Tax Tangles: REIT Spinoffs: Opportunities and Issues
This installment of Tax Tangles explains why more and more companies find enticing the prospect of transferring their real estate to a Real Estate Investment Trust (“REIT”) and highlights tax and business issues to consider in contemplating this strategy.
Readers interested in learning more about this subject or other tax issues affecting the real estate industry may contact Michael Grace, Counsel in our Washington, DC office, at 202-659-6776 or firstname.lastname@example.org. Stacey Pine, a law clerk in our Washington, D.C. office, took the lead in preparing this article.
While Real Estate Investment Trusts (REITs) have been an investment option for more than fifty years, only recently have businesses other than those in the real estate industry begun to view REITs as a valuable resource and use them to avoid double taxation, increase after-tax profits, and pass added value on to investors through higher dividends.
Corporate Double Taxation
Domestic (U.S.) corporations are subject to federal income tax (rates up to 35 percent) on their taxable income, which reduces the amount of corporate profits that can be distributed to shareholders as dividends. And the dividends shareholders do receive are then taxed at federal income tax rates ranging from 10% to 39.6%, plus possibly an additional 3.8% surtax on net investment income. That is what people refer to as the “double taxation” of corporate income. State and local income taxes can further aggravate double taxation.
If, instead of distributing the net profits as dividends, a corporation retains its earnings, the corporation’s stock price will presumably rise over time, all else being equal. While an investor is not taxed on a rise in stock price as long as he or she owns the stock, the capital gains on sale are another variation of double taxation, albeit at a lower rate.
Tax Benefits of a REIT
REITs, however, receive special treatment under the Internal Revenue Code which allows them to avoid double taxation. Basically, REITs are not required to pay federal corporate income taxes so long as at least 75% of their gross income is derived from long-term real estate holdings; 95% of their net annual income is distributed to shareholders; and they have at least 100 shareholders (subject to additional technical requirements listed below).
Congress established REITs in 1960 to give investors of all income levels an easy way to invest in a pool of income-producing real estate holdings. The intent was for REITs to be passive investment vehicles used to promote portfolio diversification. Generally, REITs are corporations organized for the purpose of owning and operating income-producing real estate holdings, such as office buildings, shopping centers, multi-family residential buildings, and healthcare facilities.
The preferential tax treatment afforded REITs offers regular corporations an attractive opportunity. A corporation may enter into a sale/lease-back agreement with a REIT under which the corporation sells real estate to the REIT, and the REIT agrees to rent the asset back to the corporation. This allows the corporation to deduct the total lease payments made to the REIT, thereby lessening the corporation’s tax liability. The REIT is not subject to income tax on the rents received provided the REIT distributes its income to its shareholders and satisfies the other requirements.
In addition, there is a further benefit: under current law, corporations may deduct interest but not payments of principal on their mortgages. Making the same principal and interest payment in the form of lease payments to a REIT effectively makes both parts deductible.
Major corporations throughout the country such as AutoZone, Bank of America, and Wal-Mart realize substantial tax savings by utilizing REITs. From 1998 to 2001, Wal-Mart reportedly avoided $350 million in tax liability by having transferred its real estate assets to a REIT. In some cases, a corporation has “spun off” its real estate to a new REIT to be owned by the corporation’s shareholders. In specific instances, the IRS has approved this technique as a tax-free reorganization. Many real estate development corporations also form REITs in order obtain capital for projects by selling REIT shares to investors.
Potential Pitfalls of REITs
While transferring corporate real estate assets to a REIT does offer a tax advantage, there are other issues to consider. For one, a company transferring a real estate asset to a REIT gives up control of how the asset will be used or when it might be sold, unless the corporation has preferential voting rights in the REIT’s governance structure.
Additionally, if the corporation wants to set up a new REIT, instead of transferring assets to an already existing REIT, there are strict requirements that must be met. In addition to the income, distribution, and shareholder requirements mentioned above, the new entity must satisfy the following conditions:
- It must not be a financial institution or an insurance company;
- It must have centralized management by one or more trustees or directors;
- It would be taxable as a domestic corporation but for the REIT election; and
- It must have transferrable shares.
These may sound simple as summarized here, but the elements necessary to comply with each of these conditions are highly technical and nuanced, so it isn’t always easy to meet these requirements. And failing to meet them not only will result in the double taxation the company was trying to avoid but could also trigger a monetary penalty.
Finally, there are also accounting and cash flow issues to be considered, which we don’t have space to deal with here.
Using a REIT may save a corporation a great deal of money in taxes, but it is a complex decision that should be guided by expert financial and legal advice.