2014-Issue 46—In our recent article on converting real-estate-related businesses into real estate investment trusts (REITs), we outlined key business and tax issues that accompany the REIT conversion process. (See “REIT Conversions — A Primer on Key Business and Tax Considerations,” September 2, 2014.) This edition of Tax Advisor Weekly expands on the 2014 REIT legislative landscape and current trends in corporate REIT conversions.
In February of this year, the House Committee on Ways and Means released the proposed Tax Reform Act of 2014, which included several restrictions on REIT conversions including but not limited to disallowing tax-free spinoffs into a REIT and more narrowly defining real property for REIT purposes (see below for a brief explanation). However, despite Congressional intent to maintain the corporate tax base, the IRS has issued favorable private letter rulings for REIT conversions across several industries and proposed regulations that highlight what some perceive to be an expanded definition of real property. Despite congressional proposals that are at odds with the IRS interpretation of current law and the potential for restrictive legislation in the future, REIT conversion activity is strong. Current corporate activity suggests that the timing is ripe for considering whether certain activities are better held in a REIT than a C corporation.
One of the main tax benefits of a REIT is that it often avoids the double-taxation of a corporation because it is required to distribute at least 90 percent of its taxable income and is entitled to a corresponding dividends paid deduction. One of the business benefits of a REIT is that it allows a corporation access to additional sources of capital. To access these benefits, a company must predominantly own or invest in income-producing real estate assets. Qualification is very strictly determined by the asset and income tests (among other organizational requirements) set forth in Internal Revenue Code Section 856:
- The asset tests include a requirement that the company invest no less than 75 percent of its total assets in cash, cash items, government securities and real estate assets (this is only one of the total of six assets tests).
- The income tests require that the company derive no less than 95 percent of its income from dividends, interest, rents from real property and gains from the sale of real property and no less than 75 percent of its income from rents from real property and gains from the sale of real property, among other requirements.
These two key requirements hinge on the definition of what constitutes real property for REIT purposes.
Tax Reform Act of 2014
The Tax Reform Act of 2014 is a 979-page proposal that has been three years in the making, 25 pages of which are dedicated to REITs. This proposal includes a restriction of what qualifies as real property, namely that real property would not include any tangible property with a class life of less than 27.5 years and would specifically exclude timber. For tax purposes, 27.5-year property is generally limited to residential rental property and its structural components; this revised classification standard would significantly impact the current interpretation of real property for REIT purposes. While the proposal is not anticipated to have an impact on legislation in the near future, it has been suggested that it is a guide to the future of tax policy. If that is true, REITs may continue to be part of tax reform efforts.
Proposed REIT Regulations
In contrast to Congress’s proposed restrictive approach to REITs, the IRS has been much more expansive in its interpretation of what activities can qualify for real property for REIT purposes under current law. This year, the IRS has issued a handful of REIT-favorable private letter rulings (PLRs) approving REIT conversions for asset classes that are (or include) non-traditional real estate assets. The IRS held that customary information technology services revenue derived in connection with the rental of data center properties would qualify as “rents from real property” under IRC 856 in PLR 201423011. In PLR 201424017, the IRS ruled that commercial plants were natural products of the land and constitute real property until they are severed from the land. In PLRs 201431018 and 201431020, the IRS ruled in favor of billboard assets as qualified real property, ruling that certain qualified outdoor advertising displays constitute real property when a Section 1033(g) election has been made and, as a result, the income derived from certain use agreements for these outdoor advertising displays is rent from real property for REIT purposes, respectively. These examples of IRS rulings in favor of a broad interpretation of real property at least suggest that the term is open for non-traditional interpretation under current law.
The IRS also issued proposed regulations in June that clarify and expand on what qualifies as real property for REIT purposes. Proposed Treasury Regulation Section 1.856-10 defines real property to include land, buildings, inherently permanent structures, structural components and certain intangible assets. Furthermore, the regulation contains a facts and circumstances analysis for determining whether a particular asset would be tested on a standalone basis or as part of a larger asset with respect to the definition of real property. The table following summarizes these updates:
These proposed regulations essentially document previous PLRs in a treasury regulation and demonstrate the IRS’s broadening interpretation of what qualifies as real property for REIT purposes under current law.
The recent history of successful IRS letter rulings combined with the release of the proposed REIT regulations seems to have spurred corporate REIT activity in the past year. The conversion of a trade or business into REIT status is subject to complex requirements, but if a corporation can meet the hurdles of qualifying for REIT status, the tax and business benefits can be tremendous.
These benefits may explain why REIT conversions are making headlines. Sears Holding Corp announced earlier this month that is considering forming a REIT for 200-300 of its owned stores in a sale-leaseback transaction that would generate much-needed cash for the retailer. Sears currently operates more than 2,000 stores in the U.S. and Canada, 200 stores for which it owns the underlying property. The retail corporation has been making big moves to liquidate assets and generate cash, and this latest idea is an opportunity to monetize its most valuable asset of real estate. Ceasar Entertainment, which owns and operates casinos, just announced its proposal to split its operating division in two, a REIT and an operating company, as part of a debt restructuring plan. Pinnacle Entertainment, another casino operator, also announced this month that it will request a letter ruling from the IRS for a spinoff of its gaming entertainment properties (casinos) into a REIT. And Life Time Fitness, which operates over 100 fitness centers and owns most of the underlying real estate, announced at the end of the summer that it is exploring a conversion of real estate assets into a REIT.
For every company that has announced it is considering a REIT conversion, there are more companies that are actually in the process or have converted this year (some of them align with the previously mentioned IRS private letter rulings). Iron Mountain, a document storage company, elected REIT status effective January 1 of this year and declared its first dividend as a REIT on September 14. All of the real property of Penn National Gaming was spun off as a REIT, Gaming Leisure Properties, which will elect REIT status effective for the 2014 tax year. CBS Outdoor, a billboard and outdoor advertising company, was spun off from CBS Corporation and intends to elect and qualify to be taxed as a REIT for the 2014 tax year. Lamar Advertising, also an operator of outdoor advertising, has announced that it intends to elect REIT status for the 2014 tax year as well. Windstream Holdings is in the process of spinning off its fiber optic and copper cable lines into a REIT, Communications Sales & Leasing, Inc., and will elect to qualify as a REIT for the 2015 tax year. Equinix, a company that runs data centers, is taking steps now (through special distributions) so it can qualify as a REIT for the 2015 tax year. These examples offer a glimpse into the corporate activity around REITs.
Alvarez & Marsal Taxand Says:
The requirements to qualify for REIT status are strict, but based on current IRS letter rulings and proposed regulations at least the definition of what qualifies as real property under current law may appear to have broadened. While tax reform threatens to restrict the definition of what qualifies for REIT real property in the future, there is no clear indication of if or when that would occur and how any limitations would be effective retroactively, if at all. Corporations seeking REIT status appear to be taking advantage of the IRS’s interpretation without regard to future limitations, and all signs seem to indicate that the timing is ripe for REIT conversions. If your business holds assets that meet the current definition of real property outlined in the proposed regulations, now could be a good time for your organization to take a look at the analysis for a REIT conversion, described in “REIT Conversions — A Primer on Key Business and Tax Considerations.”
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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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