The Internal Revenue Service has finalized regulations governing certain transfers of property to regulated investment companies and real estate investment trusts.

 

In  TD 9626, the IRS issued final regulations under Section 337(d) of the Tax Code to provide guidance concerning certain transfers of property from a C corporation to a regulated investment company (RIC) or a real estate investment trust (REIT). The regulations will affect the parties to such transactions, the IRS noted.The regulations took effect last Friday, August 2.

On April 16, 2012, the IRS issued a notice of proposed rulemaking concerning certain transfers of property from a C corporation to a RIC or a REIT in the Federal Register. It received only one written comment, and no public hearing was requested or held. The Treasury Decision adopted the proposed regulations with only a few changes.

Section 1.337(d)-7 of the Tax Code generally provides that if the property of a C corporation becomes the property of a RIC or REIT by the qualification of that C corporation as a RIC or REIT or by the transfer of assets of that C corporation to a RIC or REIT in a conversion transaction, then the RIC or REIT will be subject to tax on the net built-in gain in the converted property under the rules of Section 1374 and the underlying regulations. This general rule, however, does not apply if the C corporation transferor makes a “deemed sale election” to recognize gain and loss as if it sold the converted property to an unrelated person at fair market value.

The IRS’s notice of public rulemaking proposed to amend Section 1.337(d)-7 to provide two exceptions from the general rule. First, the general rule would not apply to the extent that the conversion transaction qualifies for nonrecognition treatment under either Section 1031 (relating to like-kind exchanges) or Section 1033 (relating to involuntary conversions).

Second, a conversion transaction in which the C corporation that owned the converted property is a tax-exempt entity would not be subject to the general rule if the tax-exempt entity would not be subject to tax (such as under the unrelated business income tax rules of Section 511) on a gain resulting from a deemed sale election had such an election been made under Section 1.337(d)-7(c)(5).

The commenter requested clarification regarding the application of the tax-exempt exception. The IRS and the Treasury Department recognized that it might be unclear whether the tax-exempt exception applied to a transaction in which some of the gain resulting from a deemed sale election would be subject to tax if such an election were made, and some of the resulting gain would not be subject to tax. For example, if a tax-exempt entity transferred an asset to a REIT and a portion of the gain resulting from a deemed sale election would be subject to tax under Section 511, it might be unclear whether the tax-exempt exception applied to the portion of the gain that would be  exempt from tax under Section 501(a). Under one interpretation of the proposed regulations, the tax-exempt exception would not apply to any of the gain, including the portion that would be exempt from tax under Section 501(a), because a portion of the gain would be subject to tax under Section 511.

As noted in the notice of public rulemaking, the IRS and the Treasury said they believed that the general rule should not apply to transfers by tax-exempt entities to the extent that the resulting gain (if any) would not be subject to tax under some Tax Code provision were a deemed sale election made. Accordingly, the final regulations clarify that the general rule does not 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 would not be subject to tax under Title 26 of the U.S. Code if a deemed sale election were made.

Thus, in the example described, the tax-exempt exception applies to the extent that the tax-exempt exception applies to the extent the deemed sale gain with respect to the converted property would be exempt from tax under Section 501(a) because that portion of the gain would not be subject to tax under any Tax Code provision had a deemed sale election been made. This is the case even though the tax-exempt exception does not apply to the extent the deemed sale gain with respect to the converted property would be subject to tax under Section 511.

The commenter also requested clarification about whether the exchange exception applies to certain multi-party like-kind exchanges of property involving intermediaries, including “reverse like-kind exchanges” in which the replacement property is acquired before the relinquished property is transferred. The IRS and Treasury said they believe that the language of the exchange exception is sufficiently clear and operates to exclude from the general rule any realized gain that is not recognized by reason of either Section 1031 or 1033, regardless of the specific transactional form. Accordingly, the IRS and Treasury Department do not believe that any change to the notice of public rulemaking is necessary on this issue.

In addition, the commenter requested that a new exception to the general rule be added to address the fact pattern in which a REIT purchases appreciated property from a C corporation for cash or other consideration equal to the property's fair market value. According to the commenter, if the REIT does not have a continuing relationship with the C corporation, the REIT would have no way of knowing the extent to which the C corporation might not recognize any gain, whether pursuant to Section 1031, 1033, or some other Code provision. Because the REIT’s basis in property purchased in an arm's length transaction generally is its cost, the REIT should generally not have any built-in gain in the converted property. Thus, the commenter suggested that this fact pattern should never give rise to a conversion transaction.

The IRS and the Treasury Department said they agreed with the commenter that a RIC or REIT that purchases property in an arm's length transaction from a C corporation for an amount of cash equal to the property's fair market value should have a cost basis equal to fair market value.

Thus, if the RIC or REIT subsequently were to sell the property at a gain during the recognition period, the RIC or REIT should be able to establish that the gain recognized is not built-in gain within the meaning of Section 1374(d)(3). Accordingly, the IRS and the Treasury Department said they do not believe that any change to the notice of public rulemaking is necessary on this issue.