The U.S. Treasury Department and the Internal Revenue Service published on January 18, 2017 final regulations (the "Final Regulations")1 reducing from ten years to five years the recognition period for the corporate-level tax imposed on certain property dispositions by a real estate investment trust ("REIT") or a regulated investment company ("RIC") under Section 337(d), and otherwise generally adopting the approach set forth in prior temporary and proposed regulations.2 The need to have a recognition period for corporate-level tax in this circumstance is related to General Utilities repeal3 as applied for RICs and REITs, and the five-year recognition period established in the Final Regulations was indirectly mandated by the provisions of the PATH Act4 addressing General Utilities repeal and which we have previously discussed. The Preamble to the Final Regulations states that the intention of the change is to conform the Final Regulations to the PATH Act. Continue reading the discussion for further background and context for the Final Regulations.
The prior temporary and proposed regulations, released on June 7, 2016, were intended to limit so-called "conversion transactions," involving assets transferred from fully taxable corporations to a REIT or a RIC and to prevent abuses of the PATH Act. Under the temporary and proposed regulations, if a REIT or RIC sold property acquired in a conversion transaction that occurred on or after August 8, 2016 within ten years of the acquisition, the REIT or RIC would be required to recognize all the resulting gain or loss as if it had sold the property to an unrelated party at fair market value on the date of the conversion transaction in a taxable transaction (i.e., subjecting any otherwise unrecognized gain to full corporate-level tax).
The ten-year recognition period on conversion transactions was inconsistent with the terms of the PATH Act. The PATH Act required the same length of recognition period for REITs and RICs as is imposed on transfers to Subchapter S corporations, and that recognition period is statutorily established by Section 1374(d) as five years (not ten). Members of Congress noted this inconsistency and advised the Secretary of the Treasury that they believed the inconsistency stymied congressional intent and the longstanding practice of treating REITs and RICs as having the same built-in gain recognition period as S corporations.5
The Final Regulations resolve this inconsistency directly, by changing the recognition period for RICs and REITs in conversion transactions to mean the recognition period described in Section 1374(d)(7). Section 1374(d)(7) specifies that the recognition period is the five-year period beginning, in the case of a conversion transaction that is a qualification of a C corporation as a RIC or a REIT, on the first day of the first taxable year of the RIC or the REIT; for other affected conversion transactions the five-year period begins on the day the RIC or the REIT acquires the property.
The five-year recognition period does not apply where a C corporation that qualifies as a RIC or a REIT or transfers property to a RIC or a REIT makes an election to recognize gain or loss as if it sold the converted property to an unrelated party at fair market value on the deemed sale date. Certain C corporations or REITs will be treated as having made this election if the conversion transaction occurs within ten years of a Section 355 distribution.
The Final Regulations were published on, and are effective as of, January 18, 2017. The modification of the recognition period generally applies prospectively from February 18, 2017, but taxpayers may treat the five-year period as applicable to affected conversion transactions occurring on or after August 8, 2016. However, there is some uncertainty as to the effect on these Final Regulations of a memorandum issued by the White House on January 20, 2017. That memorandum ordered a freeze on regulatory actions, including a temporary, 60-day postponement on the effective date of regulations that have been published in the Federal Registry but has not yet taken effect. The effect of this memorandum on the Final Regulations is not clear since they took effect as of January 18, 2017, but also apply prospectively to transactions that occur on or after February 18, 2017.
1. T.D. 9810, amending Treas. Regs. Sec. 1.337(d)-7. Section 337(d)(1) generally provides authority for the issuance of regulations to prevent circumvention of the purposes of Section 337 by REITs and RICs. All references to Section are to the Internal Revenue Code of 1986, as amended.
2. Treas. Regs. Sec. 1.337(d)-7T was published in T.D. 9770 and simultaneously issued as Prop. Regs. Sec. 1.337(d)-7.
3. "General Utilities repeal" generally refers to the relevant provisions of the Code which require gain recognition on certain transfers of appreciated property by corporations, overruling the holding to the contrary in General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935).
4. The PATH Act is the common shorthand for the Protecting Americans Against Tax Hikes Act of 2015 (P.L. 114-113, 129 Stat. 2422). For the indirect mandate described in the text, see Section 127(a) of the PATH Act.
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