ALI-ABA Course of Study Creative Tax Planning for Real Estate Transactions September 25-27, 2008 Chicago, Illinois
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1 1023 ALI-ABA Course of Study Creative Tax Planning for Real Estate Transactions September 25-27, 2008 Chicago, Illinois Selected Tax Issues Relating to the Use of Partnerships in REIT Transactions By Peter J. Genz King & Spalding LLP Atlanta, Georgia
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3 1025 SELECTED TAX ISSUES RELATING TO USE OF PARTNERSHIPS IN REIT TRANSACTIONS Peter J. Genz King & Spalding LLP Atlanta, Georgia August 10, 2008 I. Overview of UPREIT and DownREIT Transactions A. General 1. This outline discusses the qualification requirements and tax treatment of real estate investment trusts ( REITs ) and the tax consequences to investors of acquiring and holding REIT shares or interests in (i) UPREIT partnerships, where a REIT is the general partner of a partnership that actually holds the real estate assets), and (ii) so-called DownREIT partnerships, where the REIT is the general partner of a property partnership formed to acquire a contributor s property on a tax free basis, but also holds other real estate assets directly. 2. If a corporation qualifies as a REIT, it can avoid tax at the corporate level by distributing all net income currently to its shareholders, thereby eliminating the double taxation normally associated with doing business in corporate form. Consequently, a REIT can be an attractive means of investing in real estate. B. Advantages of a REIT v. Publicly Traded Partnership 1. Publicly traded REITs offer investors a liquid vehicle for investing in real estate. 2. Publicly traded real estate partnerships are not nearly as popular as REITs, in part because such investments are not perceived to be as liquid as REIT shares and because REITs offer certain tax advantages to tax-exempt institutional investors and non-u.s. investors that are not available when a partnership structure is used. C. Exchanging Appreciated Property for REIT Shares On a Tax-Free Basis 1. Section 351 Transfers
4 1026 a. Generally, contributions of appreciated real property to a REIT in exchange for stock are not eligible for nonrecognition treatment under section 351 if the transfer results in diversification of the transferors interests. Section 351(e); Reg (c)(1). Diversification will result whenever there are multiple transferors participating in the transaction who transfer nonidentical assets in the exchange. Reg (c)(5). Thus, if the REIT transaction involves a property roll-up and IPO, with property owners contributing property and public investors contributing cash, diversification is assured and the property contributors will recognize gain or loss on the transaction. b. The section 351 regulations were amended in 1996 to provide that a transfer of stocks and securities will not be treated as resulting in a diversification of the transferors interests if each transferor transfers a diversified portfolio of stocks and securities. Reg (c)(6)(i) (T.D. 8663, C.B. 34). A portfolio is diversified if it meets the 25% and 50% tests of section 368(a)(2)(F)(ii). The preamble to the regulations notes that commentators had suggested that final regulations adopt a similar rule for contributions of diversified real estate portfolios to a REIT, but the IRS had concluded that was beyond the scope of the final regulations. c. However, notwithstanding the preamble, the IRS has issued a private letter ruling which approved in a tax-free section 351 contribution of a diversified portfolio of real estate to a REIT. See Priv. Ltr. Rul (July 15, 1997) (transitory sub of public acquiring REIT merged into public target REIT, with target REIT shareholder receiving acquiring REIT shares, while simultaneously certain limited partners of the UPREIT partnership in which acquiring REIT was a partner contributed their units to the acquiring REIT in exchange for shares; immediately following the exchange, the former target REIT shareholders and the former limited partners of the UPREIT partnership were in section 368(c) control of acquiring REIT; held, the exchanges by the target REIT shareholders and the UPREIT limited partners were tax-free under section 351; surprisingly, the ruling does not discuss the obvious section 351(e) issue). d. Note that a single transferor (such as an existing partnership owning multiple real properties) can contribute such properties to a private, or closely held, REIT tax-free under section 351. There is no section 351(e) problem because there is only one transferor and therefore no diversification. The REIT will have to issue preferred stock to sufficient accommodation shareholders (typically $1,000 par value) such that it can meet the 100-shareholder requirement 2
5 1027 commencing no later than January 30 of its second taxable year, but the de minimis cash that they contribute for such preferred shares should not cause a diversification problem. e. Query whether there is a diversification issue when a fund receives property contributions from one investor and cash from another, and then contributes the cash and property to a subsidiary REIT. There is only one transferor in form -- i.e., the partnership. The question is whether diversification is tested at the partnership level, in which case there is no diversification, or by reference to the partnership s beneficial owners, in which case diversification could result. If section 351 did not apply, of course, section 704(c) would cause the gain recognized on the transfer to the REIT to be allocated solely to the property contributing partner, so the other partners should not be adversely affected. D. Tax-Free Reorganizations Involving REITs 1. The sponsors of the REIT may wish to acquire an interest in the REIT at the outset in a nontaxable transaction, perhaps so they can have some measure of voting control over the REIT. 2. A common situation is where the developer owns a real estate development or property management business in an S (or sometimes a C) corporation together with other employees, family members or investors, and wants to get REIT shares into their hands on a tax-free basis so each can do as he or she likes with the shares without being constrained by the wishes of the other. 3. While it is sometimes hard to believe, there are still plenty of C corporations around that own substantial appreciated real estate investments or property management and development businesses for whom a tax-free merger into an acquiring REIT is the ideal exit strategy. 4. One way to do this is to use a sponsor-owned real property or management/development corporation as the REIT vehicle. This allows the sponsors to convert the value of their equity in the business to REIT shares on a tax-free basis, since it does not involve an exchange. However, if the corporation has not always been an S corporation, it may have earnings and profits that must be purged before the end of the REIT s first taxable year. Section 857(a)(2)(B). In addition, if the corporation is a C corporation, any built-in gain in its assets at the time it becomes a REIT will be subject to corporate-level tax if the assets are disposed of by the REIT within 10 years. Section 337(d)(1); Reg (d) Another possibility is to merge, on a tax-free basis, the sponsor s corporation into the REIT, with the shareholders receiving REIT shares. 3
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