In recent years, tax-free spinoffs under Sec. 355 involving REITs became popular among corporations with real estate holdings. The essence of REIT spinoffs is that valuable real estate leaves the corporation and moves tax-free into the favorable REIT tax regime. New tax legislation that took effect December 7, 2015, severely curbs this tax planning strategy.
The REIT Spinoff Transaction
The recent legislation targets the following type of transaction: a corporation conducting the core operating business (OpCo) contributes its real estate assets to a controlled subsidiary (SpinCo) in exchange for 100 percent of the SpinCo stock. OpCo then distributes the SpinCo stock to the OpCo shareholders in a tax-free spinoff transaction under Sec. 355, whereby neither OpCo nor its shareholders recognize any income or gain.
Shortly after the spinoff, SpinCo elects REIT status, and OpCo then leases the real estate from the REIT. OpCo thus makes deductible rent payments to the REIT, and the rental income passes through to the REIT investors free of corporate-level taxes. The REIT pays dividends funded by the rental income received from OpCo. Under the REIT tax regime, these dividend payments are deductible from the REIT’s taxable income. Moreover, depreciation deductions for the real property held by the REIT reduce its taxable income enough to allow it to make distributions equal to, or in excess of, the REIT’s taxable income to maintain REIT status. As a result, no tax is incurred at the REIT level, while taxable income is reduced at the OpCo level.
The dividends are subject to ordinary income tax rates at the shareholder level. From the shareholders’ perspective, steady dividend payments from the REIT and higher valuation multiples applicable to real estate could mean that their REIT shares are potentially valued higher than they would be on a stand-alone basis without the separation.
The increasing use of REIT spinoffs by large publicly traded companies as a tax reduction strategy raised policy questions under Sec. 355 as well as concerns that these transactions were eroding the corporate tax base.
Impact of Recent Tax Law Changes
On December 18, 2015, the Consolidated Appropriations Act (the Act) was signed into law, which contains the provisions of the Protecting Americans from Tax Hikes (PATH) Act (P.L. 114-113, Div. Q). This new law includes several taxpayer favorable REIT provisions, including reforms of the Foreign Investment in Real Property Tax Act (FIRPTA) that make foreign investment in REITs more attractive, and making permanent the reduction of the recognition period for a REIT’s built-in gains from 10 to five years. However, the most significant change comes in the form of the Act’s restrictive provisions regarding tax-free REIT spinoffs, which make REITs generally ineligible to participate in a tax-free spinoff either as a distributing or a controlled corporation under Sec. 355.
Under the new law, tax-free treatment under Sec. 355 is not available where either the distributing or the controlled corporation is a REIT. There are two exceptions for existing REITs:
Tax-free treatment is still available for the spinoff of a REIT by another REIT where, immediately after the distribution, both the distributing and the controlled corporation are REITs.
A REIT may spin off its Taxable REIT Subsidiary (TRS) if (i) the distributing corporation has been a REIT at all times during the three-year period ending on the date of the distribution, (ii) the controlled corporation has been a TRS of the REIT at all times during such period, and (3) the REIT has had control of the TRS (defined in Sec. 368(c) as at least 80 percent voting power and 80 percent of the total number of shares, taking into account stock owned directly or indirectly, including through one or more partnerships) at all times during such period.
Moreover, under newly enacted Sec. 856(c)(8), if a non-REIT was a distributing or controlled corporation in a Sec. 355 transaction, that corporation (and any successor corporation) may not make a REIT election before the end of a 10-year period beginning on the date of the distribution.
These provisions took effect for distributions on or after December 7, 2015, but do not apply to transactions with a pending ruling request submitted to the IRS on or before that date. Several companies, among them Hilton Worldwide Holdings Inc. and Caesars Entertainment Corp., have requested a ruling prior to the Act’s effective date to be granted IRS permission to spin off their real estate holdings.
Other companies have already started pursuing alternate strategies to monetize real estate value. Among them is publicly traded casino, hospitality and entertainment company MGM Resorts International, which has announced its plan to contribute some of its real estate assets to a newly formed REIT and to use a lease structure without a tax-free spinoff.
The recent legislation makes it almost impossible for an existing business to separate its operations from the ownership of real estate without incurring significant tax liability. While the restriction of tax-free REIT spinoffs marks a significant change to the restructuring environment for the real estate industry, its impact remains to be seen.
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By Randy Schwartzman & Patricia Brandstetter. This article originally appeared in BDO USA, LLP’s “Real Estate Monitor Newsletter” (Spring 2016). Copywrite 2016 BDO USA, LLP. All rights reserved.