IRS Allows Tax-Free Conversion Of Corporate Real Estate to REITs

Restructuring companies have a potent new weapon for unlocking value by cleaving physical assets from operating assets without triggering taxes. The Internal Revenue Service (IRS) issued a revenue ruling in early June that allows operating companies to spin off real estate holdings to shareholders tax-free if the newly formed entity takes shape as a real estate investment trust (REIT). The opinion offers potential for action on a wide range of operating businesses that are heavy in real estate properties. A partial sampling would include restaurants, retailers, distributors, utilities, railroads, manufacturers, airlines, truckers, and paper and lumber companies with large timberland interests. At least one company, McDonald’s Corp., said that it is considering cutting its extensive network of real estate free from its restaurants, although stopping well short of any commitment. Many analysts have expressed doubts that McDonalds will follow through, given the significant rental income it now receives as a landlord. A long-time fight against the stock market But other operating companies that long chafed under what they consider the stock market’s refusal to accord them adequate value for their real estate may find the newly granted tax shield a tempting option. Robert Willens, managing director and tax expert at Lehman Brothers, said that operating companies freed from the real estate shackles “may well experience higher returns on assets and equity and, as a result, enjoy a higher stock price.” “At the same time, the shareholders of the corporation, who now own the REIT’s stock in the same proportions that they own the parent’s stock will own an income-producing vehicle that should presumably be assigned an appropriate value in the markets,” he wrote in a recent analysis. “I like to think of it as a way to turn tax payments into dividends,” Willens said in a subsequent interview. One of the advantages of a REIT is that it pays no income taxes, provided that it shells out at least 90% of its operating income to its shareholders. The IRS ruling reversed a longstanding position by the agency that a REIT was not an active business – a major requirement for executing a tax-free spin-off. Ironically, Willens said, the law that allowed REITs to be classified as active businesses has been on the books since 1986 but the IRS never changed sides until now because no one had asked for a ruling. The law allowed REITs to both collect rents and provide management and other services to tenants. Willens said that the IRS’s general ruling on corporate spin-offs of REITs presages a favorable ruling on a specific case now under consideration – the proposed merger of The Timber Group, a tracking stock of Georgia-Pacific Corp., and Plum Creek Timber Co., a forest-owning REIT, which is before the agency with a request to be declared tax-free. In recent restructuring trends, operating companies have tried to avoid becoming muscle-bound by shaving off excess physical assets. Developments have included outsourcing manufacturing operations and challenging entire concepts of vertical integration by selling off parts of the value chain – ranging from raw material sources to distribution units. More recently, real estate holdings have come under review. Where land and building once were considered anchors of real corporate wealth, they often are regarded today as inhibitors of nimbleness and value creation. Operating corporations have perennially griped that the stock market never gave them full credit for owned real estate. They are not alone. Even corporations whose primary business is real estate claim to have been victimized by the market, and several liquidated rather than stay alive as undervalued ugly ducklings. Prospects after the REIT spin-off If an operating company follows through on the new tax advantage, it would presumably put its stores, plants, and other buildings into a REIT, spin it off to its own shareholders, and lease the properties back. Rental payments from the former parent would comprise the REIT’s initial income stream. But the newly independent REIT also would have the right to acquire other properties and pursue growth. Willens cautioned that while the tax break and the potential for shareholder value are compelling, a lot of other economic yardsticks have to be applied. Adequate management may be a problem while owned physical assets may be important to secure financing. The company still may find it more cost-effective to own than to rent.