Commercial Investment Real Estate May/June 2016

LEGAL BRIEFS Chasing Value Change in tax law for REIT spin-off deals sparks creative solutions. r by Richard Morris and Sung Hwang Recent changes to the Internal Revenue Code have ended the tax-free beneﬁ ts of real estate investment trust spin-off transactions. Characterized by some as a Wall Street loophole, the beneﬁ cial structure enabled operating companies to distribute real estate assets and realize other strategic beneﬁ ts. Tax Conundrum T e changes to the federal tax code provide that any such REIT spin-of will result in a taxable income to the operating company and, again, to its stockholders unless it involves an existing REIT and certain other specif ed conditions are satisf ed. T e IRC change also prohibits the subsidiary com- pany from electing REIT tax status for 10 years af er the spin-of . T e result is, almost certainly, to reduce the supply of commer- cial real property available for REITs, limit- ing the opportunity for operating compa- nies to monetize these assets.  May | June | 2016 In many ways, the tax code change cre- ates the same substantial economic result as if the operating company sold the property and distributed the net proceeds to its stock- holders. Proponents claim that a loophole is f xed as the economic reality of the transac- tion is subject to tax. A signif cant dif erence, however, exists that is not appreciated by the change. In the REIT spin-of , the stockholders receive stock, not cash. T is change creates taxable income to the stockholders in a non-cash transac- tion, which generally is the worst possible tax consequence. Some tax experts have estimated that more than $1.5 billion in tax revenue will be realized by ending the REIT spin-of tax-free loophole. However, any such estimate pre- sumes that operating companies will con- tinue to spin of real property with built-in gain, e.g., fair market value of the property in excess of the depreciated tax basis of the property. Operating companies may decide, how- ever, to continue to hold valuable real estate property rather than subject themselves and their stockholders to a tax liability — tax- able income — without any cash realization. Accordingly, the tax code is now compelling operating companies to retain assets with dif erent risk prof les, and this creates valu- ation complications. Creative Solutions Commercial property executives and oper- ating companies will likely search for other tax-advantaged transactions to realize the strategic benef ts of spinning of real estate assets. Here are some options. Gains from Net Operating Losses. Firms Commercial Investment Real Estate Now t that spin-of transactions lose those tax-free advantages, commercial property executives must use alternative structures to unlock the value of operating company real property assets.

Commercial Investment Real Estate May/June 2016 | Page 20