Owners of REIT properties have often been advised against state and local rules when it comes to recording assets. Here’s why owners should pay more attention to what the IRS is asking.
Many sophisticated buyers do, in fact, allocate value to intangibles for closing, but some conservative real estate investment trust owners do not—as a precaution to protect their REIT status.
They have been advised to essentially ignore state and local rules, choosing instead to overpay realty transfer taxes, record information which conveys a price paid for real estate that includes the intangible value and most likely pay higher real estate taxes in perpetuity.
Certainly, if a buyer of an operating hotel is a REIT structure, the accounting and income tax treatment of the assets must be established in accordance with REIT rules and regulations and should be consistently accounted for in accordance with all REIT requirements.
However, when recording the deal at the state and local level, rules and regulations should be employed—in which case, the owner (regardless of income tax status) should allocate the price to real estate, tangible personal property and the intangible property as identified in the purchase and sale agreement.
It is ideal for an owner with REIT status to separate the intangibles from the real estate for transfer tax and deed recording purposes and to not separate the intangibles from the real estate for GAAP (Generally Accepted Accounting Principles) and federal income tax purposes.
On 26 September 2016, the Internal Revenue Service published Internal Revenue Bulletin 2016-39 which sets forth the final regulations that clarify the definition of real property for purposes of the REIT provisions of the Internal Revenue Code. On the first page of the bulletin, there is a background section explaining: “Local law definitions will not be controlling for purposes of determining the meaning of the term ‘real property’ as used in section 856 and the regulation thereunder.”
Julanne Allen, of the Office of the Associate Chief Counsel, said the IRS does not look at how the assets are treated for state and local purposes, describing it as if the assets are in an “invisible bubble” for Federal tax purposes. She also said that no one has ever lost REIT status because of how they characterized the assets for state and local purposes and have only lost REIT status for violating federal REIT rules and regulations.
I found this direct discussion with Allen extremely comforting. To think that it could be possible to have REIT status revoked for allocating value to intangibles for real estate transfer tax purposes. And deed recording at the local level would lead one to believe that the very idea of operating hotels owned by a REIT is so tenuous that it is necessary for the owners to accept a +/-20% premium on their real estate taxes in perpetuity. That makes no sense.
The cost of not separating the value of the intangible property from the real estate at closing ranges from 15% to as much as 30% of the total purchase price. Not allocating to intangibles for state and local tax purposes results in overpayment of realty transfer taxes and subjects the asset to higher real estate taxes in perpetuity (lowering the value of the asset as NOI is affected dollar for dollar). It is also negatively impacting the information put forth in the marketplace which is used by local assessors to tax all hotel owners.
How the deed is recorded anchors assessors to that “sales price” and is very difficult, if not impossible, to argue against after the fact. This is because the deed includes the value of the intangibles without identifying the value of them. Then the battle becomes how to separate the value of the intangibles with no professional consensus to guide assessors, leading assessors to ignore the intangibles and tax them as real estate.
REIT owners should not give up their opportunity to maximize the value of their newly acquired asset by not separating the intangibles from the real estate for transfer tax filings and deed recordings. It only requires attention to the language in the PSA addressing allocations and the fact that the REIT structure requires a dual allocation—one for federal tax purposes and one for state and local purposes. Ideally both parties will agree to both allocations.
Remember, the IRS’s position is that state and local definitions are not controlling for REITs and are not grounds to have REIT status revoked—only violation of federal REIT rules. Advice to the contrary is not well thought out and is more costly than you think.
Bernice T. Dowell is the president of Cynsur, LLC and a former senior manager of Paradigm Tax Group. She has focused her career in real estate transfer and property taxes on hospitality assets and the concept of removing the value of intangibles from a going concern. She began this endeavor as an employee in Marriott International’s tax department in 1991. While at Marriott, she was a member of the inaugural class at George Washington University for the masters of science in finance program and focused her senior thesis on the topic of hotel investment analysis and the contributory value of a tradename to a going concern.
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