The regulations affect both real estate investment trusts (REITs) and regulated investment companies (RICs) that receive appreciated property from a C corporation in a so-called “conversion transaction.”
UPDATE: In response to comments consistent with those set forth below, the IRS and Treasury published final regulations on January 17, 2017 (T.D. 9810), defining Recognition Period by reference to the five-year period set forth in Code section 1374(d)(7). Although the final regulations technically apply to Conversion Transactions that occur after February 17, 2017, taxpayers may apply the five-year period with respect to Conversion Transactions occurring on or before that date and on or after August 8, 2016 (the date on which the relevant provision of the temporary regulations became effective). Accordingly, it appears that the five-year period in Code section 1374(d)(7) is generally the applicable Recognition Period after December 31, 2014 (the date on which the PATH Act’s modification of section 1374(d)(7) became effective).
On June 7, the Internal Revenue Service (IRS) and the US Department of the Treasury (Treasury) introduced a package of temporary regulations (T.D. 9770) and proposed regulations (REG-126452-15) primarily aimed at blocking “conversion transactions” in which assets held by C corporations become assets of REITs in connection with certain section 355 spin-off transactions.
These regulations bolster the recently enacted legislative prohibition on certain types of REIT spin-offs by barring indirect transfers of appreciated property to a REIT by a C corporation that has been involved in a related spin-off transaction. However, the regulations have a much broader effect on both RICs and REITs because they also restore the holding period requirement to 10 years to avoid recognizing built-in gains that are deferred in connection with any “conversion transaction” (even if the “conversion transaction” is not related to a spin-off).
Decades ago, a corporation could distribute appreciated property to its shareholders without recognition of gain to the corporation pursuant to the General Utilities doctrine (General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935)). The General Utilities doctrine was effectively repealed by the Tax Reform Act of 1986, and pursuant to current section 311(b) of the Internal Revenue Code of 1986, as amended (the Code), a corporation is generally required to recognize gain on the distribution of appreciated property. This rule generally applies to REITs and RICs, although RICs have a special exclusion from section 311(b) if they distribute appreciated property pursuant to a redemption request of a shareholder.
Section 337(d) authorizes the issuance of regulations to ensure that REITs, RICs, and other vehicles are not used to circumvent the requirement that gain be recognized by a corporation on the distribution of appreciated property. Pursuant to current Treas. Reg. § 1.337(d)-7, a RIC or REIT is generally subject to the treatment prescribed by section 1374 of the Code if property owned by a C corporation (or by a partnership to the extent owned, directly or indirectly through other partnerships, by a C corporation) becomes the property of a RIC or a REIT (Converted Property) by a transfer of the Converted Property to a RIC or a REIT or the qualification of a C corporation as a RIC or a REIT (a Conversion Transaction).
Under the principles of section 1374, a RIC or a REIT that obtains Converted Property is required to recognize and pay an entity-level tax on the net built-in gain on the Converted Property if it disposes of such property within a prescribed period (the Recognition Period). Alternatively, an election can be made for the applicable transferor C corporation to recognize any net gain on the Converted Property, and pay tax on such gain, as if such Converted Property had been sold to an unrelated party for fair market value in a deemed sale, generally on the day before the Conversion Transaction.
These rules ensure that net gain in assets transferred by a C corporation to a RIC or a REIT remains subject to corporate-level taxation (in addition to any shareholder-level taxation on distributions), unless the RIC or the REIT holds the assets for a sufficient period of time. The rules, however, contain a limited exception for certain non-recognition transactions such as section 1031 exchanges and involuntary conversions under section 1033.
The temporary regulations modify the definition of the Recognition Period for a RIC or a REIT that receives appreciated property in a Conversion Transaction by decoupling this definition from section 1374 of the Code. The temporary regulations now explicitly provide that the Recognition Period for RICs and REITs is 10 years. Although, as drafted, the current regulations contemplated that the Recognition Period would be 10 years, the regulations have always tied their Recognition Period to the Recognition Period set out in section 1374(d)(7). Since 2009, Congress has shortened the Recognition Period referenced in section 1374(d)(7) from 10 years to 7 years and, ultimately, to 5 years, retroactive to tax years beginning in 2011. It had been widely accepted that as Congress modified the Recognition Period in section 1374, the applicable cross-reference in Treas. Reg. § 1.337(d)-7 to section 1374 correspondingly adjusted the Recognition Period for RICs and REITs holding property received in Conversion Transactions. Indeed, the Joint Committee on Taxation’s Technical Explanation of the Protecting Americans from Tax Hikes Act of 2015 (PATH Act) (JCX-144-15) explicitly stated that, under then-current regulations, the PATH Act’s 5-year period “also would apply to REITs and RICs that do not elect ‘deemed sale’ treatment.”
Because the Joint Committee on Taxation’s technical explanation illustrates that Congress was aware that the PATH Act’s 5‑year period would apply to RICs and REITs, the Treasury’s subsequent decision to decouple the Recognition Period for RICs and REITs from the period under section 1374 seems questionable. Although the regulations indicate that certain transactions involving REIT spin-offs (discussed below) justify the change in the Recognition Period for REITs, there are numerous situations in which a REIT may receive Converted Property that do not involve a spin-off transaction. Moreover, there does not appear to be any current policy justification for the change, and the temporary regulations do not identify any transaction that indicates that RICs are currently being used to circumvent the policy behind the repeal of the General Utilities doctrine. Furthermore, although there are similarities between RICs and REITs under subchapter M of the Code, there are distinct operational differences between RICs and REITs that generally warrant different rules for the entities. For example, many RICs turn over their portfolios with considerable frequency, making it operationally difficult for them to avoid recognition of gain on Converted Property. Accordingly, in practice most RICs refuse to accept Converted Property in a non-recognition transaction unless the transferor makes a deemed sale election.
The new Recognition Period applies to conversion transactions that occur on or after August 8, 2016.
The PATH Act imposed new restrictions on the ability to undertake tax-free “spin-offs” of REITs under section 355 of the Code by enacting sections 355(h) and 856(c)(8). Under the PATH Act, a distribution by a non-REIT corporation (distributing) of the stock of a controlled REIT (controlled) no longer qualifies for tax-free treatment under section 355. Further, if neither the distributing nor controlled corporation is a REIT immediately after the distribution, neither corporation may elect REIT status during the 10-year period following the distribution. For a more detailed discussion, read the “Other Significant PATH Act Modifications to REITS” section of our January 2016 LawFlash.
The IRS and Treasury have indicated that they believe that the principles of section 1374 will not adequately implement the repeal of the General Utilities doctrine if a corporation effects a tax-free separation of REIT-qualifying assets from non-qualifying assets in a section 355 distribution and the REIT-qualifying assets become the assets of a REIT. Treasury and the IRS apparently believe that the enactment of section 856(c)(8) (i.e., the 10-year waiting period to elect REIT status following a spin-off) requires that either all of the economics from a REIT-eligible real estate portfolio must remain fully subject to corporate level taxation for 10 years following a spin-off, or all built-in gain must be immediately accelerated and subject to taxation.
Under the temporary regulations, a C corporation engaging in a Conversion Transaction involving a REIT within the 10-year period following a tax-free spin-off under section 355 is treated as making an election to recognize gain and loss as if it had sold all of the Converted Property to an unrelated party at fair market value on the deemed sale date. Section 1374 treatment is no longer available in those cases. The temporary regulations also provide that a REIT that 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 must recognize any remaining unrecognized built-in gains and losses resulting from the Conversion Transaction (after taking into account the impact of section 1374 during the interim period). The regulations indicate that they also apply to predecessors and successors as well as to all members of the separate affiliated group of the distributing or controlled corporation.
The regulations provide two exceptions to the above-mentioned rules. Consistent with the PATH Act, the new regulations do not apply if both the distributing and controlled corporations are REITs immediately after the spin-off and at all times during the two years thereafter. The regulations also do not apply if the distributing corporation is a REIT and the controlled corporation is a taxable REIT subsidiary. Also consistent with the PATH Act, the new regulations do not apply to certain transactions for which a ruling request was submitted to the IRS prior to December 7, 2015. The IRS has also indicated that they expect to correct these temporary regulations to clarify that conversions that occur prior to August 8, 2016, but relate back to a spin-off distribution that occurred before December 7, 2015, will still receive the 5-year recognition period.
It is noteworthy that the IRS is relying on its regulatory authority under section 337(d). Last year, the IRS indicated in Notice 2015-59, 2015-40 IRB 459 that it is considering issuing regulations under section 337(d) that would prohibit spin-offs in which either the distributing or controlled corporation has a small active trade or business compared to its liquid assets (such as cash or portfolio stock investments). The IRS expressed concern that the current regulations under section 355 were too permissive. Whether the IRS will issue more restrictive regulations by relying on section 337(d) is yet to be seen.
The above new rules with respect to REIT spin-off transactions are effective as of June 7, 2016.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
 Elliott, Amy S., Correction Expected for Temp Regs on C-Corp-to-REIT Conversions, 2016 TNT 112-3 (June 10, 2016).