses that are associated with Trust’s holding Blackacre and that are payable out of trust funds;

(3) Required quarterly distributions of all available cash, less reserves, to each beneficial owner of Trust in proportion to that owner’s relative interest in Trust;

(4) The right of each beneficial owner to an in-kind distribution of that owner’s proportionate share of trust property;

(5) A requirement that Trust invest all cash that it holds in either—

(a) Short term obligations of (or guaranteed by) the United States, or any agency or instrumentality thereof; or

(b) Certificates of deposit of a bank or trust company having a minimum stated surplus and capital;

(6) Requirements that the trustee both invest only in obligations maturing prior to the next distribution date and hold those obligations until maturity;

(7) A limitation on the activities of the trustee to collection and distribution of income;

(8) A prohibition against the trustee— (a) Exchanging Blackacre for other property;

(b) Purchasing assets other than the short-term investments described above;

(c) Accepting additional contributions of assets (including money) to Trust;

(d) Renegotiating the terms of the debt used to acquire Blackacre; and

(e) Renegotiating the lease with Tenant except in the case of Tenant’s bankruptcy or insolvency;

(9) The termination of Trust at the earlier of 10 years or the disposition of Blackacre.

.06 The ruling states that Trust would have been treated as a business entity and not a trust if Trust’s trustee had a power under the trust agreement to, among other things, renegotiate the lease with its tenant, to enter into leases with other tenants, or to renegotiate or refinance the mortgage loan whose proceeds were used to purchase Blackacre.