IRS and Congress Exploring Definition of Real Estate for Variety of Firms Seeking to Tax Advantage by Qualifying as REITs
Under pressure to reconsider some longstanding corporate tax loopholes, the IRS and Congress have both recently launched efforts to define what exactly constitutes as real estate for purposes of businesses seeking to qualify as a real estate investment trust (REIT) under the tax code.
The results of those efforts could affirm or undo a host of tax advantages for existing REITS, and block the efforts of several companies currently seeking to reorganize as REITs.
In the past few weeks, CoStar has reported that the Internal Revenue Service has informed a handful of potential REITS (Iron Mountain Inc., Equinix Inc. Lamar Advertising Co. and CBS Outdoor Americas) that the Treasury agency has formed a new internal working group to study the current legal standards it uses to define "real estate" for purposes of firms qualifying as a REIT, and what changes or refinements, if any, should be made to those legal standards.
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The IRS review appears to be prompted by an increase in the number of firms seeking to take advantage of the significant tax benefits afforded REITs by companies that are outside the traditional owner-operators of income-producing properties.
The list of candidates for REIT conversion or REIT initial public offerings has been expanding in recent years and eight and companies have converted or spun-off non-traditional real estate assets into a REIT since 2010. Their properties billboards, landfills, casinos, document storage facilities and solar energy infrastructure. Niche REITs often have differentiated risks that may be less familiar to investors who concentrate in the traditional commercial property sectors -- office, industrial, multifamily, retail, and health care.
The latest to be informed of that re-examination is Penn National Gaming Inc. which is seeking to spin off its casino operations into a stand-alone REIT called Gaming and Leisure Properties Inc.
Gaming and Leisure Properties expects to generate its revenues in the property business primarily by leasing gaming facilities to gaming operators in “triple-net” lease arrangements, a business model common to a number of publicly-traded REITs in other industries. Its portfolio will consist of 19 gaming and related facilities.
“While GLPI [Gaming and Leisure Properties] has no reason to believe that its “private letter” ruling will be adversely affected by the IRS internal working group,... GLPI cannot predict how changes in the tax laws might affect its investors or GLPI,” the company warned potential shareholders in a recent securities filing.
Concerns Raised that REIT Status May Be Rescinded
Even companies that have already converted to REITs are worried. Power REIT, which was formed through a reorganization and reverse merger of the Pittsburgh & West Virginia Railroad in December 2011 to invest in transportation and energy infrastructure assets such as railroads and solar farms, noted the latest IRS efforts could impact its plans to raise additional money from the sale of common shares.
“Power REIT must meet income and asset tests to qualify as a REIT. If an investment that was originally believed to be a real asset is later deemed not to have been a real asset at the time of investment, our status as a REIT may be jeopardized or we may be precluded from investing according to our current business plan, either of which would have a material adverse effect on our business, financial condition and results of operations,” the company said in its stock offering filing.
Power REIT's wholly owned subsidiary, Pittsburgh & West Virginia Railroad, received a revenue ruling in the 1960s qualifying passive railroad property, including bridges, tunnels and railroad track as “real assets”. Since the railroad revenue ruling in the 1960s, the company noted that the IRS has issued numerous other private letter rulings defining certain assets, including cell towers, data centers, electric and gas transmission and distribution assets, qualify as real assets for tax purposes and can be held by REITs.
"Although these private letter rulings may only be relied upon by the taxpayer to whom they were issued, we believe these rulings provide insight into the current thinking of the IRs with respect to infrastructure assets,” the company said.
David Burton, a partner in the tax practice at Akin Gump Strauss Hauer & Feld LLP, writing on the law firm’s blog last month said other solar REITs may be unlikely to win favorable IRS rulings.
“In early 2013, many in the solar industry appeared to be thinking that the IRS’s blessing of a solar REIT would be provided within weeks. It is now the middle of 2013, and it appears the thinking from a few months ago was at best irrational exuberance,” Burton said.
“The IRS working group appears to have at least two origins,” Burton said. “First, certain members of Congress... were concerned about the loss of revenue from public corporations converting from C-corporation status, with two layers of tax, to REIT status with effectively a single layer of tax.”
“Second, I suspect that the IRS had trouble articulating why ground-mounted solar did not constitute 'real estate' for REIT purposes in light of rulings it had issued about assets such as electric transmission systems and data storage centers. This challenge may have made the IRS question the accommodating rulings it had issued in recent years,” he added.
“I believe the IRS working group will take at least six months to complete its review. In that time, any REIT eligibility rulings will be relatively plain vanilla,” Burton said. “At the end of the review, I suspect the IRS will decide not to back-track on its prior positions regarding assets like transmission, cell towers and data storage centers, but it will decline to further expand the definition of real estate for REIT purposes.”
“Therefore, new asset classes like solar and warehouse storage for physical documents may not receive favorable rulings,” he said. “Nonetheless, after the dust settles, I suspect the IRS may have a favorable view of roof-mounted solar systems that only provide power to the building on which they are mounted.”
The renewed interest in the definition of real estate for REITs also stems from strong interest in tax reform among members of Congress. In May a group of U.S. Representatives and Senators prepared a report for the U.S. House Committee On Ways And Means on suggestions for reform current tax laws. That report included a number of suggestions for changing the laws relating to REITs, including: updating and modifying REIT income and asset tests, including allowing more investment in debt securities of publicly offered REITs; making permanent mineral royalty income provisions, and reinstating permanently certain timber provisions.
As of this writing, neither the IRS nor Congress has changed the rules on what constitutes real estate for REIT purposes. In fact, the IRS has been very consistent in its application of the law in recent conversion ruling requests, according to Surabhi Sheth, real estate research leader for Deloitte Services LP. While certain asset classes in recent ruling requests may be considered non-traditional, those assets have met the historical REIT standards. The standards themselves have not changed.
That said a company electing REIT status or considering a REIT conversion may find itself having to reclassify assets, Sheth said.
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