Is the IRS Reining in REITs?

 | Jun 08, 2013 | 1:30 PM EDT
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The Internal Revenue Service has formed a working group to study and possibly recommend changes to current legal standards defining "real estate" for purposes of the real estate investment trust (REIT) provisions of the tax code. This point, revealed in the 8-K form filed Thursday by data-management company Iron Mountain (IRM), caught investors and most of Washington off guard. IRM shares lost more than 15% on Friday, while recently converted prison REITs Corrections Corp. of America (CXW) and GEO Group (GEO) lost 0.22% and 1.33%, respectively.

In its disclosure, Iron Mountain acknowledged having been informed that the IRS was "tentatively adverse" to providing a private letter ruling that the company's "racking structures constitute 'real estate' for REIT purposes." According to the filing, this initial judgment could have been based on either the agency's preliminary indecision on the matter or need for additional information. In the past, the company stated, it has been "not unusual" for other entities receiving similar notifications to ultimately prove successful.

But the news tapped into investors' broader worries. Recent media accounts have raised fears that the expansion of REITs might lead regulators to rethink related provisions, either through the IRS or through tax reform efforts in Congress. Those fears have been heightened by news coverage of the tax agency's alleged targeting of conservative advocacy groups for unusual scrutiny in applications for tax-exempt 501(c)4 status.

It was difficult to get transparency regarding the IRS before this. Washington sources say the agency is even more difficult to penetrate in the wake of the scandal. As a result, the IRS is in the equivalent of an information lockdown. Meanwhile, reports of the working group are new, but they could be misreading the scope of IRS officials' intentions. I would say that while caution toward Iron Mountain's future tax status seems warranted, it is very possible that investors could be overreacting. Any reading of broader implications from the company's disclosure, in my view, also seems premature.

The general take ahead of last night's news was that the media focus on REIT expansion was unlikely to change the agency's approval processes any time soon. I am passing along some reassuring thoughts concerning prison REITs, which have recently been the subject of press reports. But these entities should have little difficulty in justifying the fees they collect from public entities as rents, thus meeting the tax code's requirement that at least 75% of a REIT's income must be derived from real estate sources.

Meeting this income qualification might be more of a hurdle for a data management company like IRM. But, one wonders, if a forest products company like Weyerhaeuser (WY), with its fields of timber, has been allowed to qualify as a REIT, why would not a company with hard-copy and electronic paper-record storage facilities? When I have queried D.C. tax lawyers in the past, the issue was explained as concerning what could be classified as "rents" rather than strictly definitions of property or "real estate."

That could be changing. But the scope and intent of the working group are hardly clear yet. Meanwhile, Iron Mountain's disclosure seemed to concern the unpredictability of whether the working group might produce results in time for the agency to clear the company's tax-status shift by 2014.

Separately, the broader issue of REIT expansion could become a discussion point in tax reform, of course. But the odds of such an effort seem a tossup at best for this Congress. The Ways & Means Committee has expressed concern about lost revenues due to burgeoning use of pass-through entities, and it issued a related white paper in early spring. Yet this focus has largely centered on Subchapter S corporations.

Indeed, I have been led to believe that the bigger threat for diversified firms like Weyerhaeuser is that, in broadly changing depreciation rules, tax reform could make it harder for these firms to comply with the 90% income pass-through requirement.

I will pass along more information as the issue becomes clearer. But for now, the fears of an IRS crackdown on REIT expansion, and of tax reform more broadly, seem premature.

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