IRS Reduces Built-in Gains Tax Period For REITs

US map dollar (2)By:  Amanda Wilson

Ownership structures using real estate investment trusts (“REITs”) are common in the Senior Housing industry.  One of the key benefits of a REIT is that it is effectively a pass through entity for income tax purposes.  While a REIT pays tax on its taxable income, it also receives a dividends paid deduction on dividend distributions to its shareholders.  Since a REIT has to distribute at least 90% of its taxable income ever year, this dividends paid deduction effectively wipes out the REIT’s taxable income, avoiding an entity level tax.

To avoid corporations electing REIT status and then selling their assets under this preferential tax regime, the REIT rules require a REIT to pay a built-in gains tax on any gains that were built-in at the time of the REIT election if the REIT disposes of that property within a specified recognition period.  The built-in gains tax rules for REITs are found in Treasury Regulation Section 1.337(d)-7, which applies the S corporation built-in gains tax rules of Section 1374.

The Protecting Americans Against Tax Hikes Act of 2015 (“PATH Act”) amended Section 1374 to reduce the built-in gain recognition period for S corporations from 10 years to 5 years.  Practitioners expected the IRS to modify Treasury Regulation Section 1.337(d)-7 similarly.  However, the IRS instead issued proposed and temporary regulations in the summer of 2016 that kept the built-in gains tax recognition period for REITs at 10 years.

I am happy to share that today, the IRS backed away from this position, and issued final regulations providing that the recognition period for REITs is the same period provided for under Section 1374.  As a result, the recognition period for REITs has been officially reduced from 10 years to 5 years.   This change can provide significant tax savings for REITs previously subject to the 10 year rule, and can free up many REITs to do transactions that might otherwise have been on hold or limited to like-kind exchanges.

This change will go into effect February 17, 2017, but taxpayers may affirmatively apply this new recognition period for any transactions that occurred on or after August 8, 2106

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