Last fall, the IRS issued long-awaited final regulations providing guidance on the recognition of built-in gains when the appreciated property of a C corporation becomes the property of a real estate investment trust (REIT) or regulated investment company (RIC). Such a situation can arise when a C corp becomes a REIT or RIC or because it transfers its property to a REIT or RIC in a “conversion transaction.” The regs include two important exceptions to the general rule on gain recognition.
The general rule
Unlike C corporations, REITs and RICs usually aren’t subject to corporate income tax when they dispose of appreciated property, such as real estate. The general rule limits the ability of C corporations to avoid corporate-level taxes by converting into a REIT or RIC and having the new entity sell appreciated assets or contributing such assets to a REIT or RIC in a tax-free contribution. If a C corporation’s property becomes the property of a REIT or RIC, the REIT or RIC is subject to tax on the net built-in gain in the converted property.
The general rule, however, doesn’t apply if the C corporation transferor makes a “deemed sale election,” which accelerates the gain. Under the election, the C corporation recognizes gain and loss as if it sold the converted property to an unrelated person at fair market value. The REIT or RIC then takes a fair market value basis in the converted property.
The proposed exceptions
In April 2012, the IRS released proposed regulations with two exceptions to the general rule:
- 1. Exchange exception. A REIT or RIC isn’t subject to the built-in gains tax if the conversion transaction qualifies for nonrecognition treatment as a like-kind exchange or involuntary conversion into similar property or money, where the C corporation replaces the transferred property with other property with the same basis as the transferred property.
- 2. Tax-exempt exception. If the C corporation falls within one of eight categories of tax-exempt entities (including charitable remainder trusts), the transaction isn’t subject to the general rule if the tax-exempt entity wouldn’t be subject to tax (such as under the unrelated business income tax rules) on gain resulting from a deemed sale election if the election had been made.
The final regs retain these exceptions, with some critical clarifications in response to feedback on the proposed regulations.
The final regs’ clarification of the proposed exceptions
The IRS acknowledged that the proposed regs may have been unclear about whether the tax-exempt exception applies to a transaction where some of the gain from a deemed sale election would be subject to tax if such an election were made, while some of it wouldn’t be.
The final regs clarify that the general rule doesn’t apply to a conversion transaction in which the C corporation that owned the converted property is a tax-exempt entity to the extent that gain wouldn’t be subject to tax if a deemed sale election were made. In other words, if the tax-exempt entity would have been subject to the unrelated business income or similar tax on only a portion of the gain if the entity had made the election, the built-in gains tax applies only to that portion of the gain — not the entire built-in gain.
The IRS also considered a requested clarification that the exchange exception applies to certain multiparty like-kind exchanges involving intermediaries, including reverse like-kind exchanges (where the replacement property is acquired before the relinquished property is transferred). The IRS declined to change the proposed regulations. But it stated in the preamble to the final regulations that the exception operates to exclude any realized gain that isn’t recognized by reason of either a like-kind exchange or an involuntary conversion regardless of the transaction’s form.
While the final regs are intended to prevent the avoidance of corporate-level taxes, the exceptions do provide some protections. Your financial advisor can help you determine the best tactics for minimizing your liability for built-in gains tax.