Sec. 355 and REITs: opportunities for owner-occupied real estate.

• Author: Gruidl, Nick
• Position: Real estate investment trusts

For a transaction to qualify as a tax-free spinoff under Sec. 355, numerous tests must be satisfied, three of which are of particular relevance to real estate investment trusts (REITs): (1) An active trade or business must exist that must have been actively conducted for the five-year period ending on the transaction's distribution date; (2) the new controlled corporation must continue that active trade or business, or a part of it, after the transaction; and (3) the transaction must have a business purpose. This item explores the challenges taxpayers have historically faced when contemplating a Sec. 355 transaction that involves a REIT holding owner-occupied real estate. It also examines a potential active trade or business planning opportunity brought to light by a recent private letter ruling.

REITs and Sec. 355

To qualify for REIT status under Sec. 856, in general, an entity must derive 95% of its gross income from passive sources (interest, dividends, rents, capital gains, etc.) and 75% of its gross income from passive real property sources (mortgage interest, real estate rents, gains on real estate sales, etc.). Historically, these income percentages generally precluded a REIT from having an active trade or business and, therefore, from completing a Sec. 355 spinoff transaction.

However, in 2001 the IRS issued Rev. Rul. 2001-29, which concludes that some of the activities a REIT undertakes to manage its properties through independent contractors qualify as an active trade or business, without affecting the entity's REIT status. The ruling specifically states that it is not all-encompassing, in that not all REITs would qualify for Sec. 355 treatment because of it. Rather, under certain circumstances, a currently electing REIT or a newly formed controlled corporation electing REIT status could successfully accomplish a Sec. 355 spinoff.

Satisfying the requirements of Sec. 355 with owner-occupied real estate, whether or not held by a REIT, is an area that has drawn significant IRS scrutiny (see Coady, 33 T.C. 771 (1960), aff'd per curiam, 289 F.2d 490 (6th Cir. 1961); Appleby, 35 T.C. 755 (1961), aff'd per curiam, 296 F.2d 925 (3d Cir. 1962); King, 458 F.2d 245 (6th Cir. 1972); and Rafferty, 452 F.2d 767 (1st Cir. 1971)). Treasury highlighted these challenges in Regs. Sec. 1.355-3(b)(2)(iii), which states that "[separations of real property all or substantially all of which is occupied prior to the distribution by the distributing or...