New legislation restricts tax-free REIT spinoffs.

• Author: Brandstetter, Patricia
• Position: Real estate investment trusts

In recent years, tax-free spinoffs under Sec. 355 involving real estate investment trusts (REITs) became increasingly popular among corporations with sizable real estate holdings. Since a REIT is generally not subject to corporate-level taxes on income distributed to its shareholders, it is an attractive entity in which to house income-producing real estate. The essence of REIT spinoffs is that valuable real estate leaves the corporation and moves tax-free into the favorable REIT tax regime, which creates value for shareholders while reducing corporate-level taxes for the real estate portion of a business. However, new tax legislation, effective for distributions on or after Dec. 7,2015, curbs this tax planning strategy by severely restricting the application of tax-free spinoff treatment under Sec. 355 to REITs.

The REIT Spinoff Transaction

From a tax perspective, the type of REIT spinoff addressed by the recent legislation can be described as follows: A corporation conducting the core operating business (OpCo) contributes its real estate assets to a controlled subsidiary (SpinCo) in exchange for 100% of the SpinCo stock. OpCo then distributes the SpinCo stock to the OpCo shareholders in a tax-free spinoff transaction under Sec. 355. If the transaction qualifies under Sec. 355, neither OpCo nor its shareholders wifi recognize any income or gain.

Shortly after the spinoff, SpinCo elects REIT status, and OpCo then leases the real estate from the REIT, with the rental income passing through to the REIT investors free of corporate-level taxes. The lease is typically a long-term, arm's-length "triple net lease," whereby OpCo is responsible for the maintenance, taxes, and insurance of the leased properties. Since triple net lease activities may not meet the "active trade or business" requirement of Sec. 355 (discussed in more detail below), the OpCo usually contributes a small amount of its active trade or business assets to the REIT.

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The effect of this transaction is that OpCo makes deductible rent payments to the REIT, thereby reducing its taxable income. The REIT initially is owned by OpCo's shareholders and pays dividends funded by the rental income received from OpCo. Under the REIT tax regime (outlined below), these dividend payments are deductible from the REIT's taxable income. The depreciation deductions for the real property held by the REIT reduce its taxable income enough to allow it to make distributions equal to or exceeding the REIT's taxable income.

Since dividends paid by a REIT to its shareholders are deductible for tax purposes, the distribution eliminates taxable income, along with any corporate-level taxes, to the REIT. Since there is generally no entity-level tax as a result of this mechanism, the dividends are subject to ordinary income tax rates at the shareholder level, as opposed to the more favorable capital gains tax rates applicable to dividends from most domestic C corporations and certain foreign corporations. From the shareholders' perspective, the steady dividend payments from the REIT and the higher valuation multiples generally applicable to real estate mean that their REIT shares are potentially valued higher than C corporation shares would be. Often, the sum of the parts is greater than the whole.

REIT Taxation and Tax-Free Spinoffs Under Sec. 355

A REIT is a U.S. entity that owns and operates income-producing real estate assets and otherwise would be taxed as a corporation but elects to be taxed under a special REIT tax regime. A REIT is effectively exempt from entity-level taxation but must annually distribute at least 90% of REIT taxable income (except net capital gain) to its shareholders in the form of dividends that are generally subject to ordinary income tax rates. REITs are taxed at corporate tax rates on amounts not distributed; in addition, strict distribution requirements must be met to avoid an excise tax under Sec. 4981. To be a REIT, the entity must meet the following requirements under Sec. 856 with respect to its income and assets:

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