I. Introduction
Companies from industries as diverse as casino gaming, private correctional facilities, data warehouses, and billboard companies have all recently applied for or been granted status as a real estate investment trust. These conversions have strained statutory requirements and come with significant tax consequences that erode federal income tax collection efforts. At a time when corporate tax avoidance measures have reduced the corporate income tax base, REIT conversions allow even more companies to partially or entirely avoid paying corporate taxes. These REITs effectively exist as passthrough entities for income tax purposes, further lowering an already decreasing tax base.
These REIT conversions provide significant tax benefits for the eligible businesses; however, even bigger consequences may stem from the grant rate for REIT conversions in private letter rulings. Those rulings stretch the intent of the formal REIT qualifications to the point that any business with an immovable structure that creates revenue might qualify as a REIT. The IRS took notice of that development and formed a working group in 2013 to consider whether the definition of real property in the REIT provisions needed modification. Treasury also recently released amended regulations about what qualifies as real property for REIT purposes.1 Even if those proposed regulations become effective, they may be insufficient to effectively tackle REIT expansion. Because of congressional gridlock on meaningful tax reform,2 REIT growth may remain problematic for years to come.
Although media sources have observed this REIT expansion, little scholarly attention has been devoted to it. This report attempts to fill that gap. REIT qualification has potentially become a runaway train, creating perverse incentives for entities with marginal real estate interests to apply for REIT status in a way Congress likely never intended. Further, the ability for taxable REIT subsidiaries (TRSs) to perform many of the services that would otherwise disqualify most entities from operating as a REIT has allowed virtually any company with significant real estate holdings to reduce its tax bill.3 The ability of these subsidiaries to eliminate passive real estate income from the corporate tax base has significant implications for the expansion of REIT qualification.
The problem in the recent REIT trends is not necessarily that they represent a departure from a principled definition of real estate but that they demonstrate that the IRS and Congress have fundamentally erred in determining how to approach the tax treatment of REITs and companies with passive REIT-like characteristics. Lawmakers are essentially at a fork in the road. Taking one path, they might conclude that the recent expansion of the definition of real property is problematic and requires a reining in of REITs. Alternatively, one might also conclude that the real REIT problem stems not from how real property is defined but from inconsistent tax treatment of REITs relative to other passive businesses. There may be little about real estate that merits the type of favorable tax treatment that REITs receive and that forecloses passthrough treatment for other passive investments by corporations. This potentially illogical distinction, rather than the REIT-specific trends, may be the most troubling aspect of the recent conversions.
II. REIT History
A. Pre-1960s' Legislation
An early form of REIT was the Massachusetts business trust (MBT). In the 19th century, Massachusetts law restricted corporate ownership of real estate. As a result, many corporations formed trusts as an instrument for investing in real estate.4 As a passthrough entity, MBTs provided tax-advantaged status for investors. But the Supreme Court's decision in Morrissey v. Commissioner5 effectively stripped tax advantages of REITs in MBT form. It held that any business trust with sufficient corporate characteristics should be subject to the corporate income tax. Shuttered as an opportunity to mitigate the effects of double taxation, REITs often failed to receive the beneficial tax treatment pre-Morrissey unless the entity sufficiently resembled a partnership. Investment funds obtained relief from the Morrissey decision in 1936 when Congress provided statutory exemptions from corporate taxation for entities qualifying as regulated investment companies.6 Real estate interest groups, however, waited 20 years for any similar legislation.
In 1956 Congress passed legislation that would have allowed REITs to operate with tax benefits similar to what they had under the MBT form. President Dwight D. Eisenhower vetoed the legislation, however, expressing concern about enabling corporations to qualify, harming the corporate income tax base, and enacting provisions broader than those for RICs.7 REITs thus had to wait four more years before legislation was passed that provided them tax-advantaged treatment like RICs.
B. REIT-Enabling Legislation and Slow Growth
A bill proposed in 1960 attempted to address Eisenhower's earlier concerns. Importantly, the new legislation would not allow existing corporations to qualify as REITs. It was designed to extend to REIT investors effectively the same tax treatment that taxpayers would receive if they directly invested in the real estate entities. REITs would be treated as mere investment pools in which smaller investors could pool assets to acquire real estate interests previously available only to larger-scale investors.8 REIT proponents, who sought to effectively eliminate the corporate tax on these entities, likened the pooling and diversification benefits of REITs to those of RICs. Importantly, the tax status provided by the bill was "intended to be limited to passive investment in real estate, not to extend to entities engaging in the active operation of a real estate business."9 The REIT-enabling legislation was eventually added as a Senate floor amendment to the Cigar Excise Extension Act of 1960 and was signed into law.10
Growth was slow in the early REIT years, with only 10 REITs of any meaningful size existing during the 1960s.11 There were, however, a total of 15 REITs that had filed with the SEC within the first six months of 1961, with a total offering of approximately $125 million.12
REIT growth was slow for two reasons. First, REITs operated as passive investment vehicles for real estate but could not actively operate or manage the real estate assets. When management of the property was necessary (as, for example, in the ownership of apartment complexes), REITs had to engage third-party contractors to provide management services.13 Third-party contractors often had divergent interests from the REIT owners in operating and managing the property, thus creating a potential principal-agent problem between the REIT investors and their operator-managers. The market for investment did not respond favorably.14
The second reason for slow growth was that before 1986, many non-REIT real estate investors could take advantage of favorable provisions in the tax code to shelter income.15 Taxpayers would incur high debt levels, depreciate the real property aggressively, and, through interest and depreciation deductions, use paper losses to offset other income.16 REITs, by contrast, are designed to create taxable income and cannot pass losses through to shareholders the same way partnerships can. That restricted the REIT industry from competing with tax shelters for investors.17
C. The 1986 Revisions Through the 1990s
The Tax Reform Act of 1986 resulted in several significant changes that made REITs a more attractive investment vehicle. TRA 1986 permitted REITs to own and operate most types of income-producing properties merely by providing the type of customary services associated with real estate ownership.18 For the first time, REITs could provide an increasing amount of services to their tenants, which liberalized the use of REITs and began eroding the notion that they were purely passive investments.19 But growth in the REIT industry after TRA 1986 did not come until around 1992.20 That was when the real estate market began to turn around, and real estate investors began to realize that the best way to access public capital was through a REIT.21 Those factors combined to produce significant growth in the REIT industry through the rest of the 1990s. The total market capitalization of the REIT industry in 1992 was approximately $13 billion and grew more than tenfold to $150 billion by 1998.22
D. The Evolution of the Taxable REIT Subsidiary
one of the biggest legislative changes was enacted in December 1999 with the REIT Modernization Act.23 The legislation enabled nearly any REIT to form and own a TRS to perform substantial services to tenants without jeopardizing the REIT's tax-favored status.24 No longer required to earn their income primarily through passive sources, REITs could now provide typical real estate management services without using third-party contractors.25 REITs became a more attractive investment choice than other forms of property ownership because they were allowed greater oversight over the services offered and had the opportunity to earn additional non-rental income.26 Soon after the TRS-enabling legislation, TRSs grew at a breakneck pace. From 2001 to 2004, the number of TRSs increased from 379 to 704, and total TRS assets quadrupled from $16.8 billion to $68.2 billion.27 That expansion caused some to question whether the original justification for creating REITs -- passivity -- was still a requirement for REIT eligibility.28
The picture over the last decade is not all rosy, however. With the burst of the real estate bubble in the mid-2000s came poor returns for REITs. The combined effect of the burst buble, the increasing subprime mortgage crisis, and a global credit crunch caused REIT performance to suffer significantly. In 2007 and 2008, for example, annual REIT returns were -14.9 percent and -49.1 percent, respectively, as compared with Standard & Poor's 500 returns of 2.1 percent and 45.7 percent for the same periods.29 REITs have made a strong recovery since the crash, more than tripling in market capitalization from their all-time low in 2008.30 As of January 1, 2012, there were 166 publicly traded REITs registered with the SEC, with a combined market capitalization of approximately $580 billion to $650 billion.31 However, there are many more non-publicly-traded REITs -- approximately 1,10032 -- that when combined with the publicly traded REITs, own more than $1 trillion in real estate assets, according to the leading REIT industry group.33
III. Qualifying as a REIT
Qualifying as a REIT involves satisfying many requirements. The most important are that the REIT (1) invests no less than 75 percent of its total assets in real estate assets;34 (2) derives no less than 95 percent of its income from dividends, interest, and rents from real property, and no less than 75 percent of its income from rents from real property;35 (3) has no more than 25 percent of assets represented by securities (including ownership of TRSs);36 and (4) during a given tax year, distributes as a dividend to shareholders an amount that generally equals or exceeds 90 percent of REIT taxable income.37 These requirements essentially establish a sharp line between passthrough treatment and double taxation, thereby giving savvy companies and tax lawyers an incentive to exploit the code's provisions.38
A. Asset Test
As was evident from the initial REIT-enabling legislation, Congress intended REITs to invest primarily in real estate assets.39 Thus, the statutes require a REIT at the end of each quarter to have at least 75 percent of its assets represented by "real estate assets, cash and cash items . . . and Government securities."40 Real estate assets are defined in the Treasury regulations and include real property, which the IRS has defined as "land or improvements thereon, such as buildings or other inherently permanent structures thereon (including items which are structural components of such buildings or structures) [and] interests in real property."41
While the definitions appear to foreclose various types of assets from qualifying under the statute, the statutory language and regulatory definitions are not as airtight as one might believe. For example, in LTR 201236006, the IRS indicated that some deferred offering costs -- similar to prepaid expenses in that generally accepted accounting principles treat them as an asset to be included on a company's balance sheet -- were to be treated as having a value of zero. That, of course, artificially reduces the total value of the non-real-estate assets held by the REIT and makes it easier for its real estate holdings to constitute 75 percent of the REIT's total assets. In a similar vein, the IRS has treated investments in a money market fund as a cash item eligible for inclusion in the 75 percent test.42
These examples, combined with a potentially liberal interpretation of what constitutes real property, have made REITs a more attractive entity structure for avoiding taxes.43 The formalistic definition gives entities with significant real estate holdings the opportunity to engage in tax planning to exploit the significant tax benefits associated with REIT classification. Similar issues arise under the REIT income tests.
B. Income Tests
A REIT must annually satisfy two separate income tests. First, at least 75 percent of its gross income must result from passive income connected with various real estate activities, the most prevalent being rents from real property.44 The second test, which significantly overlaps the 75 percent test, requires that 95 percent of the REIT's gross income results from passive income from dividends, interest, rents from real property, and from various categories similar to those under the 75 percent test.45
The key element of the two income tests is the definition of the term "rents from real property." That definition includes and excludes specific forms of income. It includes rents from interests in real property, charges for customary services furnished in connection with real property rental, and some amounts of rent attributable to personal property leased in connection with a real property lease.46 It excludes rents determined based on the net profits of any tenant.47 Presumably, that is to prevent the REIT from conducting an active business in order to support or solicit the operations of the tenant.48 Also, rents received by some related parties -- any entity in which the REIT owns 10 percent or more of the stock (by vote or value), assets, or net profits -- do not qualify as rents from real property.49 In what has become understood as another attempt to ensure the passivity of the REIT, "impermissible tenant service income" is not treated as rents from real property. This is any amount received for furnishing to the tenant services that are generally not customary, provided by an independent contractor, de minimis, or provided by a TRS.50
C. Ownership of Taxable REIT Subsidiaries
In addition to the 75 percent asset test, a 25 percent test limits a REIT's total assets to no more than 25 percent securities.51 After legislation in 1999, a REIT may now own a TRS, but no more than 25 percent of the REIT's assets can be represented by ownership of securities in one or more TRSs.52 Except for TRSs, the REIT may own no more than 10 percent of the total value of the outstanding securities of a single issuer.53
As noted above, the TRS legislation was significant for the REIT industry.54 Before the REIT Modernization Act, REITs primarily used independent contractors to provide noncustomary services to tenants. This was unappealing for REIT investors because the REIT was unable to receive any income from the services provided by an independent contractor.55 Further, because of rules that prevented significant overlap between the REIT and the independent contractor,56 the REIT could exercise only a limited amount of quality control over the services provided to tenants.
The TRS-enabling legislation eased that problem for REITs. In essence, a REIT may own a TRS and have the TRS provide noncustomary services to tenants without disqualifying the rents as impermissible tenant service income. In exchange, all activities performed by the TRS are subject to a corporate-level tax. There are few limitations on a TRS's activities, but it cannot operate a lodging or healthcare facility or provide any person rights to the brand name of a hotel or other lodging facility.57
The REIT statutes appear to delineate tax treatment based on active management versus passive ownership. The passive REIT can generally avoid paying corporate-level taxes, whereas the TRS that actively provides non-customary services to the REIT's tenants is subject to the corporate-level tax. This allows a company like McDonalds to hold its land and real estate assets as a REIT with a TRS that operates the restaurant business -- effectively separating capital from labor and applying passthrough taxation to the capital inputs and corporate tax treatment to the labor-related income.58
D. Distribution and Resulting Tax Treatment
A REIT is obligated to distribute a significant amount of income to shareholders. This makes REITs attractive for those seeking investments that actively pay dividends.59 In general, a REIT is required to distribute at least 90 percent of its otherwise taxable income.60 To reduce its taxable income to zero, however, a REIT will typically distribute all of its otherwise taxable income in the form of a shareholder dividend. The dividend must be pro rata and without preference to any class of stock, except if the REIT organization documents provide that a particular class of stock is entitled to a preference.61
Satisfying the distribution test and the various other REIT requirements described above entitles the REIT to passthrough-like treatment. The IRS will effectively treat the REIT as a mere conduit and not impose an entity-level tax on income, but the current statute prevents the REIT from passing losses through to shareholders. That prevents the REIT from being used predominantly as a tax shelter.62 But rather than subject the REIT to the partnership tax treatment of subchapter K, the statute provides that the REIT receives a full deduction for any dividends paid to shareholders.63 If the REIT fails to meet the 90 percent threshold, it will be obligated to make an allocable corporate-level tax payment. The REIT investors typically pay taxes based on ordinary income, rather than capital gain, for the dividends received.
While other real estate investment forms avoid the payment of corporate taxes by using debt to finance the acquisition of property and taking interest and depreciation deductions, the REIT structure provides an advantage for entities that wish to eliminate the risk of debt-financed property acquisition.64 The flip side is that REITs, by distributing their income annually, do not retain earnings like most corporations and therefore must often depend on frequent equity infusions in order to grow. But a REIT has the ability to avoid corporate-level taxes, which is one of its most attractive features. Paying just one level of tax provides a significant savings to the entity and generally makes the investment more appealing to investors.65 Industry insiders estimate that the stocks of corporations that convert to REITs are worth from 15 percent to 20 percent more based merely on the tax arbitrage opportunities available by converting.66
The market thus indicates that investors value REITs' potential as investment vehicles, and it suggests that corporate requests for REIT qualification will increase. Given the IRS's apparent leniency in granting REIT status in recent private letter rulings, this trend could pose problems for revenue collection and maintenance of the corporate tax base in the United States.
IV. The IRS's REIT Problem
Critics have argued that the IRS, through a series of recent letter rulings, has expanded the definition of real property to enable entities with core activities far outside the real estate business to obtain REIT status.67 In response, the IRS in June 2013 temporarily suspended all REIT rulings in order to conduct a study with an internal working group to determine whether the standards the agency used to define real property require any adjustments.68 The IRS elected to resume its practice of issuing REIT rulings in November 2013, with no public announcement on whether any changes were made in interpreting the REIT statutes or whether any additional guidance would be forthcoming.69 As discussed in Section IV.D, Treasury recently issued proposed regulations on the definition of real property for REIT purposes.
The letter rulings could entice real estate businesses that otherwise would not have considered a REIT conversion to pursue one now. That outcome would further erode the tax base, perhaps at the expense of a principled interpretation of the REIT statutes. Under the framework the IRS has created, it would be conceivable to see industries as diverse as infrastructure (builders of private highways, bridges, or ports) and farm operation, and owners of cemeteries, landfills, and vineyards -- presumably any other immovable structure that yields revenue -- lining up for REIT rulings.70 Whether intended or not, the IRS has opened the door to further corporate tax erosion through its interpretation of real property.71
Of course, private letter rulings officially have no precedential effect and cannot be relied on by other taxpayers or by IRS personnel.72 But because the IRS arguably has a duty to rule consistently when similar or analogous facts are presented, taxpayers often unofficially rely on letter rulings when determining whether to take a particular course of action.73 (And with the recently proposed regulations, companies may have more than just private letter rulings to rely on in the future.)
Over the last two years, the IRS has granted REIT status to such varied industries as private prison operators, server farms, casino gaming resorts, and billboard companies. The following discussion focuses on those rulings and the potential expansionary interpretation the IRS took in each case.
A. Private Prison Operators
Two separate private prison operators -- GEO Group and the Corrections Corp. of America (CCA) -- received private letter rulings in the past 18 months giving them the green light to convert to REITs. The underlying facts of each letter ruling are remarkably similar. The following analysis focuses on what is believed to be CCA's letter ruling, 201320007, although distinguishing aspects of GEO Group's ruling are also described.
CCA represented to the IRS that it owned and operated correctional facilities, formed lease-to-own agreements with government tenants, or managed government-owned correctional facilities.74 In most cases, CCA owned a correctional facility and entered into a lease with a local, state, or federal government to allow that government to house inmates. CCA would provide various services incident to incarceration, including security, food service, medical and dental services, mental health services,75 educational programming, and inmate transportation. CCA agreed to form a TRS to provide all non-customary services, but the parent REIT would collect the charges paid by the government agency for work done by the TRS and remit payment to the TRS under an arm's-length agreement.76 CCA requested advance rulings that (1) the facilities were neither lodging nor healthcare facilities77 and (2) that the contracts with the various governments constituted rents from real property for purposes of satisfying the income test under section 856(c). The IRS ruled in favor of CCA on both issues.
In ruling 1, the IRS focused on the healthcare facility question. It concluded that although CCA was obligated by its contracts with government agencies to provide "some level of medical, dental, and mental health services, as required by the prisoners and detainees," its correctional facilities were not healthcare facilities because those services were not part of the facilities' "primary function." Because CCA's facilities were not licensed as medical facilities, the IRS ruled that they did not constitute congregate care facilities. Thus, the TRS was able to provide those services without violating the statute. Whether this results in substandard levels of care in private prisons is a question that largely exceeds the scope of this report, but the IRS certainly has provided an incentive for CCA and GEO Group to provide the minimum level of care in order to satisfy the REIT qualification requirements.78
The IRS's ruling on whether the contracts with the government constitute rents from real property is light on justification, spanning merely two paragraphs. The IRS seems to be satisfied that the contract payments received by the REIT (not the TRS) are payments for the right to use space within the facilities and that the non-customary services are provided by the TRS.79 In this realm, there are significant obstacles in determining customary income. Treasury regulations observe that services are customary if buildings in the geographic market provide the same service.80 With prisons, however, there are often few -- if any -- located in similar geographies. This provides little actual comparison for the IRS to base its determination on and effectively allows the prison operator to establish what sorts of services are customary for the tenants. To borrow an analogy, it is a case of the inmates running the asylum.
This arrangement has faced widespread scrutiny from mainstream media sources and tax scholars alike.81 The operation of private prisons by CCA and GEO Group was converted into separate entities -- one serving as the passive owner of real estate earning rents from so-called tenants, while the other conducted the actual business -- all to escape the corporate tax associated with the real estate aspects of the operation. If one believes that the money received from government agencies for housing prisoners is properly characterized as rent, the IRS's determinations are consistent with the statutory definitions. But the fact that the actual tenants of the building are not the government agencies contracting with the private prison operators raises several questions.
Looking at the business model of CCA and GEO Group, disentangling the service-related aspects of the business from the real-estate-related aspects is difficult. While real estate is a necessary aspect of the business, the differentiator for governments when selecting which private prison operator to contract with is likely determined more on the basis of the value-to-cost ratio of services provided by the contractor. To suggest that this type of operation, which has significant aspects of tax avoidance embedded in the proposal, has at its core a real estate business is, at best, a charitable description of private prisons. Because the businesses share an umbrella entity, the possibility of tax avoidance is an even greater concern given the potential abuse in establishing the purported arm's-length terms of the deal between the parent and the TRS. It certainly exceeds the congressional intent behind the REIT-enabling legislation.
B. Data Warehouses and Server Farms
To a client storing off-site data with an external vendor, the physical location of the computer servers is usually of minimal consequence. These centers use a significant amount of energy -- in some cases enough to power a small town -- and the value of the data center lies not in the physical structure of the building but in the infrastructure, cooling, and power systems that exist within the facility.82 The charge for customers of these services is based on a combination of actual space used and power usage.83
These industries have been very active in seeking REIT conversion rulings. Many of them were placed on hold while the IRS investigated its letter ruling decisions, but one in particular, from early 2013, illustrates the trend toward more favorable rulings. In LTR 201314002, the taxpayer (believed to be CyrusOne) requested a ruling that a newly formed company that was to serve as the general partner in an operating partnership organized to "acquire, lease, purchase, develop, and build data center buildings and to lease such properties to . . . tenants" would be treated as a REIT. The space to store the virtual data and physical documents was constructed on raised flooring to facilitate the various heating, ventilation, and air conditioning (HVAC), security, electrical, and power systems. The ruling makes clear that each of the electrical, HVAC, security, fire protection, and telecommunications components is designed to remain permanently in place and is unlikely to be moved or removed, but no similar mention was made regarding the raised flooring.
The taxpayer represented that the partnership would provide the following "customary" services: controlled humidity, security, fire protection, maintenance and repair of the building, parking, telecommunications infrastructure, cleaning of public areas, and landscaping.84 Other non-customary services, including the repair and maintenance of the data equipment (owned by the tenant) and the information technology management services, were to be provided by either an outside contractor or a to-be-formed TRS.85
Ultimately, the IRS ruled that the components that housed and stored documents and data constituted real property under section 856(c) such that the price paid by the so-called tenants was the rental of real property under section 856(d).86 The IRS relied on Rev. Rul. 75-424, 1975-2 C.B. 270, which concluded that heating and air conditioning systems are real estate assets but that prewired modular racks that support the equipment installed on them and that are bolted into the floor and ceiling are accessory to the operation of a business and are not real estate assets. Relying on that revenue ruling, the IRS determined that the structures inside the data centers help facilitate the businesses of the tenants and that the components themselves were not assets accessory to the operation of a business.87
A structure that merely serves as a mounting point for equipment could produce rents from real property if it is substantial and permanent in nature.88 But the raised flooring (which may or may not be bolted to the floor) in the CyrusOne letter ruling bears some similarity to the modular racks in Rev. Rul. 75-424 that were treated as accessory to the operation of the business and not real estate assets. What's more, the use of racks and movable server cabinets appears to be an industry standard.89 To suggest that these entirely movable components that are integral to the operation of the data storage business constitute real estate assets seems to strain the definition of real property. Further, the value proposition of these types of businesses comes from their ability to provide power and cooling services rather than as providers of value through real estate. Not only do they benefit from the avoidance of corporate tax, they also are not scrutinized by other regulatory agencies for their pricing practices.90 By selling power and energy services in order to allow the data collocation that its customers request, these server farms and data centers operate more as unregulated utilities than as real estate landlords.
C. Billboard Advertising
Two published letter rulings shed light on taxpayers' ability to convert billboard advertising businesses into REITs. In both, the taxpayer rented space on outdoor billboard structures connected to the underlying property in various ways. In LTR 201143011, the billboard structure was mounted to either the roof or an exterior wall of the building by bracing it to the beams of the building. Alternatively, the billboard structure was anchored into the earth through concrete foundations as deep as 30 feet. In LTR 201204006, the signs were connected to a steel frame that was bolted to the facade of each building. In each ruling, the billboard space was leased out to various advertisers to market their products and services. The billboard structures added nothing to the structural integrity of the buildings themselves.
Both rulings invoked Rev. Rul. 75-424, 1975-2 C.B. 270, which considered a system containing transmitting and receiving towers that were built on pilings or foundations, and transmitting and receiving antennae that were affixed to the towers. The revenue ruling concluded that the antennae connected to the towers were not real estate assets for REIT qualification purposes. By analogy, it seems that a billboard structure, connected physically to the building that is connected to a foundation within the ground, also fails to qualify as real property for REIT purposes. The IRS concluded otherwise.
In both LTR 201143011 and LTR 201204006, the IRS determined that the billboards connected to the building facades and roofs were real estate assets because they were constructed to remain in place and removal would be a costly, time-consuming undertaking. That conclusion is somewhat ironic, given the IRS's disavowal of the use of state law fixture definitions in the Treasury regulations. By attaching otherwise personal property to a building or a structure that is intended to stay in place in a building91 -- something the taxpayer alone controls -- the taxpayers effectively received permission from the IRS to convert personal property into real property for REIT purposes.
The rulings were an about-face from those on the now-repealed investment tax credit. The credit was available for the use of specified tangible personal property used in the taxpayer's business.92 In line with the statutory framework, the Tax Court held in Whiteco Industries v. Commissioner93 that the use of outdoor advertising signs placed along a highway and cemented into the ground was tangible personal property and eligible for the ITC. Indeed, regulations said that neon and other signs attached to a building constitute tangible personal property for purposes of the ITC.94 The IRS, instead of relying on regulations that spoke directly to the issue, relied on a set of judicially created factors to conclude that the billboard structures were real property.95
D. Proposed Treasury Regulations
on May 9 Treasury issued proposed regulations that provide additional clarity to businesses that might seek REIT status. The regulations primarily address determining when an asset is deemed real property for purposes of satisfying the 75 percent asset test. They note that three different categories of property can qualify as real property: land, improvements to land, and other inherently permanent structures.96 For non-land and non-building properties, the IRS has designed a "distinct asset" standard whereby a taxpayer must first determine the property subject to classification and then test it against the definitions of real property.97
Under the distinct asset test, a taxpayer can establish that property is real property in several ways. If the asset is specifically listed in the regulations or in public guidance and it has a passive function -- meaning an asset that is not involved in the production of goods -- it will qualify as real property.98 For other property not listed in the regulations, the IRS will apply various factors, including several discussed in Whiteco, to determine whether the property should be considered a real estate asset.
Although there are other important details in the proposed regulations, they would largely codify the results in the previously discussed letter rulings. That endorsement of the letter rulings has done little to resolve the problem that they created. on the contrary, if these regulations are adopted in final form, they will further widen the gap between current law and a principled definition of real property. The combination of the letter rulings and the proposed regulations has created a potentially inappropriate application of the code. So what can be done? If lawmakers are concerned about the effects of the rulings, there are many options for eliminating or reducing the growth of these types of REITs.
V. Reining in REITs
It is difficult to assess the costs associated with the recent REIT conversions. However, analysts are able to estimate the annual tax savings for companies that convert to REITs. For example, CCA's REIT election saved it an estimated $70 million in 2013 taxes,99 and the tax savings associated with GEO Group's REIT conversion allowed it to increase its dividend payment from 80 cents per share to $2 per share.100 If one is convinced that these entities are straining the definition of real estate in order to minimize their taxes, Congress should take action to mitigate the erosion of the corporate tax base in this area. Fortunately, there are several tools at the IRS's and Congress's disposal to curb the growth of REITs.
A. Defining Real Estate
Among the loudest complaints about the recent REIT conversions are concerns about a principled use of the definition of real property.101 The recently proposed regulations reflect that concern, and there is much discussion of whether the definition of real property should be reined in to restrict the types of entities eligible for REIT rulings. It has proven administratively challenging for Congress to provide consistent definitions of real estate in the tax code, given the code's complexity and the different intent behind various real-estate-related provisions. Consistency among the code's real property provisions has recently been considered as a possible way to restrict the broadening of the IRS's interpretation of real property for REIT rulings.
John Patrick Dowdall recently looked at sections 48, 168, 263A, 897, and 1031 to consider whether the IRS could consolidate its interpretation of real property.102 Ultimately, he rejected the notion that the IRS should apply its REIT definitions consistently with the approach in any of those other provisions. Dowdall cited congressional intent, the risk of expanding the definition of real property, and a lack of coherence in other provisions as reasons to reject this comparative approach.103 Importantly, he also referenced differing policy objectives embedded in other provisions.104 That final argument is the most compelling reason to revise the REIT definition without any reference to other provisions in the tax code. Those other real estate provisions were designed to address different issues than those facing REITs. Any resulting comparisons could be overbroad, too specific, or at least not on point with the concerns associated with the tax consequences of an expanded definition of real property. If the solution is to change the definition of real property, that should be done independently of the real property definitions outside the code's REIT provisions.
Another alternative is the recent proposal by House Ways and Means Committee Chair Dave Camp, R-Mich., to limit the definition of real estate by excluding tangible property with a class life of less than 27 1/2 years for depreciation purposes.105 That would eliminate the possibility of billboard companies qualifying as REITs, because the IRS has determined that billboards have a class life of only 20 years for depreciation purposes.106 Not only would this legislation reverse the letter rulings discussed above, it would also prevent CBS Outdoor Americas from obtaining the REIT conversion it is now seeking.107 Other categories of assets that would be treated as personal property include transmission towers, service stations, gas pipelines, railroads, and some types of storage.108
This approach has some intuitive appeal. For one, it simplifies the IRS's job by creating a relatively easy bright-line standard.109 The IRS has established significant guidelines regarding what type of property qualifies under various class lives, and taxpayers have advance notice of whether their type of property would qualify. But this approach also demonstrates the potential limits of the recently proposed regulations clarifying the definition of real property. It is doubtful that Treasury has the authority to make such a significant modification to the law. So even if the REIT regulations are finalized, Camp's proposal suggests that agency action may be insufficient if curbing REIT growth is the path that lawmakers ultimately wish to pursue.
The Camp proposal also addresses the REIT concern head-on by modifying what is perceived to be the root of the problem: the expanding definition of real property, which is the result of an unclear definition. Modifying that definition would indeed help curb some of the types of REIT rulings the IRS has issued in recent years, but not all of them. For example, modifying the definition would not slow the rulings for private prison operators because the actual prison facilities have a longer class life than 27 1/2 years. So while Camp's proposed solution is a promising opportunity to reduce REIT growth, it is not a cure-all.
Congress has several other opportunities for change within the definition of real property as a tool to reduce the expansion of REITs. It could look at the definition of assets accessory to the operation of a business,110 it could further limit the types of permissible customary services that qualify as rents from real property,111 or it could require that real property assets include only components necessary for the structural integrity of the building.112 Each of those modifications would restrict the types of assets eligible for classification as real property for purposes of the REIT asset and income tests. In the end, Congress could decide that other, more systemic issues have led to the REIT bubble.
B. The TRS and Passivity
Shortly after the REIT-enabling legislation, a commentator said that in "the interest of a sound tax structure, it is imperative that tax exempt entities be confined in their activities to passive investment," and he observed that REITs "have been defined so as to preclude them from functioning in an active business area capacity."113 Today's REIT regime is very different from that under the original legislation. When the REIT Modernization Act passed, the introduction of the TRS altered the landscape of REITs as passive real estate entities.114 A TRS today can operate with little restriction on its active business operations.115 This opens up the REIT structure to several businesses that otherwise would fail to qualify without the ability to operate the subsidiary as an active business. As seen from the various REIT rulings, the TRS is an integral part of nearly all REITs.116
Perhaps the most effective way to curb the growth of REIT expansions is to repeal the permissibility of TRSs. Because the TRS is an integral part of most REITs today,117 eliminating its use would significantly curtail the expansion of REITs. Not only does the REIT-TRS relationship provide for potential abuse in establishing purportedly fair market prices for transactions between the parent and the subsidiary, but the existence of the TRS negates the original passive function of the REIT itself.
one of the reasons for the TRS statute was to make REITs more competitive relative to other, more traditional real estate businesses.118 But it remains a mystery why this was necessary. REITs have something traditional real estate corporations do not: They are largely freed from paying corporate income taxes. It seems only natural that there must be trade-offs when such a benefit is conferred by the government. For the first 40 years of the REIT's existence, that trade-off was passive operation. But for the past decade, REITs have been free to operate largely without the restriction of passivity as long as they operate with a TRS. Eliminating the permissibility of the TRS could restore that necessary trade-off.
And the potential for transfer pricing abuse between the REIT and the TRS is just as present as it is in the international transfer pricing context.119 That is yet another justification for Congress to consider repealing the TRS statute. It is true that the TRS provisions allow the IRS to impose a 100 percent tax on the REIT for any income received from the TRS that exceeds the amount that would be paid under an arm's-length agreement.120 Although this may deter some would-be offenders, evidence suggests that REITs are audited relatively rarely.121 The lack of effective enforcement combined with the high stakes involved in lowering the tax burden creates an area ripe for abuse -- an area that the IRS could close entirely by eliminating the opportunity for REITs to operate through TRSs.
In the end, eliminating taxpayers' abilities to use TRSs may be too blunt a weapon to solve a problem that seems to stem from the definition of real property. This is especially true if REITs can still revert to using independent contractors to provide active services, since REITs would essentially be allowed to operate in the same manner as with TRSs but with some restrictions on how much of the REIT the independent contractor owns.122 But even that result is unclear. As discussed earlier, operating a TRS has several advantages over using an independent contractor, and even this minor adjustment might make REITs a less attractive option than with a TRS. This method would likely curb the growth of REITs significantly, but Congress might be providing the right solution to the wrong problem if it took the TRS-elimination path.
C. Make Conversions More Difficult
Perhaps it is true, as some claim, that the recent letter rulings apply a consistent definition of real estate and that the definition is not really expanding. Even one who accepts that argument can still be concerned by the growth of REIT conversions. In that case, Congress could create rules that foreclose taxpayers' ability to convert or that impose some sort of financial penalty for conversion.
Last year was a year of innovation in REIT conversions. In 2013 Penn National Gaming shunned the use of a TRS and instead split into two companies in a tax-free spinoff. In the spinoff, Penn dropped its real estate assets into to a newly formed subsidiary (the PropCo) while the parent retained responsibility for the operations of the casino business (the OpCo). After the spinoff of the PropCo to the OpCo's shareholders, the PropCo and OpCo entered into a lease agreement whereby the OpCo retained the right to operate the PropCo's facilities. The IRS blessed this entire transaction in LTR 201337007.
Penn was the first entity to try this strategy, 12 years after the IRS gave consent to the method in Rev. Rul. 2001-29, 2001-1 C.B. 1348. To qualify for a tax-free spinoff, both the distributing and the controlled corporations must be engaged in the active conduct of a trade or business.123 Because a corporation is treated as engaged in active management only when performing active and substantial management and operational functions, there was doubt about whether REITs would qualify, given their existence as holding companies for real estate. Despite a REIT's purported passivity, the IRS deemed that REITs can perform activities that constitute active management because they are permitted to provide specified services that are not primarily for the convenience of the tenant. With Penn's success, there is a potential for much larger companies with sizable real estate holdings -- McDonald's, for example124 -- to isolate and ensure tax-free treatment of the passive real estate holdings. It might also stimulate investor value in ventures that might otherwise have been unattractive.125
Perhaps as a sign of Congress's disapproval of this transaction structure, Camp's 2014 tax reform draft includes a proposal that would eliminate REITs' ability to engage in section 355 tax-free spinoffs.126 The provision would apply to companies seeking to follow the Penn model; it would prevent the distributing corporation and the controlled corporation from electing REIT status within 10 years following the spinoff.127 Camp's method is essentially another way to attempt to limit the REIT conversion without touching the definition of real estate. By proposing to make the conversion process more difficult (with or without removing the ability to form a TRS), Camp signaled his disapproval of the expanding universe of REITs.128
The Camp proposal would do more than just eliminate the use of tax-free spinoffs by legislatively overriding Rev. Rul. 2001-29. It would also impose a tax on the amount of built-in gain inside the corporation when it elects REIT classification.129 Rather than impose a corporate-level tax on the REIT for the sale of any built-in gain assets sold within 10 years of the conversion, the proposal would require immediate recognition of all built-in gain immediately after the conversion.130 That requirement could "effectively eliminate REIT conversions."131
Either of these proposals could significantly change REIT conversions. But if Congress is forced to make difficult political choices, should it pursue this option or instead target the purported culprit of the REIT expansion problem -- the definition of real estate? The Camp approach is decidedly different from restricting the types of real estate businesses that are eligible to become REITs. It certainly provides additional opportunities to ensure revenue generation. Repealing the spinoff rules and requiring recognition of all built-in gain would increase revenues by nearly $6 billion over the next 10 years, according to the Joint Committee on Taxation.132 But that, too, is the right solution to the wrong problem. Critics of the recent REIT rulings have been concerned not with the ease with which corporations can convert to REITs without incurring a corporate-level tax on the built-in gain, but that they are doing so under an expansionary interpretation of real property.
only when one reframes the argument as being more broadly about corporate tax evasion do the conversion proposals begin to make sense as a tactic to restrain REIT growth. But if the goal is truly to curb the continuing erosion of the corporate tax base, Congress might be better off focusing on other high-dollar areas.133
Another challenge to implementing the conversion policies would be the significant advantage to existing REITs at the expense of companies seeking to convert under the new rules. Although any new rule could come with a transition period for companies to complete their conversions (which might itself cause a surge of conversions), Congress is free to change the rules before, or even after, entities have made economic commitments. The larger issue, however, is that curtailing conversions does not address the problem of inappropriate entities operating as REITs. Benefiting the existing REITs at the expense of otherwise eligible REITs also introduces fundamental questions of fairness.134 And given the administrative, accounting, and record-keeping requirements associated with making the REIT election, it would likely be difficult for newly formed entities to operate as REITs as an initial corporate structure.135 The conversion proposals might thus create a closed universe of existing REITs, which would slowly wean down until the REIT structure became extinct in the United States. It seems unlikely that this is the result Congress is seeking.
D. Antiabuse Backstop
Congress could take yet another path by introducing some soft factors to determine whether a REIT conversion is appropriate. In other parts of the code, the IRS applies a multifactor test to determine whether tax deferral is proper for some corporate transactions.136 Congress could enact similar legislation here to determine whether conduit treatment is suitable for some would-be REITs. This could involve a holistic review that primarily evaluates the nature of the underlying business. Consider, for example, CCA's overview of its business model:
We specialize in owning, operating, and managing prisons and other correctional facilities and providing inmate residential, community re-entry, and prisoner transportation services for governmental agencies. . . . Our facilities offer . . . basic education, religious services, life skills and employment training and substance abuse treatment [, which] are intended to help reduce recidivism and to prepare inmates for their successful reentry into society upon their release. We also provide or make available to inmates certain health care (including medical, dental, and mental health services), food services, and work and recreational programs.137
There is little evidence of the importance of the real estate to CCA's business, aside from the use of the term "facilities" in the overview found in the annual report. Given that CCA's business is described in those terms, it is hard to imagine that the average CCA investor views its interest as primarily a real estate investment. Indeed, the value proposition for CCA is, of course, partly based on the value of its assets but is also based on the company's ability to provide better prison operating services at a lower cost than its many competitors. The value to investors, then, is less about the passive investment than it is about the active services provided by CCA's TRS. This investment description is problematic. The REIT structure initially existed to give investors access to liquid investments in the real estate market without making significant capital injections on their own.138 But if investors can no longer determine with certainty how the business derives value other than knowing that REIT investments provide regular dividend income, the REIT structure has failed to serve its original purpose.
Congress can try to resolve this by developing an antiabuse backstop similar to the provisions in section 355 and the related regulations, which prevent spinoffs that are used as a device to distribute earnings and profits. In the analog REIT provision, the IRS would ultimately need to determine whether the purpose of the conversion was to avoid payment of corporate income taxes. It could balance several factors, including (1) whether there was a corporate business purpose or shareholder purpose for the conversion; (2) the importance of real estate to the business operations; and (3) the amount of active services performed by a TRS. The types of entities that successfully obtain REIT status would likely be those that more closely resemble the traditional landlord-tenant investment envisioned by the REIT-enabling legislation of the 1960s.
Importantly, the IRS no longer provides advance rulings to taxpayers for some important spinoff-related transaction issues.139 Applying that practice to the newly created REIT antiabuse test might be another way to limit the types of entities seeking to convert to REITs. And even if the IRS needed to opine on some narrow matters on which the law is unsettled, it could resist taxpayers' desire to get clarity through the advance ruling process. That would prevent the IRS from overburdening already scarce agency resources and allow it to avoid binding its own hands on some issues.140
Ultimately, if an entity attempted to convert to a REIT and it was determined that it did not qualify because it failed this to-be-created test, undoing the REIT conversion would open up a virtual Pandora's box of problems for that company and create significant litigation exposure in shareholder suits in both state court and under federal securities laws. That might provide some entities a sufficient disincentive to seek conversion if their case for being a REIT was not an obvious one.
Various government actors have expressed concern with the recent REIT expansion. As this report has shown, Congress and the IRS have several nonexclusive tools to slow down or reverse that growth. Decision-makers can pick and choose a la carte to serve whatever external policy goals the government might desire. What is certain, however, is that any of these policy options would have an impact on the REIT industry and would slow what has been perceived as an unwarranted encroachment on the corporate tax base. But what if that perception is wrong? Perhaps rather than curbing the growth of REITs, Congress should instead evaluate the possibility of extending the REIT tax treatment based on principles that apply to all businesses.
VI. Expansion Beyond Real Estate
Passivity's inconsistency with the corporate income tax predates the original REIT and RIC rules and was even discussed in the early entity classification cases.141 With consistency in mind, there is an alternative option that would preserve the existing tax treatment of REITs and in fact expand it to other forms of passive income. Perhaps, rather than guard against the slow expansion of REITs through incremental changes in the IRS's approach to the definition of real estate, the more appropriate solution is to open up the REIT conduit structure to non-real-estate entities. However, given current concerns about continued erosion of the corporate tax base, this is unlikely a politically viable option. But if Congress is serious about horizontal equity in the tax code, providing similarly situated taxpayers with the same tax treatment may merit reconsideration of what seems to be the prevailing approach.
What, then, is the feature that would make the REIT structure unique and suited for non-real-estate businesses? In light of how RICs and REITs evolved, one would expect to draw the line based on whether the entity (or a part of its business) operates passively and whether that passive income is distributed to shareholders. In allowing an entity that satisfies those two requirements to avoid the corporate-level income tax, Congress could remain true to the theoretical underpinnings supporting the same treatment for RICs and REITs. And opening up the tax-free treatment to different trades might reduce claims that Congress unfairly favors industries that have lobbying influence.142
Professor Reuven S. Avi-Yonah has offered a defense of the corporate income tax, largely because it serves a regulatory function to limit the "excessive accumulation of power in the hands of corporate management."143 He maintains that the corporate income tax operates as a restriction on managerial power by limiting the wealth accumulation of the corporation and providing some positive and negative incentives to corporate managers. Central to this claim is an argument that the "accumulation of financial resources [is] the foundation of managerial power" and that the corporate tax system slows the accumulation of those resources and thus provides a limit on the power of managers.144 In this sense, Avi-Yonah says, the corporate tax rate operates as a lever that lawmakers can raise or lower depending on their view about the value of corporate assets.
Avi-Yonah briefly touches on how his theory would apply to nonprofit entities: But for their provision of functions that would "otherwise fall to the state," nonprofits should be subject to corporate tax because their management has "as much power as the management of for-profit entities."145 And although he discusses tax evasion and tax mitigation behavior by corporations, he makes no specific comparison with partnerships or other passthrough entities like RICs and REITs. He also claims that such control cannot "be effectively achieved in a capitalist economy by means other than a corporate tax imposed at a significant rate,"146 but the very existence of RICs and REITs provides a strong counterargument to that claim. And broadly speaking, these two types of entities have had two features in common for most of their history: passivity and distribution. Restricting passthrough treatment to corporations -- real estate or not -- that are obligated to annually pass along their passive earnings to investors provides a justification to forgo the double taxation associated with the corporate income tax, since managers lose some managerial power when a portion of their earnings are automatically distributed.
Other theories of the corporate income tax also support this result. For example, professor Steven A. Bank has argued that capital lock-in can explain the existence of the corporate income tax.147 He says that capital lock-in exists because the legal power to distribute earnings "is in the hands of the board of directors and not because of the tax disincentive to distribute dividends."148 Mirroring the REIT structure, a requirement to distribute passive income would take the legal power from the hands of the board of directors and eliminate the tax disincentive to distribute those dividends, thus reducing the justification for the corporate income tax on that form of income. Much like the argument against Avi-Yonah's claim that the corporate income tax limits managerial power, treating distributed passive income as tax-free also comports with Bank's theory of lock-in as a justification for abandoning corporate tax treatment.
Even if it did not eliminate the corporate-level tax for distributions of passive income, Congress could find a middle ground. It could offer a rate preference for this passive distributed income in a way that might mirror the personal income tax in terms of capital gains rates versus ordinary income rates. This would create inevitable complexity, but the businesses most likely to seek this type of preferential tax treatment would also be the most likely to engage in advance tax planning and hire sophisticated counsel to ensure that their passive income and distributions satisfy any newly created statute.
The resulting structure would operate as a double-edged sword for the recent slew of REIT rulings. on one hand, it would seriously curtail the real estate industry's ability to maintain its current system of tax-free investments because passivity would be required in the investment of specified assets. on the other hand, it would invite entities that are making passive investments that yield regular cash flow to distribute that income to their shareholders, avoid corporate-level tax on that income, and avoid excessive control in the hands of mangers by reducing the cash retained by corporations. To the extent that real estate businesses operate in this fashion, their ability to avoid the corporate tax regime is unlikely to change. If, however, a business cannot isolate passive income from active income, the fair consequence is to require it to pay the corporate income tax.
There are inevitable administrative complexities associated with this proposal. For example, the IRS would have to define passivity in a way that avoids the expansionary issues that have recently become associated with REITs. But the IRS already has a provision that defines passive activity -- section 469. This could be used as a model for lawmakers to use (or adopt in full). Also, Congress could rely on the existing REIT distribution requirements for determining when specific income merited tax-free treatment on the distribution side of the equation.
Of course, enacting this type of regime would impose a significant record-keeping burden on businesses that elected to receive the benefit of a lowered corporate tax liability. But what makes sense is for the business to determine whether the tax-free treatment is worth the associated additional responsibilities. For some corporations, the amount of passive income the business earns will not be worth the cost of compliance with the new law. Others may prefer to retain their earnings -- active and passive -- and reinvest them in other parts of the business, thus subjecting the entity to the corporate income tax. But at least Congress would place all industries on a more even playing field if it gave taxpayers the opportunity to elect this status.149
VII. Conclusion
Baseball great Yogi Berra famously said, "When you come to a fork in the road, take it."150 Federal lawmakers are better off choosing a single path. The incoherence of the current system has placed REITs in the cross hairs, and there is obvious concern by many about the use of REITs as a mechanism to avoid paying corporate income taxes.151 Driving this concern are myriad factors: general worry about the erosion of the corporate tax base, advantageous behavior by questionable "real estate" companies, and perhaps a perception that Congress has gone astray in its recent liberalization of REITs through the TRS. But the recent IRS rulings and proposed regulations can serve as a canary in the coal mine.
If Congress or the IRS chooses to limit this tax avoidance scheme, they have many tools at their disposal. But they can instead try to offer a potentially fairer solution by expanding the ability to treat distributed passive income as free from corporate taxation. Each option comes with its own consequences, and there is no inherently best choice. But choosing a single path is a better option than inaction, and only after choosing one of these options will the REIT structure be coherent and consistent. Whatever direction the Treasury regulations take after public comment, now is the time for lawmakers to consider whether the appropriate action for REITs is contraction or expansion.