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Anticipating an increase in audits in the area, the authors explore the use of taxable subsidiaries by real estate investment trusts to help entities qualify with REIT criteria via arm's-length transactions. They describe the background on taxable REIT subsidiaries and relevant transfer pricing rules and discuss how supporting analysis and documentation could be helpful during an audit.
Recently, the IRS released reports1 indicating that about 17 percent of returns filed by large corporations were examined in fiscal year 2010. The reports also indicate that real estate investment trusts made a total of 1,679 filings of Form 1120-REIT for tax year 2008. These reports do not separately show how many of those REIT returns were examined, especially concerning the transfer pricing transactions these REITs may have entered into with their taxable REIT subsidiaries (TRSs) to facilitate REIT qualification.
According to attendees of a March 2011 conference organized by the National Association of Real Estate Investment Trusts (NAREIT), IRS audit coverage among REIT returns is low. However, formal and informal discussions at the NAREIT conference, public information, and the authors' experiences suggest that audits of TRSs may be on the rise. The recent quarterly financial report of a publicly traded lodging REIT disclosed that the IRS audited one of its TRSs leasing two properties for 2007. According to the financial report, the IRS notified the REIT of its intent to impose a 100 percent federal excise tax on the rents charged in excess of the arm's-length rate, and the REIT would owe approximately $5.7 million in U.S. federal excise taxes if the IRS proceeds with the excise tax and prevails. The financial report also discloses that the IRS has commenced an audit of the same TRS for 2008 and intends to examine the TRS's return for 2009.
A TRS is taxed separately from its REIT parent, and because of a 100 percent tax on non-arm's-length dealings between a REIT and its TRS, REITs should consider whether their transactions with their TRSs could become subjects of in-depth scrutiny by the IRS during an examination.
While REITs are subject to various tax rules, this article focuses on the requirement that REIT-TRS transactions be arm's-length. It first describes the relevant background on TRSs and implications of the Section 482...