Sec. 355 and REITs: Opportunities for Owner-Occupied Real Estate

By Nick Gruidl, CPA, MBT, Washington, D.C., and Parr Thomson, CPA, New York City

Editor: Mindy Tyson Weber, CPA, M.Tax.

Real Estate

For a transaction to qualify as a tax-free spinoff under Sec. 355, numerous tests must be satisfied, three of which are of particular relevance to real estate investment trusts (REITs): (1) An active trade or business must exist that must have been actively conducted for the five-year period ending on the transaction’s distribution date; (2) the new controlled corporation must continue that active trade or business, or a part of it, after the transaction; and (3) the transaction must have a business purpose. This item explores the challenges taxpayers have historically faced when contemplating a Sec. 355 transaction that involves a REIT holding owner-occupied real estate. It also examines a potential active trade or business planning opportunity brought to light by a recent private letter ruling.

REITs and Sec. 355

To qualify for REIT status under Sec. 856, in general, an entity must derive 95% of its gross income from passive sources (interest, dividends, rents, capital gains, etc.) and 75% of its gross income from passive real property sources (mortgage interest, real estate rents, gains on real estate sales, etc.). Historically, these income percentages generally precluded a REIT from having an active trade or business and, therefore, from completing a Sec. 355 spinoff transaction.

However, in 2001 the IRS issued Rev. Rul. 2001-29, which concludes that some of the activities a REIT undertakes to manage its properties through independent contractors qualify as an active trade or business, without affecting the entity’s REIT status. The ruling specifically states that it is not all-encompassing, in that not all REITs would qualify for Sec. 355 treatment because of it. Rather, under certain circumstances, a currently electing REIT or a newly formed controlled corporation electing REIT status could successfully accomplish a Sec. 355 spinoff.

Satisfying the requirements of Sec. 355 with owner-occupied real estate, whether or not held by a REIT, is an area that has drawn significant IRS scrutiny (see Coady, 33 T.C. 771 (1960), aff’d per curiam, 289 F.2d 490 (6th Cir. 1961); Appleby, 35 T.C. 755 (1961), aff’d per curiam, 296 F.2d 925 (3d Cir. 1962); King, 458 F.2d 245 (6th Cir. 1972); and Rafferty, 452 F.2d 767 (1st Cir. 1971)). Treasury highlighted these challenges in Regs. Sec. 1.355-3(b)(2)(iii), which states that “[s]eparations of real property all or substantially all of which is occupied prior to the distribution by the distributing or controlled corporation . . . will be carefully scrutinized with respect to the requirements of section 355(b).” As a result, taxpayers often try to avoid relying on those activities to satisfy the active trade or business requirement. A recent private letter ruling identifies an opportunity to distribute a REIT without having to rely on the REIT’s rental of owner-occupied real estate to satisfy the Sec. 355 active trade or business requirement, which may eliminate at least one significant obstacle to a REIT distribution under Sec. 355.

Owner-Occupied REIT Private Letter Ruling

Letter Ruling 201337007 involves the creation and distribution of a controlled corporation (Controlled) to primarily hold real estate that would be leased back to the distributing business (i.e., owner-occupied real estate). Following the distribution, Controlled would elect REIT status. In addition to the REIT assets, Controlled owns a subsidiary (Subsidiary) that would elect taxable REIT subsidiary (TRS) status. Subsidiary owned and operated casinos for at least five years before the distribution. Though the IRS was unlikely to rule favorably that the leasing of property back to the distributing business was an active trade or business, it appears the addition of the Subsidiary allowed the transaction to satisfy the active trade or business requirement. Thus, it appears the taxpayer relied on the active trade or business held in the TRS to satisfy the active trade or business requirement.

When looking at the active trade or business relied upon for purposes of Sec. 355(b) qualification, it is important to remember that the size of the active trade or business as compared to the other assets held is not necessarily significant. While the IRS has limited its ruling policy on Sec. 355, previously it required only that the active trade or business represent 5% or more of the fair market value (FMV) of the total gross assets for ruling purposes (Rev. Proc. 2003-3).

In Letter Ruling 201337007, the fact that the active trade or business was conducted through a TRS, by definition, meant that the value of investment in the TRS by the newly formed controlled entity equated to less than 25% of the FMV of the assets in the controlled entity because Sec. 856(c)(4)(B)(ii) limits those subsidiaries to 25% of the REIT’s assets.

While satisfying the active trade or business test is a critical factor, taxpayers should not overlook the business-purpose requirement or that Letter Ruling 201337007 did not rule on whether the taxpayer satisfied the business-purpose requirement. In the ruling, the taxpayer represented that a business purpose for the distribution was to allow the post-distribution REIT to expand its business to various competitors, which would be more difficult if the distribution did not occur.

Expanded Opportunities?

Over the past few years, there appears to have been an increase in the use of master limited partnerships and REITs to provide more tax-efficient investment vehicles to domestic and global investors. Like many tax planning opportunities, the avenue highlighted in Letter Ruling 201337007 did not result from a recent change in the law but rather a taxpayer’s identification of an opportunity under existing law that had not been widely used. There is no reason to believe that a taxpayer in a similar situation could not implement a similar transaction to separate owner-occupied real estate from its core business. The key to implementing the opportunity identified in the letter ruling is to identify a qualifying active trade or business to accompany the soon-to-be REIT assets. The business would need to be large enough to satisfy the active trade or business requirement, yet small enough to allow the REIT to meet the Sec. 856 income requirements.


This approach to a Sec. 355 REIT distribution in many ways resembles the manner in which the active trade or business requirement was satisfied in “cash rich” spinoff transactions prior to the enactment of Sec. 355(g). Due to recent changes in the IRS ruling policy, there will probably not be many more rulings similar to Letter Ruling 201337007, but there may nonetheless be an increase in the number of these transactions. It remains to be seen whether this increase in Sec. 355 transactions involving REITs holding owner-occupied real estate could lead Congress to enact a provision similar to Sec. 355(g) to limit those transactions.


Mindy Tyson Weber is a senior director, Washington National Tax, for McGladrey LLP.

For additional information about these items, contact Ms. Weber at 404-373-9605 or

Unless otherwise noted, contributors are members of or associated with McGladrey LLP.

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