Tuesday, October 7, 2014

WHO LET THE REIT OUT? Tax Inversions

What’s happening to capital in America today is beginning to resemble the bible’s Exodus.  Corporations are fleeing in droves, incorporating in other industrialized nations to avoid evil Pharaoh, Uncle Sam.  Called, tax-inversions, companies who have operations and a significant portion of their earnings generated abroad, side-step the double taxation that would otherwise take place by re-incorporating in a country with a lower corporate tax rate.  With the U.S. corporate tax rate currently at 35% (the highest of all the industrialized nations) and with “tax-credits” unable to offset taxes levied by host countries, it is hard to cast patriotic shame on a business that completes this maneuver.  The situation is worrisome for Congress.  The US treasury stands to lose billions in possible corporate tax revenue.  Look for Congress to pass a bill this year to curb the flood of tax-inversions.

Tax-inversions have taken the lion’s share of media coverage.  Fewer people (who work in D.C.) are aware of the tax saving move other corporations are taking to avoid Uncle Sam’s whip: REIT conversions.  Real Estate Investment Trusts are not new.  Since the 60’s, Congress and the IRS have been relatively easy on REIT entity formation.  Indeed, nowadays non-traditional assets, such as timber, data centers, prisons, billboards, and others, are qualifying for REIT status.

Even with the recent spike in REIT conversions, the treasury’s loss of tax revenue will only be a blip compared to other tax avoidance ploys like inversions.  REITs were a middle-class spurred creation, allowing more investors access and participation in real estate deals.  Despite revenue loss, our government gains by not having to subsidize urban improvement projects.

Why would a corporation (C-corp) want to restructure into a REIT or spin-off part of itself (its real estate assets, traditional or otherwise) into a REIT entity?  There are many benefits.  By electing REIT status, companies can essentially hand off an eventual tax burden, in the form of appreciation of its RE assets, to the newly structured and independent REIT.  For tax purposes, the transaction from parent to offshoot is either a sale or a transfer.  If it is not something known as a “deemed sale election,” a transfer in other words, the REIT becomes responsible for the net built-in gain in the converted property.  If the parent company declares the transaction a deemed sale, they pay the tax man for any appreciation (there could be a loss in value of the subject properties as well, i.e., depreciation) from the original cost basis.  For most people, trying to understand the tax code and the regulations that come with REIT election is as painful as learning Latin at the dentist’s office.  But if one is a glutton for punishment, consider starting out with the Thomson Reuters’ Legal Solutions Real Estate Investment Trusts Handbook, 2013-14 edition.

Incentives to Spin-Off Assets into a REIT: Valuation

So far, companies can shield themselves from the taxes in capital gains from their RE assets by passing these off to the newly formed REIT entity.  From an equities standpoint, the parent company, if publicly traded, stands to benefit with investors bidding up their common shares from the news release.    Companies can unlock intrinsic value (instantly increasing their market cap) with a REIT announcement, and keep it for the short term if they can follow through with the spin-off.  The REIT entity in turn commands an enterprise valuation of its own once the IRS gives its blessing.  It can be indeed attractive for a management team to consider a stock that fetches a higher price in the open market with both the operating and REIT entity combined.  People are familiar with the tax benefit REITs enjoy.  REITs can deduct 100% of their profits (by issuing a dividend to shareholders) on their specific tax returns.  They can keep up to 10%.

Surely, electing REIT status is financial alchemy at its best.  But it is not for every C-Corp.  There are REIT “tests” that must be passed yearly.  For example, can the ensuing REIT entity prove it has at least 100 different shareholders?  Can it show that no more than 5 individuals own more than 50% of the value of the common shares?  Will the REIT generate at-least 75% of its gross income from real estate related activity (collecting rents or interest from mortgage notes, e.g.)?  There are other operational, organizational, and compliance limitations that have to be resolved by a board of directors.  In general, REIT structure is not an appropriate choice for a closely held family business.

How Can a C-Corp Become a REIT?

To qualify for REIT status a company first has to make a REIT election with the IRS.  They must file an income tax return using Form 1120-REIT at the end of the REIT’s first year (or part-year), on or after March 15th.  The corporation must not necessarily meet the 100 Shareholder or 5/50 Test if it seeks to qualify that same year, but it will upon the start of its second taxable year.  Also be prepared to send plenty of letters to shareholders of record, telling them details of share ownership.  C-corporation management teams do right by their shareholders when they consult with law, accounting, and investment banking firms that specialize in REITs.

Thanks for Reading!

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