IRS Puts Brake on REIT Conversions – Real Estate Matters
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IRS Puts Brake on REIT Conversions

Reports by CoStar and the Wall Street Journal indicate that the IRS may be shifting gears with regards to its policy on REIT conversions. Real Estate Investment Trusts were established in 1960 as a vehicle for small investors to invest in portfolios of income-producing real estate, such as office buildings, shopping malls, apartments, and hotels. REITs are exempt from corporate income taxes and must distribute at least 90% of their taxable income to shareholders. Traditionally, REITs did not do any business other than own real estate, which is part of the reason they are exempt from federal corporate taxes.

However, in recent years the IRS has broadened the definition of what types of companies can convert to REITs. The Corrections Corporation of America, which owns and operates over 40 prisons across the country is one such company which recently converted to a REIT. The company argued that the money it collects from governments for holding prisoners is essentially rent. Thanks to the switch in tax designation, Corrections Corporation expects to save approximately $70 million a year in taxes. Similar moves have been made by companies which operate cell phone towers, outdoor advertising facilities such as billboards, and document storage facilities. Even Penn National Gambling, which operates 22 casinos, recently won approval to change to REIT status.

While the IRS had for several years made policy decisions which increasingly broadened the scope of what can be considered a REIT, it may be backing away from that trend. Last week three firms in the midst of the process of converting to REITs were notified by the IRS that their moves will be delayed while the agency studies the standards it uses to define “real estate” for purposes of qualifying as a REIT. Iron Mountain Inc., a document storage company, is one of those firms and is a good example of how corporations have stretched the definition of “landlord” and “real estate” in an effort to achieve favorable tax status.

Despite the recent hold on REIT conversions and the IRS internal study, some analysts believe the agency will maintain its consistent stance of a broad definition of real estate. However, analyst¬†Ross L. Smotrich at Barclays worries that the rush of conversions to REITs could attract unfavorable attention from Congress in an era of constrained budgets and political talk about “tax loopholes.” In the 1980’s, Congress limited the use of master limited partnerships after a wave of companies used that structure to obtain tax-exempt status. Might Congress do the same with REITs?

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