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IRS Reduces Built-in Gains Tax Period for REITs to Five Years

New law ahead road signBy:  Amanda Wilson

One of the key benefits of a real estate investment trust (“REIT”) is that it is effectively a pass through entity for income tax purposes.  While a REIT pays tax on its taxable income, it also receives a dividends paid deduction on dividend distributions to its shareholders.  Since a REIT has to distribute at least 90% of its taxable income ever year, this dividends paid deduction effectively wipes out the REIT’s taxable income, avoiding an entity level tax.

To avoid corporations electing REIT status and then selling their assets under this preferential tax regime, the REIT rules require a REIT to pay a built-in gains tax on any gains that were built-in at the time of the REIT election if the REIT disposes of that property within a specified recognition period.  The built-in gains tax rules for REITs are found in Treasury Regulation Section 1.337(d)-7, which applies the S corporation built-in gains tax rules of Section 1374.

The Protecting Americans Against Tax Hikes Act of 2015 (“PATH Act”) amended Section 1374 to reduce the built-in gain recognition period for S corporations from 10 years to 5 years.  Practitioners expected the IRS to modify Treasury Regulation Section 1.337(d)-7 similarly.  However, the IRS instead issued proposed and temporary regulations in the summer of 2016 that kept the built-in gains tax recognition period for REITs at 10 years.

I am happy to share that today, the IRS backed away from this position, and issued final regulations providing that the recognition period for REITs is the same period provided for under Section 1374.  As a result, the recognition period for REITs has been officially reduced from 10 years to 5 years.   This change will go into effect February 17, 2017, but taxpayers may affirmatively apply this new recognition period for any transactions that occurred on or after August 8, 2106

Shorter Built-in Gains Period for S Corporations

New law ahead road signBy:  Amanda Wilson

An S corporation is a popular tax vehicle, as it allows for a single layer of tax instead of the double layer of tax imposed on regular corporations.  Instead of the S corporation paying tax, the taxable income of the S corporation passes through to the shareholders and is reported on the shareholders’ personal tax returns.  The S corporation can generally then distribute the accompanying profits to the shareholders free of federal tax.

To avoid corporations converting to S corporations and then selling their assets (thereby taking advantage of the single level of tax imposed on S corporations), the Internal Revenue Code imposes a 10 year built-in gains tax on S corporations.  If an S corporation sells assets within this 10-year period, it pays the normal corporate level tax to the extent any of the gain on the sale was already built-into the asset at the time it made the S election.  For example, assume a corporation has an asset with a fair market value of $10 at the time it converts to an S corporation.  If the corporation later sells the asset for $12 within the 10 year built-in gain period, the S corporation would pay corporate level tax to the extent that it had gain attributable to the first $10 of the sales price.

On Friday, legislation was enacted that permanently reduced the 10-year period to 5 years.  This change is retroactive to tax years beginning on or after January 1, 2015.  This change is great news for S corporations!

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