December 11, 2015

Congress Proposes Legislation Which Would Eliminate REIT Tax-Free Spin-Offs; Provision Would Also Fund FIRPTA Relief

Recently proposed legislation would eliminate future Prop Co/Op Co tax-free spin-offs for REITs. While it’s unclear whether Congress will act on the Bill before its upcoming recess, it’s clear that REIT tax-free spin-offs are under attack. Nevertheless, the Bill itself contains much more good news than bad news for REITs and the real estate industry, including expanded exemptions to FIRPTA.

In our December 3, 2015 REIT Alert we suggested that the Prop Co/Op Co structure implemented by a tax-free REIT spin-off may not be dead. On December 7, 2015 House Ways and Means Committee Chairman, Kevin Brady (R-TX) introduced an amendment to a Senate-passed bill, H.R. 34 (the “Bill”), that contains a provision1 which, if passed, would eliminate any future Prop Co/Op Co tax-free REIT spin-off transactions.

This provision would amend Section 355 of the Internal Revenue Code, which generally governs tax-free spin-offs, to provide that Section 355 would not apply to any spin-off distribution if either the distributing or distributed corporation is a REIT or makes a REIT election within 10 years after the spin-off distribution. There would be exceptions for (i) spin-offs where both corporations are REITs and (ii) spin-offs of certain taxable REIT subsidiaries owned for at least three years before the spin-off distribution.

Unlike other provisions in the Bill, the effective date of this provision would be retroactive to spin-off distributions made on or after December 7, 2015. Accordingly, even if Congress does not pass the Bill in its current session, the proposed effective date of December 7, 2015 is likely to further “chill” companies considering such a transaction. This provision does not adversely impact Darden Restaurants or other companies which have completed their tax-free spin-off prior to December 7, 2015, or companies considering a taxable spin-off, or companies which are converting the whole company into a REIT.

We note, however, that the Bill itself contains much more good news than bad news for REITs and the real estate industry. The spin-off provision of the Bill is a revenue raiser intended to fund other provisions in the Bill. The Bill encourages foreign investment in U.S. real estate generally and in REITs specifically, by expanding or creating new exceptions to the imposition of the FIRPTA tax on the sale of U.S. real estate or REIT stock by foreign investors. The Bill exempts shareholders of publicly traded REITs owning 10% or less of the REIT stock (up from 5%). In addition, the Bill creates a new FIRPTA exception for real property interests held by certain foreign pension plans. Finally, the Bill includes many of the favorable REIT provisions contained in prior legislative proposals.

As indicated in our December 3, 2015 REIT Alert, MGM Resorts International’s proposed “captive” REIT transaction does not involve a tax-free spin-off of its newly formed REIT subsidiary under Section 355, but rather an IPO of a minority position in the new REIT’s shares. Accordingly, the MGM transaction, as proposed, would not be adversely impacted by the spin-off provision of the Bill. However, the Bill contains an additional revenue raiser,2 which provides that percentage rent and interest (which is based on a fixed percentage of tenant or borrower receipts or sales) would no longer be considered good REIT income if more than 25% of all of the REIT’s rent and interest receipts comes from a single tenant or borrower.

This provision would be effective for taxable years after 2015 with respect to leases or loans entered into, acquired or materially modified after 2015. To date, many of the specifics of the MGM transaction have not been made public. Accordingly, it remains to be seen to what extent MGM intends that the lease between the “captive REIT” and MGM would contain percentage rent, which would be limited by this proposal of the Bill.

It is unclear whether Congress will act on this Bill before it leaves for the year; however, it is clear that REIT tax-free spin-offs are under attack.

1 Section 201 of the Bill (originally proposed last year by former Chairman Dave Camp in H.R. 1).

2 Section 202 of the Bill, also originally proposed last year by former Chairman Dave Camp in H.R. 1.