IRS Ruling May Free Up Corporate Real Estate Value
In June, the Internal Revenue Service issued Revenue Ruling 2001-29, which states that a real estate investment trust might be party to a tax-free separation of corporate-owned real estate if certain conditions are met. This ruling comes as great relief to many corporations that have significant untapped value in real property that, at the same time, negatively affects their balance sheets and certain financial ratios.
The opportunity to transfer corporate-owned real estate to a separate off-balance-sheet entity such as a REIT always has been available; however, the new guidance revokes a nearly 30-year-old ruling that created significant doubt on the ability to separate the real estate on a tax-free basis if the subsidiary intended to make a REIT election. If the spin-off transaction did not qualify for non-recognition treatment, it would trigger a tax to both the distributing corporation and the shareholders. While a taxable transaction may have merit, most corporations and shareholders prefer a tax-free transaction with favorable non-tax results, which the new ruling provides.
Corporations can complete a tax-free transfer of corporate-owned real estate to a subsidiary that can be spun off to the corporation's shareholders as a stand-alone business. The subsidiary then can elect to be treated as a REIT for federal income tax purposes and enter into an agreement to lease the real estate back to the parent corporation for an arm's length fee. Generally, a REIT is not subject to corporate-level federal income tax as long as it distributes all of its taxable income for that year and satisfies qualification tests related to its income, assets, ownership, and organization.
This structure permits the parent corporation to take a deduction for the rent it pays to the REIT. The shareholders, who are now shareholders of both the corporation and the REIT, receive the rental value of the real estate property, free of any corporate-level income tax.
While the spin-off transaction may not result in a tax for the parent corporation or the shareholders, the REIT might inherit certain tax attributes of the corporation that would require a distribution that would be taxable as a dividend to the shareholders by the end of the REIT's first taxable year.
In addition to favorable current and permanent tax consequences that can result from a spin-off transaction, the separation of the real estate also offers the distributing corporation other benefits, including the potential for higher returns on operating assets and equity, which can lead to a higher stock valuation and an improved debt-to-equity ratio or earnings per share. The spin-off also allows each of the resulting companies to focus on their core businesses, making both the distributing corporation and the REIT more attractive to outside investors. This should enable corporations to have better access to capital markets than they would as single corporate enterprises and, accordingly, help them expand and grow.
The revoked ruling held that a REIT could not engage in an active trade or business, one of the technical requirements for completing a tax-free spin-off transaction. The 2001 guidance acknowledges that, in certain circumstances, a REIT can satisfy this requirement while remaining a passive investment company in order to meet REIT qualifications.
In a tax-free division, a corporation is separated into two or more corporations. The stock distribution to the original corporation's shareholders must satisfy Internal Revenue Code Section 355 requirements for non-recognition treatment. Section 355 outlines the statutory and non-statutory requirements to take advantage of the non-recognition treatment of a spin-off company. These govern the distribution of stock and securities in the controlled company, active conduct of both businesses after distribution, and the definition of business purpose for both the distributing and controlled companies.
When the requirements are satisfied, non-recognition treatment applies to the distributing corporation, the shareholders, and the subsidiary.
In general, a spin-off transaction must meet a set of statutory and non-statutory requirements to take advantage of the non-recognition treatment. First, the spin-off transaction must have a substantial business purpose. The IRS closely scrutinizes any spin-off that involves a REIT election because of REITs' special tax status. The regulations specifically state that the reduction of federal income taxes is not a proper business purpose for a transaction.
Immediately after the distribution, both the distributing corporation and the subsidiary must engage in an active trade or business that has been conducted for at least five years. Internally managed real estate, depending upon the activities of the real estate group, may satisfy the active business requirement.
After the spin-off, the REIT's activities must continue to demonstrate an active business. A REIT that merely triple net leases the real estate back to the corporation may not satisfy this requirement. As an alternative, the REIT might acquire, manage, and lease other income-producing real estate properties.
While the recent guidance represents a significant development in permitting the separation of corporate real estate into a tax-advantaged REIT vehicle, the intended tax consequence is not a guarantee nor is it without a potential price.
First, a satisfactory business purpose must exist, the real estate activities of the distributing corporation as well as the REIT must satisfy the business requirements, and the other requirements for a tax-free transaction must be met. Second, if historically a company's real estate has been held in a separate subsidiary that would be distributed to shareholders, any implications under the consolidated tax rules related to the distribution of the subsidiary's stock must be considered, such as intercompany transactions and excess loss accounts. And last, a REIT election by the distributing or distributed corporation likely would require a taxable stock distribution to the shareholders.
Consult a tax professional for further information on individual cases.