The recently passed tax extenders legislation, Protecting Americans from Tax Hikes (PATH) Act of 2015, includes changes to various provisions which place new restrictions on real estate investment trust (REIT) spin-offs. It is estimated that approximately $4 billion in revenue over the next 10 years will be generated as a result. PATH also includes other REIT provisions that change the REIT compliance rules. Therefore, corporations considering spin-offs to form REITs and operating REITs should be familiar with these important developments. Here are the key changes:
- Corporations are not allowed to “spin off” their real estate into a REIT in a tax-free manner. There are a few exceptions, but the purpose of this law is to curtail the increasingly common practice of large public corporations moving their real estate holdings to REITs to reduce their overall effective tax rate.
- A REIT will be charged a 100 percent excise tax if a taxable REIT subsidiary (TRS) charges a REIT a “below-market” fee for services it renders to the REIT. The 100 percent excise tax equals the difference between the amount charged and the amount that should have been charged at fair market value (FMV). These rules also include: (a) a provision where marketing and development costs must be made through an independent contractor or TRS for timber REITs and for all REITs if the 7-sale rule of the prohibited sale safe harbor test is not met and (b) a requirement that a REIT use an independent contractor or TRS to operate “foreclosure” property.
- Public REITs are now allowed a dividends paid deduction for “preferential dividends” in certain situations. A preferential dividend is a distribution to a shareholder that receives preferential treatment compared to other shareholders that hold the same class of stock. Public REITs were not allowed a deduction for these types of dividends before the law change.
- The treatment of personal property for purposes of the REIT “asset test” has been modified. Under the new law, personal property will be treated as a real estate asset to the extent that rents attributable to the personal property are treated as rents from real property for purposes of the “income test.” The act also has a similar favorable law change for loan receivables secured by both real and personal property.
- The aggregate amount of dividends designated by a REIT as a capital gains dividend or as qualified dividend income cannot exceed the dividends paid by the REIT for that year.
- A REIT’s real estate assets include debt instruments issued by publicly traded REITs. The act also provides that an interest in a mortgage will qualify as a real estate asset even if the mortgage is not on the real property itself, but on an interest in real property, such as a leasehold interest in real property.
- REITs can potentially sell more property in a given year and still meet the “prohibited transaction” exception safe harbor. Under this law change, the amount of property a REIT may sell in a tax year under the safe harbor jumps from 10 percent to 20 percent of the aggregate basis or FMV subject to certain limitations.
- REITs can exclude an additional type of hedging income from gross income for purpose of the REIT “income test.” For a REIT to exclude the income, it must identify the hedge under the REIT tax rules.
- The calculation of earnings and profits (E&P) for the dividends paid deduction has been modified. Prior to the law change, E&P could not be less than the taxable income to make sure there was a large enough dividends paid deduction to offset taxable income. However, this could result in a REIT, over its life span, reporting more E&P to shareholders than taxable income. As a result of the law change, this has been corrected so E&P will be the same as tax over the life of the REIT. If a REIT uses a different method to calculate depreciation for taxable income compared to E&P, the REIT may, in a particular year, not have sufficient E&P to eliminate all taxable income unless there is return of capital distribution.
- The maximum amount a REIT can invest in one or more taxable REIT subsidiaries drops to 20 percent of FMV of assets, from 25 percent, for tax years beginning after 2017.
If you are currently operating a REIT or considering forming one, connect with a tax advisor to ensure compliance and plan appropriately.
For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.