Defining REITs

Jun 14, 2013 by

Defining REITs

[From my latest NYT column.  I plan to do a related column on energy MLPs soon.]

Shares of the information storage company Iron Mountain dropped about 15 percent last week on the news that the I.R.S. was “tentatively adverse” toward at least one aspect of its plan to convert into a Real Estate Investment Trust, or REIT. The primary legal issue appears to be whether Iron Mountain’s racking storage units qualify as real estate assets.

To qualify as a REIT, a company must meet certain numerical tests, including a requirement that 75 percent of its assets be “real estate assets.” REIT status is important because it allows a company to avoid paying the corporate tax. REITs instead pay out most of their income as dividends to investors, who are taxed at individual rates.

REITs were intended to be the equivalent of mutual funds for real estate investing. Publicly traded companies are normally taxed as corporations, and in the absence of the REIT provisions, it would be more difficult for small investors build a diverse portfolio of real estate assets.

The problem is that many companies that resemble normal operating businesses now qualify as REITs.

Iron Mountain is a great example. Only on its tax return would one describe it as a real estate business. The value of the business turns on its ability to deliver information management services, including virtual and real document storage. The value of its real estate holdings is almost incidental to the business model.

Even though it seems like a stretch, Iron Mountain’s legal argument is not bad. Iron Mountain argues that the racking units are properly thought of as real estate, as they are affixed to the foundation of the building shell and intended to remain permanently in place.

In a securities filing, Iron Mountain disclosed that it learned that the I.R.S. formed a working group to define real estate for purposes of the REIT provisions. That the I.R.S. was “tentatively adverse” suggests it may not be persuaded by Iron Mountain’s arguments, or perhaps that it may simply be holding off on decisions like this while the working group examines the issue.

Other companies trying REIT conversions that could be affected include Lamar Advertising, an outdoor advertising firm, and Equinix, a data center operator. A front page New York Times article in April described other kinds of companies, like prison and casino operators, that have successfully converted to REITs.

The problem for the taxing authorities is that as the definition of REITs has expanded over time, the corporate tax base has eroded as more companies that look and act like ordinary businesses avoid paying the corporate tax.

The significance of the formation of an I.R.S. working group on the issue is unclear. In a newsletter, a tax expert, Robert Willens, apparently referring to The Times article, suggested that “the I.R.S. is reacting, uncharacteristically I might add, to the articles in the popular press that have questioned whether the Service has been unduly liberal in awarding REIT rulings.” Mr. Willens predicts that the working group will review recent rulings and conclude quickly that that nothing needs to be changed.

The erosion of the corporate tax base is a problem for Congress and the Treasury Department to address through tax legislation, not for the I.R.S. to change through its ruling policy. Congress shares responsibility for the problem thanks to its decision to allow taxable REIT subsidiaries to conduct activities that would otherwise jeopardize the qualifying status of REITs.

REITs often enter into cost-sharing agreements with taxable subsidiaries. One thing we learned from the Senate investigation into Apple’s offshore tax planning was the mischief that can be achieved through innocuous-looking cost-sharing agreements. Allowing the tax status of a parent company to depend on the arm’s length agreements of subsidiaries under common control is a proven recipe for tax avoidance.

Congress should revisit the broad availability of REIT status. Only by stemming the erosion of the corporate tax base will it be able to bring the corporate tax rate down to be more in line with our global trading partners.

For a discussion of how “blocker” entities, including taxable REIT subsidiaries, enable alterations to the tax base, see “ ‘Blockers,’ ‘Stoppers,’ and the Entity Classification Rules,” The Tax Lawyer (2011) by Willard B. Taylor.

via Defining Real Estate Broadly to Avoid Corporate Taxes – NYTimes.com.

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Lisa Kyle for The New York Times