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IRS issues final regulations on transfers of property to REITs

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Tax Hot Topics newsletter The IRS has issued final regulations (T.D. 9862) that provide guidance on transfers of property by C corporations to a real estate investment trust (REIT) and following a spinoff transaction. The final regulations largely adopt proposed regulations issued earlier this year without substantive change.

Generally, when a C corporation converts to a REIT or transfers its assets to a REIT (a conversion transaction), the REIT is subject to tax on the net built-in gain in the converted property under the rules of Section 1374. With Section 1374 treatment, built-in gain in property is recognized only to the extent the property is disposed in the five-year period following the conversion transaction.

Before 2015, some taxpayers took advantage of this regime by effecting tax-free separations of REIT-qualifying assets from non-qualifying assets in a Section 355 distribution. In these transactions, taxpayers generally avoided corporate-level tax on the gain held by the REIT by having the REIT hold the appreciated assets long enough to avoid taxation under Section 1374. Meanwhile, the REIT could lease back the property to the operating business, resulting in rental deductions for the operating business and rental income for the REIT that was subject only to one level of tax pursuant to the REIT rules.

In 2015, Congress passed legislation intended to prevent these transactions. Section 355(h)(1) provides that the section shall not apply to a distribution if either the distributing corporation or the controlled corporation is a REIT. Under section 856(c)(8), a corporation may not elect REIT status during the 10-year period following a Section 355 distribution if it was the distributing corporation or the controlled corporation in that distribution.

In 2016, Treasury and the IRS issued proposed regulations intended to prevent taxpayers from using successor entities and related parties to get avoid Section 355(h) and Section 856(c)(8) . Under the proposed regulations, if a C corporation is the distributing corporation or the controlled corporation in a Section 355 distribution and the C corporation or its successor engages in a conversion transaction within 10 years, the C corporation or its successor would be required to immediately recognize the built-in gain on its assets. The proposed regulations defined “successor” broadly to include any corporation that takes items of the distributing corporation or controlled corporation into account under Section 381.

Commenters suggested these rules could result in recognition of gain greatly in excess of the amount that would have been recognized if the distributing corporation or the controlled corporation had directly engaged in a conversion transaction. In 2019, the IRS issued proposed regulations withdrawing the 2016 proposed regulations and replacing them with a new set of rules intended to remedy this issue.

The preamble to the 2019 proposed regulations included an illustrative example of the taxpayer unfavorable result that the new regulations were designed to solve. In the example, Distributing and Acquiring are unrelated C corporations that each hold real estate assets with $1 billion fair market value and $0 adjusted basis. Distributing owns 100% of the stock of Controlled, which holds assets with $20 million fair market value and $0 adjusted basis. In Year 1, Distributing distributes the stock of Controlled in a Section 355 distribution. In Year 3, Acquiring acquires Controlled in a transaction in which Acquiring becomes a successor of Controlled. In Year 9, Acquiring merges into a REIT. As a successor to Controlled, Acquiring itself was ineligible to make a REIT election until Year 11 under Section 856(c)(8). However, the merger of Acquiring into a REIT is not addressed by Section 856(c)(8). Because Acquiring is a successor to a controlled corporation and engages in a conversion transaction within 10 years of a related Section 355 distribution, the 2016 proposed regulations would treat Acquiring as making a deemed sale election and require Acquiring to recognize $1.02 billion gain ($1.02 billion fair market value less $0 adjusted bases of all its property at the time of the merger). This gain would greatly exceed the $20 million gain ($20 million fair market value less $0 adjusted basis) Controlled would have recognized if Acquiring had been a REIT when it acquired Controlled's converted property.

To address this flaw, the 2019 proposed regulations limit gain immediately recognized by a C corporation engaging in a Section 355 distribution and a later conversion transaction to built-in gain on property traceable to the Section 355 distribution. In an example illustrating this new rule, Distributing is a C corporation that owns 100% of the stock of Controlled. In Year 1, Distributing distributes the stock of Controlled in a Section 355 distribution. At the time of the Section 355 distribution, Controlled has one asset (Asset 1) with $5 million fair market value and $0 adjusted basis. In Year 2, Controlled purchases a second asset (Asset 2), which has $1 million fair market value and $1 million adjusted basis. In Year 5, Controlled engages in a conversion transaction when it merges into a REIT in a transaction described in Section 368(a)(1). At the time of the merger, Asset 1 has $5.5 million fair market value, and Asset 2 has $1.1 million fair market value. The adjusted bases of Asset 1 and Asset 2 are both unchanged. Because of the limitation proposed in the 2019 proposed regulations, Controlled is only required to immediately recognize gain on Asset 1 (and not Asset 2) because Asset 1 was held by Controlled immediately after the related Section 355 distribution and is therefore distribution property. Because Controlled can establish that it did not own Asset 2 immediately after the related Section 355 distribution (and the basis of Asset 2 was not determined, directly or indirectly, in whole or in part, by reference to the basis of an asset held by Controlled immediately after the related Section 355 distribution in Year 1), Asset 2 is not distribution property, and Controlled will not be required to recognize gain with respect to Asset 2. Accordingly, Controlled would recognize $5.5 million gain on Asset 1 ($5.5 million fair market value less $0 adjusted basis), and the REIT would be subject to section 1374 treatment with respect to Asset 2 and its $0.1 million built-in gain.

Commenters suggested various changes to the 2019 proposed regulations. One commenter suggested a rule that immediate recognition of built-in gain would only be triggered if the spinoff and conversion transaction were part of the same plan. Another suggested a reduction of the period after which a distributing corporation or controlled corporation could engage in a conversion transaction without triggering immediate recognition of built-in gain. IRS ignored these comments and published the final regulations without substantive changes.

Contacts:
Jeff Borghino
Partner
Washington National Tax Office
T +1 202 521 1532

Evan Adams
Manager
Washington National Tax Office
T +1 202 521 1591

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