IRS Ruling Allows Corporates To Spin-Off Real Estate Into REITs

by Mike Godfrey, Tax-News.com, New York

07 June 2001

An IRS ruling handed down during an acquisition by a Seattle timber company has opened the way for US corporates to divest themselves of their real estate holdings into tax-effective REITs (Real Estate Investment Trusts).

The income of a REIT is untaxed at the level of the trust provided that not less than 90% of its income is distributed to its shareholders, who are then responsible for tax in the normal way; but it had been thought that the IRS would not accept such treatment for corporate real estate assets.

The ruling, given as part of clearance procedures during the acquisition by Plum Creek Timber Co, a Seattle REIT, of the Timber Group, a division of Georgia-Pacific Group, creating the second largest private timberland owner in the US, appears to extend the beneficial tax treatment to such corporate reorganisations.

The IRS has effectively revoked a 1973 interpretation of the original REIT legislation barring REITs that are exempt from corporation tax from engaging in any active businesses. However, IRS officials indicated privately that they are only likely to offer approval on a case-by-case basis to ensure there are genuine business reasons for the spin-off, and that the purpose is not simply to avoid tax.

For many US corporations, removing real estate from their balance sheets will greatly enhance return on equity and return on assets. The law changed to allow such tax-free spin-offs in 1986, but the IRS had not acknowledged the change until now and its announcement this week was unexpected. The ruling seems to allow retailers with large real estate holdings such as McDonald's, Wal-Mart Stores and Bob Evans Farms to separate those assets from their commercial operations into REITs if they choose to do so.

For instance, McDonald's, which is as much of a real estate company as a hamburger company, has $8bn worth of property and equipment. By spinning off its real estate, McDonald's would lose a steady income stream from rentals of more than $1.4bn annually, but analysts said this would be more than offset by the tax benefits and higher returns on capital employed. One said that a rough calculation suggests McDonald's could unlock $270m in value from such a move.

In recent years, many companies have chosen to transfer real estate to another entity and lease it back because the real estate placed too much of a demand on its capital. Property-rich industries that stand to benefit from the ruling include the logging sector, movie theatre chains, car dealerships, manufacturers and hotel companies not currently organised as REITS. The ruling may also be attractive to firms such as Microsoft Corp and General Electric Co, which have multiple bases and manufacturing plants.

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