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November 12, 2012
The Expanding Universe of REITs

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by Amy S. Elliott

The number of C corporations seeking to convert to real estate investment trusts has increased considerably, according to recent data. However, the increase is not the result of a change in IRS standards regarding acceptable REIT income.

In 2012 at least 10 C corporations took steps to explore conversion to a REIT. That compares with only four C corporations that have made the REIT election in the last nine years, according to data from the National Association of Real Estate Investment Trusts (NAREIT).

Why the sudden interest in REIT conversion? Investors are hungry for dividend-paying stocks, and REITs must pay dividends -- new REITs even more so because they are required to pay out all of their accumulated earnings and profits.

"The reason why people are exploring this is market conditions," said Robert Willens of Robert Willens LLC. "It's not that great to be a REIT except in cases where the market is favoring REITs, and that's what's precipitating this whole thing."

Dianne Umberger of Ernst & Young LLP agreed. "Companies that even start exploring this are getting a pop in their stock," she said.

While the recent uptick in REIT-conversion interest may not have resulted from a liberalization of the IRS's ruling position regarding REITs, it is important to consider whether the expansion of income not subject to the corporate tax, particularly in nontraditional REIT sectors, poses a threat to the corporate tax base.

What Are REITs?

REITs are generally thought of as companies that own and manage several income-producing real estate properties such as shopping malls or office buildings. Congress created REITs and gave them preferential tax treatment similar to mutual funds because it wanted the average investor to be able to own an interest in large-scale commercial real estate as a means of portfolio diversification. The average American can't afford the $165 million price tag to purchase a Kmart-anchored shopping center in the Bronx, but for about $80, he could own a tiny piece of it in the form of a share of the Vornado Realty Trust publicly traded REIT.

Congress's efforts have paid off. According to NAREIT, publicly traded REITs represent between 15 and 20 percent of the investment-grade commercial real estate market, which is far better than when essentially all of the market was in the hands of wealthy individuals and large financial institutions. Regardless, NAREIT is quick to point out that real estate remains underrepresented in the general indexes.

                          Some REIT Wannabes
                    (Anticipated REIT Conversions)

         Company Name                     Type             Effective

      Ryman Hospitality                 Hotel                 2013
      Properties Inc.

      Crown Castle                      Cellular              2016
      International Corp.               Towers

      SBA Communications                Cellular              2020
      Corp.                             Towers

      Cincinnati Bell Inc. sub          Data Centers        2012/2013
      CyrusOne Inc.

      Equinix Inc.                      Data Centers          2015

      Corrections Corp. of              Private Prisons       2013

      The GEO Group Inc.                Private Prisons     2013/2014

      Lamar Advertising Co.             Outdoor               2014

      Iron Mountain Inc.                Document              2014

      Renewable Energy Trust            Solar Power         Announced
      Capital Inc.                      Generation         Exploration

Some REIT newcomers aren't traditional landlords whose income stream is characterized almost exclusively as passive. In 2004 the forest products company Rayonier Inc. converted to a REIT. Although it owns, leases, or manages 2.7 million acres of timber and land, Rayonier is also the world's leading manufacturer of cellulose specialty fibers, or what it calls "nature's most abundant, versatile plastic." It might be surprising how Rayonier and REIT aspirants like document management/shredding firm Iron Mountain Inc. or private prison and residential treatment services firm the GEO Group Inc. could qualify for REIT status.

REITs and Active Business

REITs are corporations -- not all publicly traded -- that are allowed to deduct the amount that they pay out in dividends from their taxable income as long as they meet requirements. If a REIT distributes all of its taxable income to its shareholders, it owes no corporate federal income tax and is essentially a passthrough entity. However, REIT shareholders don't benefit from tax losses or credits and can't take advantage of the preferential dividend rate. The REIT rules were designed to benefit real estate investments that generate nearly all of their income from passive sources like rental income or interest income from mortgage-backed loans. Dealers and build-to-sell developers don't generally qualify as REITs.

Unlike other C corporations, REITs must annually distribute at least 90 percent of their taxable income in the form of dividends. Other requirements include:

  • at least 75 percent of a REIT's assets must be real estate assets (the asset test);
  • at least 75 percent of a REIT's gross income must be from items related to real estate, such as rents from real property (the 75 percent income test); and
  • at least 95 percent of a REIT's gross income must be from items related to real estate but also more passive investments (the 95 percent income test).

What qualifies under the asset and income tests is the key to REIT status. For purposes of the asset test, real property is defined in reg. section 1.856-3(d) as "land or improvements thereon, such as buildings or other inherently permanent structures." Structural components of a building, such as plumbing systems, elevators, or central air conditioning, are generally good REIT assets, whereas machinery, individual air conditioning units, and hotel furnishings generally are not.

For purposes of the income tests, rents from real property -- the most significant type of good REIT income -- are defined in reg. section 1.856-4(b)(1) as including amounts for services ancillary to the property usage as long as the services are customarily provided in connection with the rental of similar property. In the case of an apartment building, customary services might include air conditioning, the cleaning of public areas, incidental storage space, laundry equipment, security, parking, and a swimming pool.

If a company has enough income from non-customary services that are provided for the convenience and to the specifications of the lessee or tenant, it could sacrifice its REIT status. A legislative change in 1999 provided that such income could generally be earned through a taxable REIT subsidiary (TRS), which can be wholly owned by the REIT as long as its aggregate TRS stock ownership doesn't exceed 25 percent of the REIT's assets. TRSs pay corporate income tax but can pay out dividends to the REIT, which would then qualify as good income under the 95 percent test. Only in the lodging and healthcare sectors must non-customary services be contracted out to an unrelated third party.

In the case of Rayonier, timberlands are considered a real estate asset. In the late 1990s, the IRS clarified that the sale of standing timber by a REIT doesn't constitute a prohibited transaction like the sale of condominiums might, so the sale of lumber generates good REIT income. However, because Rayonier's performance fibers division generates bad REIT income, it sits in a TRS.


It's easy to blame the recent surge in REIT conversion interest on the IRS. After all, companies generally seek private letter rulings as part of the conversion process to ensure that as much qualifying assets and income as possible stay up at the REIT instead of down at the TRS. But while a review of those rulings shows that the universe of good REIT assets and income is expanding, there doesn't seem to be a real shift in the IRS's standards.

"It's not so much that the IRS has dramatically changed its policy; I think what's simply happened is the business and tax community serving REITs is just asking different and broader questions," said John Cullins of E&Y. "They weren't necessarily saying no to these questions 10 years ago; they simply weren't being asked."

Tony Edwards of NAREIT agreed that the rules haven't changed and said the broader interest in REIT conversions "just means that real estate is touching a different sector of the economy."

A lot of attention was focused on American Tower Corp.'s REIT conversion, which was effective January 1. In an October 10 Wall Street Journal article, Anton Troianovski wrote that tech firms, including cellphone tower operator American Tower, are able to avoid paying taxes by becoming REITs. "Proponents of expanding the real-estate club argue that it makes sense for the definition of real estate to evolve as technologies change," he wrote.

But for American Tower, no evolution of the IRS's definition of real estate was necessary. In 1975 the IRS issued Rev. Rul. 75-424, 1975-2 C.B. 269, which provided that towers used in the transmission of audio and video signals were real estate assets under the REIT rules. The ruling cited the definition of real property contained in the regulations to find that the tower was a real estate asset, but that the antennas affixed to it were not. "Thus, calling a cell tower owner a tech firm is like calling a shopping mall owner a retailer," Edwards said.

REITs are so popular that some companies are willing to change the nature of their business to jump on the bandwagon. Gaylord Entertainment Co. -- now called Ryman Hospitality Properties Inc. -- recently sold the rights to manage its four Gaylord properties to Marriott International Inc. as part of its efforts to operate as a REIT effective January 1, 2013.

Known for its luxury resorts and entertainment assets, including the Grand Ole Opry, Ryman had to leave the hospitality business, contracting out the management and operation of its hotel properties as required by REIT rules. Hotels generate a lot of non-customary services income (even the nightly room rate charged to guests doesn't constitute rents from real property), and hotel REITs are subject to the third-party management restriction. Ryman will continue to conduct its Opry and attractions businesses as it had before, although through TRSs.

That the lodging and healthcare sectors have that added restriction doesn't appear to be a deal-breaker, even though it means that those firms end up losing out on a large slice of the income. "The idea is to get the rental income stream that goes to the REIT to only be subject to one layer of tax," said Todd Keator of Thompson & Knight LLP. "It's usually a winning proposition. That's why so many hotels are going to REIT structures."

Ask and You Shall Receive?

Liberalization of REIT rules started with the enactment of the Ticket to Work and Work Incentives Improvement Act of 1999, which essentially codified a series of private letter rulings allowing a predecessor structure. The legislative change enabled REITs to dump their bad income into TRSs. About five years later, the IRS issued a private letter ruling to a cold-storage REIT, signing off on its ability to generate bad services income at the TRS level for charging customers for loading goods into its facilities. (For LTR 200428019, see Doc 2004-14172 or 2004 TNT 133-24.)

"That was a watershed ruling, because that was the first time that the IRS recognized that an operating company that provided storage space and services could be restructured into a REIT," Umberger said. "That's really what's at the heart . . . of the trend in nontraditional REITs."

Umberger said she believes the IRS has approached the growing interest in REIT conversion with the right amount of review. "They've been asking the right questions. I don't think they have just said anything goes by any means," she said, adding that it's clear that the agency has drawn the line when it comes to the generation of a commodity for sale to third parties. "For example, it is unlikely that [a REIT] could simply place a generator in a building and sell the electricity to third parties," she said.

Iron Mountain would be a nontraditional REIT. The company told shareholders in a June release announcing board approval of the REIT conversion that "the largest portion of our income is from renting storage space to customers in our more than 64 million square feet of real estate around the globe."

But skeptics of Iron Mountain's REIT conversion are quick to distinguish it from more traditional REITs, like a self-storage REIT. Chris Sonne, leader of Cushman & Wakefield's self-storage industry group, said that Iron Mountain's business is a much different model.

"Self-storage is really real estate, and Iron Mountain is . . . a business enterprise value. They use real estate, but they can still run the business leasing a warehouse and putting in their equipment. They have really high furniture fixtures and equipment and expense for machinery -- the automatic conveyors and the computer systems," Sonne said. "Self-storage is completely different because there is no bailment. It's just the right to rent the space and to put a lock on it."

Keator said he was skeptical that Iron Mountain could meet the REIT income tests. "In a document storage operation, I would think that all of the income would be from providing a storage service and not so much from renting real property," he said. "I doubt any lawyer could give a tax opinion that worked. You'd have to go to the IRS for a ruling."


Although the IRS is getting its chance to review the tax issues inherent in Iron Mountain's REIT conversion, it may take time to sort out, both because the business is novel and because of a recent Tax Court case.

The March decision involved a dispute over whether a 366-unit apartment complex spanning more than 40 buildings was one asset that must be depreciated over 27 1/2 years like all residential rental property, or whether some of the property (for example, kitchen sinks and shelving in pantry closets) could be depreciated at a faster rate. (For AmeriSouth XXXII Ltd. v. Commissioner, T.C. Memo. 2012-67, see Doc 2012-5206 or 2012 TNT 49-10.)

After undergoing a cost segregation study, the taxpayer took the position that if the complex was deconstructed into more than 1,000 parts, many with shorter lives than 27 1/2 years, it could defer nearly $730,000 in taxes over a five-year period. In doing so, it claimed that some elements were section 1245 depreciable personal property and not structural components. The Tax Court disagreed, effectively disallowing the division of the complex into components for depreciation purposes.

Soon after the court decision was published, the American Society of Cost Segregation Professionals responded that while some of the positions taken in the cost segregation study "are considered somewhat aggressive by most experts," the court was wrong to use a typical apartment building as a benchmark, rather than a generic shell building. "If this argument holds up in future cases, it could have widespread consequences," the society wrote. (For the letter, see

The society pointed out that at its national conference, IRS officials issued a warning regarding the Service's position on dividing residential rental property into components. The letter said that although the officials indicated that they would release a cost segregation industry directive specific to the residential rental industry, no guidance has been released.

The AmeriSouth case is good news for Iron Mountain's REIT conversion effort, because if shelving or racking is a structural component of real property, it is a good REIT asset. The company is already taking that position, which requires it to incur a tax liability for the recapture of depreciation expenses. That results in a $225 million to $275 million hit over five years, not including another $100 million to $150 million in additional REIT conversion costs -- all for the chance to save $120 million to $130 million in taxes each year.

Willens said he hopes AmeriSouth means the IRS will take context into consideration when determining what constitutes usual or customary services. "There could be quite a lot of services that are usual or customary in connection with maintaining a detention facility, which wouldn't be usual or customary obviously in the case of an apartment building," he said.

Willens said that either way, he doesn't see many more REIT conversions on the horizon. "We will have a couple more, I think, but it's not going to be an epidemic in the sense that McDonald's and Dillard's Department Stores and Sears" will all convert to REITs, he said.

NAREIT President and CEO Steven A. Wechsler agreed. "To elect to become a REIT is taking on a discipline in terms of real estate investment and operating as a real estate business that is not insignificant," he said. "That is not necessarily desirable to a lot of businesses unless at the end of the day, their assets are fundamentally real estate, their income is fundamentally based on renting that real estate in some form or fashion out to others for their use, and they are prepared to operate without the ability to retain earnings."

But not everyone agrees. Practitioners have suggested that assets such as bridges, dams, toll roads, tunnels, theme parks, and ski resorts could all be held in REIT structures in the future. In 2008 Congress enacted section 856(c)(5)(J), giving the IRS the authority to allow other items of income to be included as good REIT income, although it appears the Service's new authority won't have broad application. Tax Analysts' Martin A. Sullivan predicted in 2003 that legislative changes or changes in market conditions "could make REITs a potent tax shelter." We'll just have to wait and see if he's right. (For Sullivan's original analysis, see Tax Notes, June 2, 2003, p. 1298, Doc 2003-13468, or 2003 TNT 106-4. For additional coverage, see Tax Notes, June 23, 2003, p. 1852, Doc 2003-15044, or 2003 TNT 121-24.)

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