What are Real Estate Provisions Doing in the Latest Tax Extenders Bill?
December 8, 2015
In the latest chapter of the tax extenders saga, House Ways and Means Chairman Kevin Brady has introduced a bill to renew all fifty-plus expiring tax provisions until the end of 2016. Last week, lawmakers had been negotiating on a deal to make some of the extenders permanent – which would remove considerable business uncertainty about these perpetually precarious provisions. However, Brady’s bill signals that Congress may just do the same thing it has done year after year: renew the tax extenders for a short period of time and wait for them to expire again.
That being said, the latest tax extenders bill has a few interesting nuggets in it. For instance, thirty-eight pages of the bill have nothing at all to do with tax extenders; instead, they lay out a set of new rules for the tax treatment of real estate investment trusts (or REITs). To understand what these rules are and what they’re doing in the tax extenders bill, it’s important to understand what REITs are and why they’ve been in the news lately.
In 1960, Congress established REITs as a legal organizational form, in order to make it easier for average investors to invest in real estate. There are several strict requirements that REITs must follow: they need to have over one hundred shareholders, no five of whom earn over half of the stock; earn most of their income from real estate; and distribute at least ninety percent of their income to shareholders every year. In return for following these requirements, REITs receive a more favorable tax treatment: they are not required to pay taxes on any income they pass to shareholders, allowing them to avoid the double taxation faced by C corporations.
Recently, it’s become popular for companies to spin off their real estate assets into REITs. Over the past year, Pinnacle Entertainment, Sears, and Darden Restaurants have announced plans to transfer substantial real estate holdings to REITs and then lease the properties back. This is a common strategy for businesses to free up short-term cash – but it also can also bring significant tax advantages:
- By spinning off assets into REITs, businesses reduce the share of their earnings that is subject to double taxation and increase the share that is directly passed through to shareholders.
- Businesses that invest in non-residential real estate property are required to deduct the cost of the property over 39 years. This means that a business that bought a restaurant property two decades ago is still deducting a small fraction of the cost every year. On the other hand, rent for business property is fully deductible, making it more tax-profitable for a business to rent property from a REIT than to own it.
- Finally, businesses are usually required to pay taxes on the capital gains of assets whenever they are sold. But section 355 of the tax code makes an exception for businesses that are spinning off their assets into new businesses (this is an extremely sensible provision). So, spinning off real estate assets into REITs helps businesses avoid paying capital gains taxes on their real estate.
The provisions that Chairman Brady has put into the tax extenders bill are designed to combat the trend of companies spinning off their real estate property into REITs. The bill does this in a few ways, including:
- Denying the benefits of section 355 for spinoffs that involve a REIT – which means that companies that spin off real estate to a REIT would first have to pay capital gains taxes on the value of the real estate.
- Making the requirements for REITs stricter, by denying REIT status to any company that receives more than 25 percent of its rent income from a single corporation. In effect, this would prevent companies from setting up their own affiliated REITs, to hold their property and no one else’s.
- Preventing REITs from paying “preferential dividends” to one class of stockholders. Although REITs are required to have over 100 shareholders, they are currently allowed (under section 562) to pay higher dividends to some shareholders. Brady’s bill would prevent REITs from deducting the value of any preferential dividends paid, which would effectively end the practice. This would make it harder for businesses to set up REITs that pay most of their dividends to a single parent company.
- Giving the IRS greater authority to regulate how REITs distribute their earnings.
Like any proposed changes to the tax code, these stricter limitations on REITs have pros and cons. On the one hand, the provisions would likely raise additional federal revenue: if businesses are using REITs to avoid taxes, making it harder to form REITs would likely lead to higher tax revenue. On the other hand, REITs are pass-through businesses like any other, and their existence helps mitigate the economic harm that arises from the double taxation of corporations.
Interestingly enough, the rules about REIT spinoffs are not the only real estate provisions that Chairman Brady has inserted into the tax extenders bill. There are two provisions in the bill that relate to a bill from 1980 called the Foreign Investment in Real Property Tax Act, or FIRPTA.
FIRPTA was born out of fears in the 1980s that foreign investors would buy up substantial portions of American real estate and farm land. As a result, the law requires foreign investors to pay a high 30 percent withholding tax on real estate investments in the U.S. However, the law does not impose taxes on foreigner individuals and businesses who own shares in REITs as long as they own less than 5 percent of a REIT’s stock.
Although FIRPTA isn’t often in the news these days, it has been a major concern for many members of Congress. On several recent occasions, Congressmen have proposed bills and amendments that would significantly roll back FIRPTA’s requirements. Proponents of FIRPTA reform often argue that rolling back the law would bring much-needed foreign capital into the U.S. real estate market.
Chairman Brady has long been in favor of FIRPTA reform, and the recent tax extenders bill would also make two significant changes to this area of tax law:
- It would allow foreigner individuals and businesses that own up to 10 percent of the shares of a REIT to be exempt from FIRPTA taxes, up from the current 5 percent. This would make it easier for foreigners to invest in U.S. real estate through REITs.
- It would exempt foreign pension funds from FIRPTA withholding taxes. This would basically take the teeth out of FIRPTA, because so much investment is carried out by pension funds.
All in all, there’s not much of a justification for the existence of FIRPTA in the first place. The tax code should not pick winners and losers, and there’s is little rationale for disadvantaging foreign investors in the U.S. real estate market.
As negotiations about tax extenders continue, it will be interesting to see whether these additions by Chairman Brady make it into the final bill. Ultimately, most of the extenders are much more important than the real estate provisions discussed above, so it is unlikely that Chairman Brady’s decision to include these provisions will have much of an effect on the fate of this year’s tax extenders bill.