The Current Spin on Reit Spin-Offs

Corporations owning significant real estate as an ancillary part of their primary business must determine the best structure within which to hold the real estate. It may be to their advantage to separate ownership by conveying real estate owned to an affiliated entity that leases the property back to the business unit that will actually be occupying the space for its primary business purpose. Benefits of holding real estate in an entity other than the parent corporation include greater flexibility in acquiring and disposing of property, enhanced ability to engage in tax-free exchanges, and parent-company financial profile improvement.

Countervailing considerations include resulting intercompany debt, the difficulties of allocating lease payments among business units, and the complex tax issues that go with such decisions. The Enron debacle, for obvious reasons, may also mitigate against separation of ownership, regardless of the benefits.

Use of real estate investment trusts (“REITS”) as a vehicle for separating ownership of corporate real estate has been considered for many years. Benefits of using a REIT include the fact that a REIT satisfying gross income and distribution tests does not pay entity-level taxes, and rents paid to the REIT may be distributed to the REIT’s shareholders as dividends.

Companies seeking to spin off a corporation to own the company’s real estate followed by the conversion of that corporation into a REIT, however, historically have been thwarted by the IRS. For the spin-off to qualify for tax-free treatment, both the distributing corporation and the spun-off entity must be “actively engaged in the conduct of a trade or business.”

In order for a REIT to qualify for favorable tax treatment, its income must be derived from “rents from real property.” A 1973 IRS Revenue Ruling held that in order for a REIT’s income to be “rents from real property,” the REIT could not provide common lease services such as furnishing utilities and janitorial service. Meanwhile, if the REIT contracted that work out to a third-party property manager, the REIT was not considered actively engaged in a trade or business.

The Tax Reform Act of 1986 removed this obstacle, but the fact went largely unheralded for 15 years until the IRS issued Revenue Ruling 2001-29. The ruling formally recognized the impact of the 1986 Act in negating the 1973 Revenue Ruling and confirmed that a REIT can be engaged in the active conduct of a trade or business solely by virtue of functions with respect to rental activity.

The recent Revenue Ruling has sparked much discussion and conjecture regarding whether REIT spin-offs will now be a common vehicle for corporate real estate ownership. There are several tests that must be met in order to spin off a corporation and convert the new corporation into a REIT. The parent corporation that holds the real estate prior to the spin-off must be actively engaged in the conduct of a business for five years prior to the spin-off. This is a serious obstacle for corporations that hold real estate for their own use and do not lease it to the business units actually occupying the space.

Additionally, the spin-off will not qualify as tax-free if the transaction is found to be used primarily as a device for the distribution of earnings and profits. The corporation also must have a valid business purpose for the spin-off other than the federal tax benefits resulting from the fact the property is held by a REIT.

Despite the complexities and obstacles, the REIT spin-off may still be a viable option for those corporations devising a long-term strategy for real-property ownership given the obvious benefits of owning the property in a REIT.

Lon J. Brincks is a partner with Blackwell Sanders Peper Martin LLP. He can be reached by phone at 816.983.8184 or by e-mail at lbrincks@blackwellsanders.com.