Regulations: Tax imposed when C corporation property becomes property of REIT

When C corporation property becomes property of REIT

The Treasury Department and IRS today released for publication in the Federal Register temporary regulations (T.D. 9770) and, by cross-reference, proposed regulations (REG-126452-15) that impose corporate level tax on certain transactions when property of a C corporation becomes the property of a real estate investment trust (REIT).

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The temporary regulations [PDF 214 KB] are described as being issued to effect the repeal of the General Utilities doctrine by the “Tax Reform Act of 1986” and to prevent abuse of the “Protecting Americans from Tax Hikes Act of 2015” (PATH Act). The regulations have an effective date of June 7, 2016.

The proposed regulations [PDF 225 KB] make an amendment not addressed in the temporary regulations, and affect regulated investment companies (RICs), REITs, and C corporations the property of which becomes the property of a RIC or a REIT, and their shareholders. Comments or requests for a public hearing must be received by a date that is 60 days after publication of the proposed regulations in the Federal Register on June 8, 2016.

Background

The PATH Act added sections 355(h) and 856(c)(8) to the Code to provide that the exception under section 355 (allowing for tax-free corporation separations) will not apply to a distribution if either the distributing corporation or the controlled corporation is a REIT. Exceptions are provided permitting a REIT to distribute the stock of another REIT or taxable REIT subsidiary under certain conditions. Furthermore, section 856(c)(8) provides that a corporation that was involved in a section 355 transaction cannot elect REIT status during the 10-year period after a section 355 distribution if the corporation was the distributing or controlled corporation in that distribution. 

Regulations

The preamble to today’s regulations explains that there have been concerns that some variations of transactions may continue to be used to circumvent the PATH Act measures. Accordingly, today’s regulations are being issued to prevent abuses of sections 355(h) and 856(c)(8) and to advance the General Utilities repeal.

The temporary regulations provide that a C corporation engaging in a conversion transaction involving a REIT within the 10-year period following a related section 355 distribution recognizes gain and loss as if it had sold all the converted property to an unrelated party at fair market value on the deemed sale date, regardless of whether the C corporation makes a deemed sale election (specifically, the C corporation is treated as if had made a deemed sale election). This applies to conversion transactions occurring on or after June 7, 2016.

The temporary regulations also provide that when a REIT is a party to a section 355 distribution occurring within the 10-year period, following a conversion transaction for which a deemed sale election has not been made, the REIT recognizes any remaining unrecognized built-in gains and losses resulting from the original conversion transaction (after taking into account the impact of section 1374 in the interim period). Under the temporary regulations, for the tax year in which the related section 355 distribution occurs, the REIT’s net recognized built-in gain is the amount of its net unrealized built-in gain limitation (as defined) for the tax year. This applies to section 355 transactions occurring on or after June 7, 2016, even if the conversion transaction occurred prior to that date. As a result, the temporary regulations cause the REIT to recognize any built-in gains or losses attributable to time periods in which the REIT was a C corporation while providing that gains and losses recognized in previous tax years during the 10-year recognition period on which taxes have been paid are accounted for appropriately. 

The preamble states that the temporary regulations provide an appropriate increase to the basis of the converted property held by the REIT. The temporary regulations provide two exceptions. 

  • First, the temporary regulations do not apply if both the distributing corporation and the controlled corporation are REITs immediately after the date of the section 355 distribution and at all times during the two years thereafter. 
  • Second, the temporary regulations also do not apply to certain section 355 distributions in which the distributing corporation is a REIT and the controlled corporation is a taxable REIT subsidiary.

In addition, the temporary regulations do not apply to distributions pursuant to a transaction described in a ruling request initially submitted to the IRS on or before December 7, 2015, which request has not been withdrawn and with respect to which a ruling has not been issued or denied in its entirety as of December 7, 2015.

The temporary regulations apply to predecessors and successors of the distributing corporation or the controlled corporation and to all members of the separate affiliated group, within the meaning of section 355(b)(3)(B), of which the distributing corporation or the controlled corporation are members. For these purposes, predecessors and successors include corporations that succeed to and take into account items described in section 381(c) of the distributing corporation or the controlled corporation, and corporations having such items to which the distributing corporation or the controlled corporation succeed and take into account.

The temporary regulations make what is described as a “clarifying amendment” to the generally applicable rules of Reg. section 1.337(d)-7 in response to a provision of the PATH Act, to provide that the term “recognition period” means the five-year period beginning with the first day of the first tax year for which a corporation was an S corporation. The PATH Act had made permanent the reduction—from 10 years to five years—of the recognition period applicable to S corporations described in section 1374(c)(7).  The recognition period applicable to S corporations had several times been temporarily reduced to periods of less than 10 years; prior to the temporary regulations, the regulations included in Reg. section 1.337(d)-7 had been interpreted so as to apply the recognition period then applicable to S corporations in section 1374 to REITs involved in conversion transactions.

Notwithstanding that the PATH Act did not seemingly contemplate a divergence in the recognition periods applicable to S corporations and REITs (beyond the limited lockout on REIT qualification applicable to corporations involved in section 355 transactions), the temporary regulations provide that, for all conversion transactions involving REITs (or RICs) occurring on or after the date that is 60 days after publication in the Federal Register on June 8, 2016, the recognition period is 10 years (and, so, twice as long as the analogous period applicable to S corporations).

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