Legal Briefs

Chasing Value

Change in tax law for REIT spin-off deals sparks creative solutions.

Recent changes to the Internal Revenue Code have ended the tax-free benefits of real estate investment trust spin-off transactions. Characterized by some as a Wall Street loophole, the beneficial structure enabled operating companies to distribute real estate assets and realize other strategic benefits.

Now that spin-off transactions lose those tax-free advantages, commercial property executives must use alternative structures to unlock the value of operating company real property assets. 

Tax Conundrum

The changes to the federal tax code provide that any such REIT spin-off will result in a taxable income to the operating company and, again, to its stockholders unless it involves an existing REIT and certain other specified conditions are satisfied. The IRC change also prohibits the subsidiary company from electing REIT tax status for 10 years after the spin-off. The result is, almost certainly, to reduce the supply of commercial real property available for REITs, limiting the opportunity for operating companies to monetize these assets.

In many ways, the tax code change creates the same substantial economic result as if the operating company sold the property and distributed the net proceeds to its stockholders. Proponents claim that a loophole is fixed as the economic reality of the transaction is subject to tax.

A significant difference, however, exists that is not appreciated by the change. In the REIT spin-off, the stockholders receive stock, not cash. This change creates taxable income to the stockholders in a non-cash transaction, which generally is the worst possible tax consequence.

Some tax experts have estimated that more than $1.5 billion in tax revenue will be realized by ending the REIT spin-off tax-free loophole. However, any such estimate presumes that operating companies will continue to spin off real property with built-in gain, e.g., fair market value of the property in excess of the depreciated tax basis of the property.

Operating companies may decide, however, to continue to hold valuable real estate property rather than subject themselves and their stockholders to a tax liability - taxable income - without any cash realization. Accordingly, the tax code is now compelling operating companies to retain assets with different risk profiles, and this creates valuation complications.

Creative Solutions

Commercial property executives and operating companies will likely search for other tax-advantaged transactions to realize the strategic benefits of spinning off real estate assets. Here are some options.

Gains from Net Operating Losses. Firms with NOLs may spin off the real estate assets and offset their losses with the gain. Those considering strategic transactions that involve a change of control may find this a productive use of their losses. However, this limits the future use of NOLs.

Captive REIT Structure. Similar to the REIT spin-off, organizations may use a captive REIT structure. The difference is that the operating company continues to own the REIT subsidiary. This structure provides certain state and local tax benefits. Also, at the end of the 10-year period that is now specified by the tax code, the captive REIT shares may be distributed by the operating company without it recognizing taxable income.

Up-C Structure. A subsidiary company is formed as a limited partnership. New investors fund the subsidiary company through the purchase of stock in a newly listed public company, which purchases LP or LLC interests in the subsidiary from the operating company. A tax receivable agreement is entered into between the operating company and the subsidiary company to shift a portion of the tax benefit from the transaction to the organization, mitigating the tax costs of the spin-off.

Non-REIT Subsidiary. Companies can create a non-REIT subsidiary to hold the property. Subsidiary company preferred stock, e.g., capital class, could be structured to have a liquidation and dividend preference to the operating company, so that other subsidiary company preferred stock (income class) can be distributed to operating company stockholders without significant taxable income at that level.

Each of these alternatives have many variations available to an operating company that is considering spinning off its real estate assets. In addition, an organization may seek more-traditional structures such as mortgage financing and sale-leasebacks. Commercial property executives have always been able to unlock property value. The next phase will require an equal commitment to creative thought and Internal Revenue Service regulatory responses. The IRS has not yet addressed certain alternatives that may be useful.

 

This article is for informational purposes only and not for the purpose of providing legal advice and is not to be acted on as such.

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Richard Morris

Richard Morris is a corporate partner at the law firm of Herrick, Feinstein LLP in New York with more than 25 years of transactional experience, including public and private REIT funds. Contact him at rmorris@herrick.com.

Sung Hwang

Sung Hwang is a tax counsel at the firm and has worked extensively in structuring real estate investments. Contact him at shwang@herrick.com.

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