REIT IPO Taxation
I saw in the news today that a property is going public as a single asset REIT.
Does anyone here know the taxation implications of going public?
For example, let's say there is an asset worth $100MM and the basis is $70MM. Let's assume there is debt on it of $50MM.
Let's assume I want to issue $50MM of equity via a IPO (in effect 50% of the company/asset) in order to pay down the debt.
What is my tax basis? If it's $70MM, that means I could now sell my stock for $50MM and take a loss so that doesn't make sense.
I dont understand why it would be any different than a company. Let's say I own 100% of a company which is worth $100MM and my basis is $0. If I issue $25MM of equity for the company (but the company keeps the cash), its not taxable. So I don't know why this would be different.
If anyone has any thoughts or color to share, that would be great.
Thanks.
The reason your math doesn't make sense is because you are comparing the asset-level basis of $70M and comparing it to the stepped-up equity value of $50M. Either, compare the stepped up asset value of $100M vs $70M cost basis OR compare the stepped up equity value of $50M vs $20M equity basis.
In each case, depending on how you structure the REIT transaction, you will have a realized / unrealized gain of $30M.
In the REIT example, you are selling/converting an asset into a REIT entity and are therefore realizing a capital gain. If, for example, the REIT was raising $50M to purchase a building, it would not be taxed. Similarly, for the company example, if it was issuing shares to raise $25M of equity, it would not be taxed. However, if the company was selling a portion of the business, it would receive tax treatment similarly to how the individual selling his property to a REIT.
Thanks for the response.
So the person would have a $30MM unrealized gain (assuming he doesnt sell his shares?
If they go the OP Unit route, can they keep the depreciation?
Since we are on the topic, let's say I want to do an equity recapitalization (and use the equity to pay down debt so it is an unencumbered asset), what are the taxation implications? Is my basis for depreciation my old basis, and I can use that to offset income?
Yup. That's correct. With the caveat that if the person receives REIT shares rather than OP Units, the person would realize that gain. It's the OP Unit(s) that are associated with unrealized capital gains. If and when the person would like to sell their OP Unit(s), they first convert them into REIT shares and then ultimately sell the shares to the open market. Converting OP Units into REIT shares is a taxable event.
Could you give a numerical example of what you're asking?
Let me think this one through. Anyone else, feel free to chime in.
Now I understand. The difference is asset level basis vs. my adjusted basis on the stock.
Sure...Let's say I have a $100MM asset. I own it 100%. My basis is $70MM. I have $50MM of debt. I effectively "sell" 50% of the asset for $50MM to a newly formed REIT via issuing stock and paydown the debt. (The example above).
So now, the asset has a basis of $70MM but my stock has a unrealized gain of $30MM. Is this correct?
But now the entity keeps the depreciation and distributes it to me via a dividend.
Problem is: the dividend is taxed. Before that $5MM of income was offset by (assuming 4% interest) $2MM of interest and $2.8MM of depreciation. So I had only $0.2MM of taxable income on $3MM of cash flow.
Now i have $2.5MM of taxable income and $2.5MM of cash flow. I am paying ~40% tax.
a) Why would anyone go public? b) Is there any way to complete a recapitalization and paydown debt without having a realized taxable event and keeping some depreciation on a pass-through basis so it can offset the income?
This is a fairly complex question to answer in a text box but let's give it a shot. Note - There are a fair number of statements made on my best understanding of REITs. I am not a tax attorney so take into consideration. Anyone with more complete knowledge feel free to chime in.
First, let's tackle the aspect of capital gains (realized or unrealized) given a 100% sale to a REIT and a 50% to a REIT.
Original Purchase
$70,000,000 (Asset) = $50,000,000 (Debt) + $20,000,000 (Equity)
Initial Assumptions
Loan is Interest-Only, implying no amortization of principal by the time the asset is sold.
The Asset is held for 5 years and depreciates by $10,000,000 (Land is worth $15,000,000 and Improvements, which can be depreciated upon, are $55,000,000), implying the depreciated asset value is $60,000,000 and depreciated equity value is $10,000,000.
Sale of REIT for $100,000,000
Let's assume you sell 100% the asset for the REIT for $100,000,000 while still encumbered by $50,000,000 of debt, implying an equity value of $50,000,000. You realized or unrealized gain (depending on how it is structured) is $40,000,000, which is the $50,000,000 equity value less your depreciated equity basis of $10,000,000.
Let's assume you sell 50% the asset for the REIT for $100,000,000 while still encumbered by $50,000,000 of debt, implying an equity value of $50,000,000. I'm operating on the assumption that you are selling 50% of the equity interest ($25,000,000). By doing this, your realized gain is $20,000,000, which is the 50% of the equity value ($25,000,000) less 50% of your depreciated equity basis ($5,000,000). Your unrealized gain is also $20,000,000.
Now, let's tackle the question of taxable income before and after sale to a REIT.
Taxable Income Prior to Sale
I'm going to make up some numbers.
Income - $5,000,000
Interest - $2,000,000
Annual Depreciation ($55M of Improvements X 1/27.5) - $2,000,000
Taxable Income - $1,000,000
Taxable Income After Sale
Income - $5,000,000
Interest - $2,000,000
Depreciation - $0
Taxable Income - $3,000,000
Thoughts on Questions Asked
a) Why would anyone go public? Good question and a question I believe your asking based on the fact that taxable income is significantly higher in Scenario 2 than Scenario 1. However, first, if a building has used up its entire 27.5 years of depreciated life, it no longer receives the benefit of depreciation. Second, most times, when a person completes an UPREIT transaction, they are trading the idiosyncratic risk of that unique asset for the broader and more diverse group of asset that the REIT owns. Third, it allows the owner to capitalize on strong capital markets while being able to defer capital gains and capital gains taxes and still receiving income.
b) When an owner sell to a REIT, the basis resets at the transaction price, effectively wiping out the deprecation that the owner benefited from. To answer your question, I would say no but perhaps theirs a unique way to structure that would allow you to do so.
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