IRS Targets Tax Avoidance on REIT Conversions

The IRS initiated final and temporary regulations on June 7, 2016 impacting REIT conversions and spin-offs.  The issuance of these regulations follows a recent trend of activity in the IRS in this specific area.     

The Internal Revenue Code (“Code”) requires corporations to recognize gain or loss on the distribution of property in connection with complete liquidations other than certain subsidiary liquidations.  However, if satisfied, § 355 generally permits a corporation to distribute interests of one or more controlled corporations to its shareholders and security holders in tax-free transaction.  Sections 311(a) and (b) of the Protecting Americans Against Tax Hikes Act of 2015 (the “PATH Act”) amended §§ 355(h) and 856(c)(8) of the Code, respectively.  As amended, § 355(h)(1) of the Code provides that § 355 shall not apply to a distribution if either the distributing corporation or the controlled corporation is a REIT.  Section 355(h)(2) provides exceptions permitting a REIT to distribute the stock of another REIT or of a taxable REIT subsidiary under certain conditions.

This section seems to block the previously allowed benefit afforded to REITs under § 1374 whereby appreciated property would be not taxed at a gain if the REIT held the property if certain requirements were met.   The temporary regulations provide that a C corporation engaging in a conversion transaction involving a REIT within the 10-year period following a related § 355 distribution is treated as making an election to recognize gain and loss as if it had sold all of the converted property to an unrelated party at fair market value on the deemed sale date.  Section 1374 treatment is accordingly not available in these cases as an alternative to recognizing any gain with respect to the converted property on the deemed sale date.

The proposed regulations discussed above also have increased the “recognition period” to 10 years and thereby decoupling from the 5-year period instituted by the PATH Act.  The provisions of § 1.337(d)-7 will no longer be affected by § 127 of the PATH Act and the recognition period is no longer determined by reference to § 1374(d)(7).  Instead, the recognition period is determined by reference to the first day of the RIC or the REIT's first taxable year (in the case of a conversion transaction that is a qualification of a C corporation as a RIC or a REIT) or on the date the property is acquired by the RIC or the REIT.

These new regulations will certainly add another layer of due diligence to be performed for all REIT conversions going forward.