What the End of Tax-Free Spinoffs Means for CRE
- Jan 06, 2016
At the end of 2015, the House of Representatives approved legislation including provisions that would remove the tax advantages of spinning off corporate real estate into a separate, publicly traded REIT, and the bill was enacted into law.
“This is a significant development that may be detrimental to many companies and, some would say, is a step to tax real estate based on an inappropriate characterization of a REIT spinoff as a Wall Street loophole,” Richard Morris, a partner at Herrick, Feinstein LLP, told CPE. “The result of the amendment may be that operating companies that hold valuable real estate property will keep their real estate assets because of a significant tax liability. Accordingly, the operating company will have an asset that has a different risk profile, creating valuation issues.”
This amendment would create taxable gains that may be significant given the low basis of improved real estate (a low basis because of the depreciation). The depreciation that a corporation has taken over the years would likely result in a lower tax basis of the improved real estate. The end of such tax-free spinoffs is expected to generate $1.9 billion in additional tax revenue in the coming years, the Joint Committee on Taxation has estimated.
“In some respects, the bill relaxes some of the qualification requirements for a REIT and makes foreign investment in real estate less taxing,” explained Kevin Anderson, a tax partner with BDO’s National Tax Office. “In that respect, the market for commercial real estate might be slightly enhanced. The principal effect of the REIT spinoff provision is to make it prohibitively expensive for existing businesses to separate their operations from ownership of real estate. At this time, it’s difficult to predict whether any of these changes will have a significant impact on the market for real estate.”
Anderson explained that for businesses organized as C corporations, all of their taxable income earned in the United States is subject to a federal income tax at a nominal rate of 35 percent. If a C corporation’s after-tax income is distributed to individual U.S. shareholders, the income could be subject to federal taxes of as much as 23.8 percent.
“In contrast, if an entity qualifies as a REIT, it could be operated so that it pays no direct federal income tax. Instead, its shareholders would pay a federal income tax on the REIT’s income at a rate up to 43.4 percent, depending on their overall taxable income,” he said. “When a corporation owns its own real estate, it claims a federal income tax deduction for depreciation but not for rent. If a C corporation can move its real estate assets to a REIT without paying any federal income taxes on the property transfer, the corporation will further reduce its federal income tax liability by paying deductible rent to the REIT.”
The rent paid permanently reduces the “corporate tax base,” and is effectively transferred to the REIT shareholders, who will pay only a single level of tax on the income.
Even with the new law, shareholders may continue to press for more conventional spinoff transactions or business combinations. Spinoffs can continue to be accomplished on a tax-free basis, provided that neither of the two divided companies seeks to become a REIT within 10 years after the transaction is completed.
“An existing REIT may be able to use the tax-free spinoff form provided that one of two conditions is present,” Anderson said. “First, if both corporations are REITs after the transaction is completed, it is not subject to the new rules. Second, if a REIT is spinning off one or more ‘taxable REIT subsidiaries,’ this transaction is also not subject to the new rules.”