Ring in the New Year with 3 Tax Tips for REITs

By Tanya Thomas, Tax Managing Director, BDO USA: With the possibility of major tax reform ahead, it's critical for REITs to assess these three recent changes before additional regulations are introduced.

Thomas, TanyaIn anticipation of 2017 and the upcoming presidential inauguration, taxes are in the spotlight in the real estate industry, with many key industry leaders expecting substantial tax reform could be ahead. With the possibility of changes in the near-term, it is critical for REITs to carefully assess regulatory guidance that was issued in 2016 before additional reforms are introduced.

Among the tax changes that hit in 2016, the most critical pieces of guidance for REITs are on partnership taxation under Sections 704, 707 and 752, real property under Section 856 and the classification of debt and equity under Section 385.

Significant changes are ahead for REITs utilizing partnerships

In October, the IRS issued three long-anticipated reforms set to impact REITs that utilize partnerships in their structure, including UPREIT and DownREIT structures. The specific provisions include guidance on liability allocations under Section 752, disguised sales under Section 707 and deficit restoration obligations under Section 704. These regulations strengthen anti-abuse rules in determining whether a partner bears economic risk of loss, limit the effectiveness of the debt-financed distribution exception and clarify terms of the preformation expenditure exception. In sum, the regulations aim to address discrepancies in partnership tax filings. The regulations represent significant changes in partnership taxation and will have a critical impact on planning for partnership formation and restructuring transactions, as well as ongoing operations.

Real Property, Defined.

The IRS issued final regulations in August that clarify the definition of “real property” for the purposes of REIT asset testing under Section 856. To qualify as a REIT, a taxpayer must satisfy various testing provisions related to the type of assets owned and the nature of income generated. The new regulations address the definition of real property for purposes of the REIT assets tests and were issued to address more than 40 years’ worth of revenue rulings and private letter rulings (PLR) dealing with situations involving railroad assets, air rights over real property, billboards and other roadside signage, among other issues. Under the newly issued guidance, real property is defined as land and improvements to land, which includes inherently permanent structures and their structural components that have a passive function. In certain circumstances, intangible assets may also be defined as real property.

Debt or equity?

To curtail inversion transactions, or the movement of a multi-national U.S. group’s tax residence outside of the U.S., the IRS issued final Section 385 regulations in October. Under these regulations, the IRS has the authority to re-characterize certain inter-company debt instruments as stock. Section 385 also introduces new documentation requirements and will impact “controlled” REITs, or REITs that are 80 percent or more controlled by an includible member of an expanded group. For example, C corporations that own controlling interests in subsidiary REITs organized under Foreign Investment in Real Property Tax Act “blocker” structures are subject to Section 385. Non-controlled REITs and their taxable REIT subsidiaries, on the other hand, are exempt.

These three changes to the tax code are significant developments for REITS. To lessen the compliance burden in the event of additional significant tax reform under President-elect Trump, it’s critical for REITs–particularly those organized under “blocker” and partnership structures–to analyze the new regulations and consider their potential impact.