Taking the “Real Estate” Out of REITS for Tax Purposes

Posted on Tue, Apr 30, 2013 ©2021 Drucker & Scaccetti


There has been a lot of press recently on a growing wave of businesses that are converting to Real Estate Investment Trust ("REIT") status in order to become exempt from federal corporation income tax.  What is peculiar about this trend is that you would not ordinarily categorize these businesses as being in the real estate industry!


A few examples of some notable "non-traditional" completed or planned conversions:


  • GEO Group and Corrections Corporation of America (privatized correctional and detention facilities)
  • Penn National Gaming (gaming properties)
  • American Tower (communications towers)
  • CBS Corp (billboard unit)


In a detailed research report issued on April 10, 2013, titled, "REITs, What's Next in the REIT Conversion Phenomenon?," Omotayo Okusanya, a strategist at the Wall Street firm Jefferies, LLC writes, "With the IRS becoming more liberal with its interpretation of 'real property', we see potential for a number of new REIT sectors in the future, including energy infrastructure (midstream pipelines, solar and wind farms, etc.), railroads, public infrastructure (private highways, bridges, ports, etc.) farmland, cemeteries and others.”


Some of the advantages enjoyed by companies that convert to REITs are:


  • No corporate income taxes;
  • Capital that is used to purchase and hold fixed assets could be freed up to operate the core operating business;
  • Ability to return cash to shareholders;
  • Institutional investors favor REITs, opening up this set of investors to the company;
  • Because they provide high and stable dividends, conversion typically drives up a company's stock price because investors want the cash flow from these dividends, as opposed to earning low rates of interest.


While some of the risks and disadvantages of conversion are:


  • Conversions to REIT status could take several years (American Tower's conversion took  from 2007 to late 2011 and Weyerhaeuser's from 2008 to 2011);
  • Limitations on retention of capital and significant free cash flow;
  • Creates higher ongoing dividend payout obligations which can strain liquidity;
  • Increases the reliance on capital markets to fund reinvestment in the business or external growth;
  • Non-traditional REITS (which do not have significant investment in traditional "bricks" and "sticks" real estate) do not have access to the property mortgage market;
  • Similar to a sale-leaseback transaction, the REIT-owned real estate will now burden the operating company with a rent expense that was not there when the operating company had owned the real estate outright;
  • The impact on the operating company, as far as whether taxable gain may have to be recognized on the assets that are contributed into the REIT, is a factor that will have to be considered at some point; and
  • REIT dividends are not "Qualified Dividends".  Accordingly, this income is taxed at the 39.6%  rate for higher income earning individuals, not the normal 20% rate.


To qualify as a REIT, a company must seek a ruling from the Internal Revenue Service ("IRS").  In its request for a ruling, the company must state its intention to be taxed as a real estate investment trust under Section 856 of the Internal Revenue Code of 1986, as amended (the "Code").  In general, the company must also meet the following qualifications in its actual or intended activities:  


1)      Distribute at least 90% of taxable income in the form of dividends;

2)      At least 75% of gross income must come from qualified investments;

3)      At least 75% of total assets must be invested in real estate;

4)      Must not have any pre-REIT earnings and profits.

5)      A taxable REIT subsidiary (established to generate income from non-qualifying income such as service fees, leasing fees, janitorial, etc.) can be no larger than 25% of the REIT's assets;

6)      There must be a minimum of 100 shareholders; and

7)      No more than 50% of the shares of the REIT can be held by five or fewer individuals


As stated in the Jefferies, LLC report, the IRS has not been overly critical is disallowing REIT status for non-traditional companies.  In fact, as most recently as April 5, 2013, the IRS in Letter Ruling 201314002 permitted a company that owns and leases several data centers throughout the United States to form a REIT subsidiary, transfer the Parent Company's ownership in its data center buildings to the REIT, and then have the Parent Company pay deductible rent to the REIT.


Industry experts, however, are fearful that the rising conversion to REIT status among owners of non-traditional property may bring unwelcome scrutiny by taxing authorities and lead to a change in the rules for REITs.   According to the Jefferies, LLC report, …"we worry that the wave of REIT conversions could be problematic for the industry as a whole given the perception that companies are looking to avoid taxes through a 'loophole' in the tax code … at a time when the government is operating with deficits and just recently implemented sequestration to reduce spending across the board for government programs."


In fact, just this week, the Wall Street Journal reported that the House and Ways Committee is looking at the REIT exemption among other tax rules to close what they consider to be loopholes.  Quoted in the article was the spokeswoman for the committee who said, "Like all other aspects of the code, it is reasonable to expect that would be included in any top-to-bottom review of the code," (Congress Looks at REIT Tax Exemption; Wall Street Journal/WSJ.com; April 23, 2013, 7:23 p.m. ET).


The fate of this issue may well depend on how widespread the REIT conversion trend becomes, and how much attention it receives. It has been characterized by some as simply the latest way for entities to seek to avoid the corporate-level tax. Given the momentum towards tax reform in general, and in particular in the corporate realm, REITs may well factor into the discussion.


The Tax Warriors are keenly interested in this area as we have extensive experience in the real estate and REIT space.  We understand that although the move to convert may be enticing from a tax perspective to some businesses, for some, there are many reasons to reconsider, such as the significant, ongoing dividend commitment that can put a strain on liquidity.  As stated above, the current administration in Washington is cracking down on what it deems to be tax loopholes for corporations.  What seems like a good move today, could become very costly in the all-too-near future.


Our team of experienced tax strategists is anxious to speak with you if you are considering such a decision for your business. There are many questions to ask and have answered before venturing into this kind of business strategy, as well as other possible tax implications to consider.  And, we strongly believe that every business strategy should be coupled with a sound tax strategy


Contact us via the “Ask A Tax Warrior” button below or call us directly at (215) 665-3960.  The Tax Warriors at Drucker & Scaccetti are always prepared to help you with this or any other tax-related matter.

Topics: Tax-exempt, Conversion, REIT, Real estate investment trust, non-traditional, corporate taxes

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