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IRS Releases Final Regulations on Gain Recognition When Transferring Assets to REITs

June 26, 2019

By Donald Zief

The Internal Revenue Service has completed a long process to address gain recognition issues with respect to transfers of property to REITs following a “spin off” transaction.  On June 3, the IRS released final regulations that provide needed guidance with respect to the “anti-spinoff” rules enacted as part of the Protecting Americans From Tax Hikes Act of 2015 (“PATH Act”).

Background

Prior to enactment of the PATH Act, several REITs had taken advantage of the spin-off rules of Internal Revenue Code (the “Code”) Section 355, which permits a corporation to divest itself of a subsidiary in a nontaxable transaction as long as both corporations were engaged, immediately after the distribution, in the active conduct of a trade or business that the corporations had conducted for at least 5 years prior to the spinoff.  A REIT owning real property (“PropCo”) would distribute the stock of its property managing subsidiary to its shareholders; the subsidiary (“Opco”) would lease the property from the REIT and operate it, obtaining a deduction for rent paid to the REIT, which the REIT then deducted  upon distribution to its shareholders.

These favorable provisions were severely restricted by the PATH Act, which provided that tax-free spin-off treatment is not available for a distribution if either the distributing or distributed corporation is a REIT.  In addition, neither of these non-REIT corporations or a successor corporation could elect REIT status during the 10-year period following a spinoff.  There are two exceptions to these rules:  (i) tax-free spin-off treatment is permitted if both corporations are REITs immediately after the spinoff; and (ii) a REIT may spin-off a taxable REIT subsidiary (“TRS”) tax-free if both the REIT and TRS had been such during the 3-year period preceding the spinoff and the REIT had control of the TRS during such period.

Regulations

The newly amended statute that restricted tax-free treatment for REIT spin-offs did not address “conversion transactions” that occurred in connection with a spin-off transaction.  A conversion transaction occurs when either (i) a C corporation converts to a REIT; or (ii) a C corporation transfers assets to a REIT in a carry-over basis transaction.

The IRS’s concern is that appreciated assets owned by a C corporation will escape taxation on the gain when transferred and then sold by a REIT.   However, a REIT may sell or otherwise dispose of property it holds as a result of a conversion transaction (not connected with a spin-off) with no tax liability at the REIT level if it holds the property for at least 5 years, unless it elects, or is deemed to elect (the “Deemed Sale Rule”), to recognize gain and pay tax.

In issuing the final regulations, the IRS confirmed many of the provisions in its earlier proposed regulations and did not adopt suggestions offered by practitioners and NAREIT.  Thus, it retained the Deemed Sale Rule for conversion transactions that occurred during a 20-year period that begins 10 years before the related spin-off, rejecting a suggestion that the period be reduced to 10 years beginning 5 years before the spin-off transaction.

The IRS also did not adopt the suggestion that the Deemed Sale Rule apply only where the spin-off and conversion transaction were part of a “plan.”   Finally, for spin-offs that are not part of a conversion transaction, the IRS kept its rule that a REIT spin-off would be accorded tax-free treatment if both entities were REITs immediately after the spin-off (as per the PATH Act) and remained so for the ensuing two-year period.

Mazars Insight

Although somewhat curtailed, certain planning opportunities still exist.  The new anti-spin-off rules apply to REIT elections, but do not seem to apply to certain mergers of a C corporation into a REIT.   Thus, a C corporation that had participated in a spin-off transaction may be able to be acquired by a new or existing REIT, unless the REIT first elected to be a REIT during the 10-year period following the spin-off and the REIT is treated as a successor of the C corporation.  In addition, these rules don’t apply if both the distributing and distributed corporations are REITs immediately after the distribution (although as discussed above, the regulations added the requirement that both remain REITs for two years after the spinoff).  Finally, the statute permits a C corporation to elect REIT status and to spin off a controlled taxable REIT subsidiary as long as the spin-off occurs at least 3 years after REIT status was elected.

Please contact your Mazars USA LLP professional for additional information.



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