On February 26, Chairman David Camp (R-MI) of the U.S. House Ways and Means Committee issued a discussion draft of a comprehensive tax reform proposal entitled the “Tax Reform Act of 2014.” The draft bill proposes some far-reaching changes to the REIT and real estate related provisions of the Internal Revenue Code. No formal bill has yet been introduced, however, and the consensus appears to be that the draft bill is intended as a “starting point” for discussion, and that no legislative action is likely to be taken this year. Nevertheless, many of the provisions in the draft bill are likely to serve as benchmarks for future legislative action. This alert focuses on the proposed changes to the REIT provisions of the Code, and related proposed changes that affect real estate investments.
Carried Interest Provision
The draft bill contains a new carried interest proposal which would require a portion of net capital gains attributable to a “carried interest” in a partnership to be recharacterized as ordinary income with an effective date beginning after 2014. The good news for real estate is that the Ways and Means Committee explanation states that this provision would not apply to a partnership engaged in a real property trade or business, which should exempt operating partnerships in an UPREIT structure and certain real estate funds which operate a real property trade or business.
While the draft bill includes a number of positive changes to the REIT rules, there is more bad than good news. It is clear that the drafters of the REIT provisions are not fans of the conversion of corporations from C Corporation to REIT status, spin-offs of REITs from operating companies, or the creation of REITs other than “traditional REITs.” The Ways and Means Committee explanation indicates that these provisions are intended to prevent the “erosion of the corporate tax base” by making it more difficult for operating companies to convert into REITs. While one can agree or disagree with this goal as a policy matter, the proposed provisions are clearly “overkill” and if enacted would have adverse consequences to traditional REIT transactions.
Treatment of C Corporation Conversion to or Transfer of Assets to a REIT as Taxable
This draft bill provision imposes an entity-level tax on built-in gains at the time a C Corporation elects to become a REIT or transfers assets to a REIT in a carryover basis transaction, without regard to when the gain otherwise would be recognized by the REIT. The draft bill makes this provision effective for elections and transfers after February 26, 2014. Since an election to become a REIT is made by filing an election with the tax return for the year the election is effective, it is unclear whether this provision would apply to REIT elections made for 2013 (if filed after February 26, 2014) or 2014.
The drafters of this bill seem to favor conversions to S Corporation status over conversions to REIT status. Instead of imposing a tax at the time of conversion, the proposed S Corporation changes reduce the so-called “sting tax’ period from 10 years to 5 years.
This provision will adversely impact C Corporations with both traditional and non-traditional real estate assets that wish to elect REIT status. It will also impact REITs that wish to acquire such C Corporations, since a REIT will not be able to acquire a C Corporation without incurring the corporate level tax on the C Corporation’s assets unless the C Corporation becomes and remains a TRS of the REIT.
Non-REIT Earnings and Profits Required to be Distributed by REIT in Cash
This draft bill provision requires a REIT to distribute its pre-REIT earnings and profits in cash, effective for distributions after February 26, 2014. The IRS has ruled on numerous occasions that under current law, a C Corporation converting to a REIT can distribute its pre-REIT earnings and profits in part in stock, thereby preserving cash. This provision will adversely impact C Corporations with both traditional and non-traditional REIT assets and REITs that acquire such C Corporations.
Limit on Fixed Percentage Rent and Interest Payments
This draft bill provision would limit the extent to which rents from real property and interest payments that are based on a fixed percentage of receipts or sales received or accrued from a single tenant that is a C Corporation (other than a TRS) would constitute qualifying rents and interest for purposes of the 95% and 75% income tests. If such amounts exceed 25% of the total amounts of such rents or interest received or accrued by the REIT that are based on a fixed percentage of receipts or sales then none of the amounts received from such corporation that are attributable to leases entered into or debt instruments acquired after December 31, 2014 would be treated as qualifying rent or interest.
The provision would be effective for tax years ending after 2014. This provision is intended to limit certain OPCO/PROPCO structures. As drafted, however, it could adversely impact traditional REITs which have a limited number of such leases or loans.
Prevention of Tax-Free Spin-Offs Involving REITs
Under this draft bill provision neither a distributing corporation nor a controlled corporation in a tax-free spin-off transaction would be permitted to be a REIT, or to elect to be treated as a REIT for 10 years following the tax-free spin-off transaction. The provision would be effective for spin-off distributions after February 26, 2014. This proposal reverses a 2001 Revenue Ruling and a recent private letter ruling in which the IRS indicated a REIT could be a distributing or controlled corporation in a spin-off transaction.
Communication Towers and Other Short-Life Property Not Treated as Real Property for REIT Purposes
Under this draft bill provision, the term “real property” would not include tangible property with a class life of less than 27.5 years (as defined under the depreciation rules) for purposes of the REIT asset and income tests. The provision would be effective for tax years beginning after 2016. This provision would reverse rulings that the IRS has issued over a number of years involving communication towers, infrastructure assets and other short-life property, adversely impacting some existing public REITs who have relied on such rulings.
Other Cutbacks to REIT Rules
The draft bill cuts back on other rules in the following ways:
The permitted percentage of the value of a REIT’s assets comprised of stock in taxable REIT subsidiaries (“TRSs”) would be reduced from 25% back to its pre-2008 limit of 20%, effective for tax years beginning after 2016.
Timber would no longer qualify as “real property” for REIT purposes, and several special rules related to the treatment of timber for REIT purposes would be repealed. This change would be in conjunction with other provisions in the draft bill that eliminate capital gain treatment for sales of standing timber and cut timber. The provision would be effective for tax years beginning after 2016. This provision would adversely impact existing public REITs that have relied on existing law.
The draft bill proposes to increase the waiting period from 5 to 10 years for a corporation that has revoked or had its REIT election terminated to re-elect status as a REIT, effective for terminations and revocations after 2014.
Other Provisions Relevant to Real Estate Investments
Although not specific to REITs, the draft bill contains several other significant proposed changes that would affect real estate investments. These include the following:
Repeal of Tax-Favorable Treatment of Like-Kind Exchanges of Real Property
The draft bill proposes to repeal Section 1031 of the Code which allows for non-recognition of gain on like kind exchanges of real property used in a trade or business or held for investment, effective for transfers after 2014, subject to an exception for transfers made pursuant to a binding contract entered into prior to January 1, 2015 and consummated before January 1, 2017. (Notably, the Administration’s FY 2015 budget plan also proposes to curtail like-kind exchanges by limiting the amount of gain deferred to $1 million per taxpayer per taxable year.)
Elimination of Publicly Traded Partnership (“PTP”) Exception for Passive Real Estate Investments
Under current law, an exception is provided to the treatment of a PTP as a C Corporation if 90 percent or more of the partnership’s gross income consists of certain qualifying income, including interest, dividends, capital gains, rents from real property and income and gains from certain activities relating to minerals or natural resources. The draft bill proposes to limit the passive income exception to qualifying income from mining and natural resources activities, effective for tax years beginning after 2016. This provision would have a material adverse impact on certain operating partnerships in an UPREIT structure unless either a REIT exception is obtained or restructuring occurs prior to 2017 such that the operating partnership is not a PTP.
Elimination of Time Limit on Recognition of Gain in “Mixing Bowl” Transactions
Under current law, if a partner contributes appreciated (or depreciated) property to a partnership, and the partnership distributes such property to another partner within 7 years of the contribution (or if the contributing partner receives other property from the partnership within such period), the contributing partner generally must recognize the pre-contribution gain (or loss) at the time of such distribution. The draft bill would eliminate the 7-year time limit on the recognition of such gain (or loss), effective for property contributed after 2014.
Extension of Depreciable Life of Real Property and Depreciation Recapture
Instead of the current year recovery periods of 27.5 years for residential rental property and 39 years for non-residential real property, all real property would have to be depreciated over a period of 40 years, effective for property placed in service after 2016. In addition, effective for dispositions after 2014, the total amount of depreciation attributable to periods after 2014 (instead of only the excess over straight line) would be subject to ordinary income recapture.
IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this informational piece (including any attachments) is not intended or written to be used, and may not be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.