IRS Releases Temporary and Proposed Regulations Extending REIT Built-in Gain Recognition Period for Property Acquired from a C Corporation and Tightening the Rules for REIT Spinoffs

June 14, 2016

On June 7, 2016, the Internal Revenue Service (the "IRS") and the Treasury Department issued temporary and proposed regulations (the "New 337 Regulations") under section 337[1] that (i) extend the period during which a real estate investment trust (a "REIT") is subject to U.S. federal income tax in respect of built-in gains recognized on property acquired from a C corporation and (ii) tighten the rules for tax-free spinoffs involving REITs.  We summarize below the provisions of the regulations.

Extension of Built-in Gain Recognition Period to Ten Years

The New 337 Regulations extend from five years to ten years the period during which a REIT will be subject to U.S. federal income tax in respect of any "recognized C corporation built-in gain."  For this purpose, "recognized C corporation built-in gain" is gain recognized by a REIT on the taxable disposition of property acquired from a C corporation to the extent the gain is attributable to the period during which the property was held by the C corporation. 

Under Treasury Regulations, if a REIT acquires property in a "conversion transaction" from a C corporation and later disposes of the property in a taxable transaction, the REIT generally is required to pay U.S. federal income tax on the gain recognized, unless the REIT elects to recognize any gain in the property at the time of the conversion transaction.  A "conversion transaction" generally includes both the conversion of a C corporation to a REIT and most transfers of property to a REIT in which gain is not recognized.  Importantly, a REIT generally is subject to U.S. federal income tax on property acquired in a conversion transaction only to the extent of the built-in gain in the property at the time of the conversion transaction and only if the property is disposed of during the "recognition period."[2]   

It should be noted that, before the promulgation of the New 337 Regulations, the recognition period for REITs was defined by reference to the rules with respect to S corporations under section 1374.  S corporations are subject to similar treatment as REITs in respect of conversions from C corporations.  Prior to 2009, the recognition period under section 1374 was ten years.  The recognition period under section 1374 was temporarily reduced for years beginning after 2008 and was permanently reduced to five years in December 2015, pursuant to the Consolidated Appropriations Act of 2016 (also known as the "PATH Act").  The New 337 Regulations would no longer define the recognition period by reference to section 1374, but would separately define the recognition period as a period of ten years from the date a REIT acquires property in a conversion transaction.  This change is effective for conversion transactions that occur after August 7, 2016.

Tightening of REIT Spinoff Rules

The New 337 Regulations also tighten the taxation of REITs involved in tax-free spinoffs under section 355.

The PATH Act revised section 355 to eliminate tax-free treatment if either the distributing corporation or the controlled corporation (i.e., the corporation that was spun-off) is a REIT.  Further, the PATH Act modified section 856 to prohibit a corporation from electing REIT status during the ten-year period following a section 355 tax-free spinoff. 

According to the preamble to the New 337 Regulations, the IRS and Treasury are concerned that the PATH Act does not completely prohibit taxpayers from effecting tax-free separations of REIT-qualifying assets from non-REIT-qualifying assets.  Accordingly, the New 337 Regulations provide that: (1) if a REIT acquires property of a C corporation in a conversion transaction within ten years after a section 355 spinoff to which the C corporation (or any affiliate, predecessor, or successor) was a party, the C corporation will recognize any net-built in gain on the property acquired by the REIT in the conversion transaction; and (2) if a REIT acquires property in a conversion transaction, the REIT will recognize any remaining pre-conversion built-in gain on the property if the REIT (or any affiliate, predecessor, or successor) is a party to a section 355 spinoff occurring within ten years after the conversion transaction.

Consistent with the PATH Act, these rules do not apply if a REIT spins off another REIT or, in certain circumstances, a taxable REIT subsidiary.

The spinoff rules apply if the conversion transaction or the section 355 spinoff occurs after June 6, 2016, although an IRS official has indicated that the IRS will make a correction to the New 337 Regulations that will exempt conversion transactions following spinoffs that occurred before December 7, 2015.

   [1]   Unless indicated otherwise, all section references are to the Internal Revenue Code of 1986, as amended.

   [2]   These rules also apply to regulated investment companies.