BackgroundChanges made by the Protecting Americans From Tax Hikes Act (PATH Act) curtailed the ability of a corporation to place its real estate assets into a REIT and thereafter engage in a tax-free spinoff of those real estate assets. Combined with existing rules that prevent a corporation involved in a tax-free spinoff from electing REIT status during the 10-year period following the spinoff, the PATH Act change was intended to prevent tax-free spinoffs of real estate assets by REITs. Despite these limitations, a corporation conceivably still could spin off its real estate assets in a tax-fee transaction and then merge those assets into an existing REIT tax-free (effectively achieving the same result the PATH Act was intended to prevent).
In 2016, to address the post-PATH Act gap allowing tax-free spinoffs of real estate assets, Treasury and the IRS issued temporary regulations that generally imposed an immediate corporate-level tax on the value of the assets involved in spinoffs preceded or followed by tax-free mergers with REITs. Specifically, the conversion transaction is treated as a deemed asset sale of the appreciated assets of the corporation that become REIT assets if both of the following are true:
- The corporation is either the distributing or controlled corporation in a Section 355 tax-free spinoff.
- During a 20-year period beginning 10 years before the date of the spinoff, the corporation engages in a conversion transaction (in other words, transactions in which property of a C corporation becomes property of a REIT in a transaction that is otherwise tax-free).
Suppose that corporation A (Distributing) owns corporation B (Controlled). Controlled owns assets that are worth $20 million and that have an adjusted tax basis of $0. In a Section 355, tax-free spinoff, Distributing distributes Controlled in year one. In year three, corporation C (Acquiring), itself holding assets worth $1 billion with an adjusted basis of $0, acquires Controlled in a transaction in which Acquiring becomes a successor to Controlled. In year nine, Acquiring merges into a REIT. Under the temporary regulations, Acquiring would be deemed to sell all of its assets in a taxable transaction, triggering $1.02 billion of gain, as opposed to only the $20 million of gain attributable to assets held by Controlled at the time of the tax-free spinoff.
Proposed regulationsTo address the concern illustrated in the 2016 temporary regulations and by commenters, the proposed regulations limit their application to distribution property, which is defined as property owned immediately after a tax-free spinoff by a distributing corporation or a controlled corporation (or a member of a separate affiliated group of which the distributing corporation or a controlled corporation is the common parent). The proposed regulations require gain recognition only on the value of assets traceable to the tax-free spinoff. However, and important, the gain is not limited to the built-in gain at the time of the spinoff. It also includes any appreciation occurring between the spinoff and the conversion transaction.
To illustrate, consider the example from the preamble of the 2016 temporary regulations, but assume the assets of Controlled have appreciated to $40 million of value by year nine. The proposed regulations allow Acquiring to trace the deemed sale assets back to those held by Controlled at the time of the spinoff in year one. Acquiring does not recognize the gain on its $1 billion worth of assets, but it is required to recognize $40 million of gain attributable to the assets of Controlled.
Neither the PATH Act nor the proposed regulations impose gain recognition on the shareholders of a corporation. Shareholders participating in an otherwise valid Section 355 spinoff continue to enjoy tax-free treatment for the shares they receive. The proposed regulations are applicable to conversion transactions occurring 30 days after the proposed regulations become final. Nevertheless, taxpayers are allowed to apply the proposed regulations consistently for all conversion transactions occurring on or after June 7, 2016 (the date the temporary regulations were released).