On February 25, 2014, Chairman of the House Committee on Ways and Means, Representative Dave Camp (R.-Mich.), published the proposed Tax Reform Act of 2014 and an accompanying technical explanation written by the Joint Committee on Taxation (together, the “Camp Proposals”). The Camp Proposals are Representative Camp’s latest effort to reform comprehensively the U.S. tax code for the first time since 1986. The proposed changes with respect to real estate investment trusts (“REITs”), if enacted, would adversely affect REIT mergers and acquisitions and REIT conversions as we see them in the current market. The Camp Proposals would also curtail like-kind property exchanges, exclude certain assets from being considered “real property” under the REIT rules, and reduce to 20 percent the percentage of a REIT’s assets that may be held in a taxable REIT subsidiary (“TRS”). However, given the upcoming mid-term Congressional elections, the current political climate in Washington, the controversial nature of most of the proposed REIT changes, and, with one exception, the absence of corresponding proposals in President Obama’s Budget Proposal for 2015, which was released on March 5, 2014 (the “Obama Budget 2015”), the enactment of the Camp Proposals in 2014 with respect to REITs faces significant obstacles.
Summary
The most significant Camp Proposals affecting REITs and real estate are the following:
- No Tax-Free Spinoffs Involving REITs
- Section 355[1] permits the distribution of stock of a controlled corporation by a corporation in a manner that is tax-free to both the distributing corporation and the shareholders of that distributing corporation, if certain requirements are satisfied. In a recent private letter ruling that garnered significant attention, the IRS ruled that a publicly traded corporation, Penn National Gaming, Inc., could split into two — a service business and a real estate business — in a tax-free spinoff and elect REIT status for the real estate business.[2] The Camp Proposals would prevent these transactions from being tax-free to the distributing corporation and its shareholders by providing that a REIT cannot be a distributing corporation or a controlled corporation in a Section 355 distribution. Moreover, the Camp Proposals also provide that any distributing or controlled corporation involved in a Section 355 spinoff must wait 10 years before making a REIT election. This proposal would apply to all spinoffs occurring after February 26, 2014 unless a binding commitment to complete the spinoff was in place prior to February 26, 2014.
- The Obama Budget 2015 does not include a corresponding proposal.
- Curtailed Availability of Like-Kind Property Exchanges
- Under current law, no gain or loss is recognized pursuant to Section 1031 when a business or investment property is exchanged for “like-kind” business or investment property. The Camp Proposals would repeal Section 1031 nonrecognition of gain in the case of like-kind exchanges occurring after 2014, unless a binding commitment to complete the exchange is in place before December 31, 2014 and the exchange is completed before January 1, 2017.
- The Obama Budget 2015 contains a more limited corresponding provision that would repeal nonrecognition of gain only for any exchanges of real property where the capital gains would exceed $1,000,000 per taxable year.
- Immediate Recognition of Built-in Gains
- Under current law, a REIT election itself is a non-taxable event. Instead, an entity taxable as a corporation that converts from a “C corporation” to REIT status will be subject to tax on the disposition of any assets with built-in gains that occurs within the 10-year period after the REIT election. A similar rule applies if a REIT acquires real estate from a C corporation in a tax-free transaction. The Camp Proposals require immediate recognition of built-in gain upon the conversion from a C corporation to a REIT. This rule could impose a significant up-front cost on any such conversion.
- The Obama Budget 2015 does not provide for a corresponding proposal.
- Restricting the Definition of “Real Property”
- “Real Property” according to the REIT rules includes not only real property, but also land or improvements thereon, buildings and other inherently permanent structures. IRS private letter rulings have held that real property under the REIT rules includes cell towers, billboards, data centers, and an offshore oil and gas platform. In addition, the Code provides special rules for timber held by REITs. The Camp Proposals would restrict the definition of real property to property with a class life of at least 27.5 years (as defined in the depreciation rules of the Code) and would exclude timber from the definition of real property (and repeal special rules for REITs that hold or dispose of timber or timberland). This class life would exclude the types of properties addressed in the private letter rulings referred to above. These proposals would become effective after December 31, 2016. If enacted, they could cause a significant number of REITs to lose their status as such and could cause companies contemplating REIT conversions to abandon those plans.
- The Obama Budget 2015 does not provide for a corresponding proposal.
- Non-REIT Earnings and Profits Must be Distributed in Cash and Not Stock
- A REIT cannot have earnings and profits accumulated in any non-REIT year. Thus, a C corporation seeking to make a REIT election (or an existing REIT that acquires another C corporation’s earnings and profits) must make a distribution of all non-REIT earnings and profits to shareholders by the end of the entity’s first taxable year as a REIT. Based on prior IRS private letter rulings, REITs have routinely structured such distributions by giving shareholders the option to choose between receiving stock or cash. These stock/cash distributions have allowed converting corporations to reduce the up-front cash cost of a REIT conversion. Under the Camp Proposals, only cash distributions would qualify as distributions that cleanse the entity of non-REIT earnings and profits. This new rule would apply to all “cleansing” distributions that occur after February 26, 2014. This provision could prove to be a significant burden for companies attempting to preserve their cash.
- The Obama Budget 2015 does not provide for a corresponding proposal.
- Only 20 percent of REIT Assets May be Taxable REIT Subsidiaries
- Generally, REITs are not permitted to own securities that represent more than 10 percent of the vote or value of the entity. Additionally, a REIT is not permitted to own securities of a single issuer that represent more than 5 percent of a REIT’s value. However, under current law, there is a special rule for TRSs. Up to 25 percent of the total value of a REIT’s assets may consist of securities of one or more TRSs. The Camp Proposals reduce the permitted percentage of total REIT assets that may be securities of one or more TRSs to 20 percent.
- The Obama Budget 2015 does not provide for a corresponding proposal.
Initial Observations
The Camp Proposals relating to REITs (some of which are not discussed herein) would significantly constrain current REIT M&A and REIT conversion market activities and could affect various recently completed or currently contemplated transactions. It is unclear whether the Camp Proposals will move forward or whether they may be included in whole or in part in other legislation. However, as we noted in our introduction, we believe it is unlikely that the Camp Proposals in respect of REITs will be enacted in their current form in 2014. We will continue to monitor these developments closely.
ENDNOTES:
[1] All Section references are to the Internal Revenue Code of 1986, as amended (the “Code”) and the regulations promulgated thereunder.
[2] See Sidley Client alert http://www.sidley.com/REIT-Spinoffs-Optimizing-the-Strategic-Focus-of-a-Public-Corporation-Tax-Efficiently-02-21-2013/.
The full and original memo was published by Sidley Austin LLP on March 7, 2014 and is available here.