The Treasury and the IRS have issued final regulations (TD 9810) that reinstate a five-year recognition period for purposes of the built-in gains tax imposed on real estate investment trusts (REITs) and Regulated Investment Companies (RICs) under Regulation Section 1.337(d)-7. The preamble to the final regulations indicates that the Treasury and the IRS continue to study other issues addressed in the temporary and proposed regulations issued in June 2016.

Background

Regulation Section 1.337(d)-7 states that, if property owned by a C corporation becomes the property of a RIC or REIT (the converted property) as a result of a C corporation converting to a RIC or REIT or the transfer of assets from the C corporation to the RIC or REIT in a carryover basis transaction (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 as if the RIC or REIT were an S corporation. This applies unless the C corporation elects to recognize gain and loss as if it sold the converted property to an unrelated party at fair market value. In general, Section 1374 subjects an S corporation to corporate-level taxation on built-in gains recognized within a specified period of years (the recognition period) on assets formerly held by a C corporation. Section 1374 originally contained a 10-year recognition period; beginning in 2009, however, amendments to Section 1374 reduced the recognition period to a shorter period on a temporary basis, including a five-year recognition period for tax years beginning in 2012, 2013 and 2014.

PATH Act

The Protecting Americans Against Tax Hikes Act of 2015 (PATH Act), enacted on December 17, 2015, amended Section 1374(d)(7) to make permanent a five-year recognition period. The new five-year recognition period was effective for tax years beginning after December 31, 2014. The Technical Explanation of the PATH Act by the staff of the Joint Committee on Taxation reinforced that the five-year recognition period also applied to REITs and RICs.

Temporary and proposed regulations

On June 8, 2016, the Treasury and the IRS issued temporary and proposed regulations (the Temporary and Proposed Regulations) that amended the built-in gains tax rules under Regulation Section 1.337(d)-7 (see Tax Alert 2016-1083). Among other amendments to the built-in gains tax rules, Temporary Regulation Section 1.337(d)-7(b)(2)(iii) imposed a new 10-year recognition period, so the built-in gains tax rules no longer looked to the five-year recognition period applicable to S corporations under Section 1374(d)(7). This amendment applied to conversion transactions that occurred on or after August 8, 2016.

Final regulations

On January 18, 2017, the Treasury and the IRS issued final regulations (the Final Regulations) that amend Regulation Section 1.337(d)-7(b)(2)(iii) to provide that the "recognition period" means the recognition period described in Section 1374(d)(7), thus reinstating the five-year recognition period of Section 1374(d)(7). This amendment applies to conversion transactions that occur on or after February 17, 2017. Taxpayers may, however, also apply the amendment to conversion transactions that occurred on or after August 8, 2016, and on or before February 17, 2017.

The preamble to the Final Regulations indicates that the public hearing on the Temporary and Proposed Regulations was held on November 9, 2016. The preamble also indicates that, on October 18, 2016, the Chairmen and Ranking Members of the Ways and Means Committee of the US House of Representatives and the Finance Committee of the US Senate addressed a letter to the Secretary of the Treasury stating that the recognition period in the temporary regulations and the proposed regulations was inconsistent with congressional intent and the longstanding practice of treating REITs and RICs as having the same built-in gain recognition period as S corporations, currently five years. The chairmen and ranking members also asked to modify the temporary regulations and the proposed regulations to provide that REITs, RICs and S corporations are all subject to the same five-year built-in gain recognition period in order to be consistent with congressional intent and longstanding practice.

Implications

After the public hearing on the Temporary and Proposed regulations on November 9, 2016, it was reported in the press that a Treasury official indicated that he anticipated that final regulations would modify the recognition period for REITs and RICs to conform to the five-year recognition period applicable to S corporations. It is very good news for REITs, RICs and their advisors that the Final Regulations do in fact reinstate the five-year recognition period for purposes of the REIT and RIC built-in gains tax. Although the Final Regulations generally apply prospectively to conversion transactions that occur on or after February 17, 2017, taxpayers are also allowed to apply the Final Regulations to conversions between August 8, 2016 and February 17, 2017, inclusive, thus essentially allowing taxpayers to treat the 10-year recognition period rule in the Temporary and Final Regulations as if it never took effect.

It also should be noted that the Final Regulations only finalize the "recognition period" rule and, as noted in the preamble to the Final Regulations, the Treasury Department and the IRS continue to study other issues addressed in in the temporary and proposed regulations.

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