For more than two decades, it has been virtually (but not entirely) impossible to extract appreciated property from a taxable or C corporation without incurring a corporate-level tax. Consequently, it has become lucrative for professionals around the country to devise tax strategies that are aimed at removing appreciated property from corporate solutions without incurring such a tax liability. This article briefly discusses some of the more common tactics that are used to extract appreciated real property from a C corporation and suggests that converting the corporation into a real estate investment trust (REIT) may offer the better alternative in many cases.

Consider, for example, a C corporation (the "Corporation") whose stock is owned in equal one-third shares by a domestic limited partnership, a non-resident alien individual and another C corporation. The Corporation, in turn, owns an unencumbered piece of income-producing real estate with a fair market value of $100 million and an adjusted tax basis (original cost, less accumulated depreciation, plus the cost of capital improvements) of $20 million. In other words, the Corporation has a built-in gain (BIG) of $80 million.

If the Corporation were to sell or distribute the real estate, the BIG would be realized by the Corporation, producing roughly $28 million of federal corporate income tax liability based upon today's 35 percent maximum corporate income tax rate. The distribution of the real estate, or of the after-tax cash proceeds from the sale of the real estate, to the corporation's shareholders would also likely produce a shareholder level tax.

One possible approach to avoid corporate level tax would be for the Corporation to dispose of the real estate as the "relinquished" property in a deferred, like-kind exchange. If the Corporation designated like-kind "replacement" property within 45 days of the disposition of the real estate and closed on the acquisition of the replacement property within 180 days of the sale of the real estate, then generally the Corporation would owe no federal corporate income tax, assuming all of the proceeds from the disposition of the real estate were utilized to acquire the replacement property. However, the replacement property would take an adjusted tax basis equal to the real estate's adjusted tax basis plus any additional equity utilized by the Corporation to acquire that replacement property. As a consequence, the BIG associated with the real estate would simply be transferred to the replacement property, and any ultimate sale or distribution of the replacement property would generate a large federal corporate income tax liability.

Alternatively, the Corporation could make a tax-free contribution of the real estate to an UPREIT (Umbrella Partnership Real Estate Investment Trust) operating partnership (OP) in return for a limited partnership interest in the OP. The typical UPREIT operating partnership is owned by a REIT as general partner and by a variety of real estate owners and investors who have also contributed their appreciated real estate to the OP in return for limited partnership interests or "units" in the OP. Ordinarily, OP units are convertible at some point into cash or stock in the REIT, but such a conversion would also be taxable to the Corporation for federal income tax purposes. In other words, similar to the like-kind exchange approach, contribution of the real estate by the Corporation to an OP defers, but does not eliminate, the potential federal income tax on the BIG.

The shareholders of the Corporation might also consider converting the Corporation to an S corporation. An S corporation generally is not taxable on income and gain it realizes; rather, the income and gain pass through to the shareholders, who must report and pay tax on that income and gain on their own federal tax returns. If the Corporation elected S corporation status, then under a special provision designed to preserve the effect of the repeal of the General Utilities doctrine, the Corporation, even while an S corporation, would still be taxable on the BIG if the Corporation sold or distributed the real estate, but only during the 10-year period beginning on the date of conversion to S corporation status. If the shareholders of the Corporation were sufficiently patient, in theory they could cause the Corporation to elect S corporation status, then wait 10 years, and finally dispose of the real estate free of corporate income tax on the BIG.

However, the rules governing eligibility for S corporation status impose a number of limitations and restrictions. One of those is that an S corporation may have as a shareholder only individuals who are residents or citizens of the United States, estates and certain kinds of trusts. The limited partnership, the non-resident alien individual and the C corporation that are the shareholders of the Corporation in our example thus are all ineligible to be shareholders of an S corporation. Therefore, they cannot elect to convert the Corporation to an S corporation. Are the shareholders then without hope for permanently avoiding, rather than merely deferring, corporate level tax on the BIG? The answer, in most cases, is no.

Rather than contribute the real estate to an UPREIT operating partnership, the shareholders of the Corporation can cause the Corporation to elect to be taxed itself as a real estate investment trust. A REIT is generally not subject to corporate income tax, provided it distributes each year to its shareholders 100 percent of its "REIT taxable income." Similar to a C corporation that converts to an S corporation, a C corporation that elects to be taxed as a REIT is, after the passage of 10 years from the date of election, no longer subject to corporate level tax on the BIG inherent in the corporation's assets on the date of election. Moreover, unlike an S corporation that can only have one class of stock and no more than 100 shareholders, a REIT can have multiple classes of stock and must have at least 100 shareholders.

As is typical, Congress has imposed a number of rules governing qualification and continuing eligibility for REIT status. In addition to the 100-shareholder rule, five or fewer individuals may not own more than 50 percent of the value of the outstanding stock of a REIT. Additionally, in order to initially qualify as a REIT, a C corporation must distribute to its shareholders before the close of the first year for which it elects REIT status its accumulated "earnings and profits" from prior years. Moreover, a REIT must satisfy certain income tests each year, namely that (i) at least 75 percent of its gross income must be from "qualifying" rents from real property, gains from the disposition of real property, and certain other items, and (ii) at least 95 percent of its gross income must be from those same sources plus generally interest, dividends and gains from the sale of securities. Quarterly, a REIT must satisfy certain asset tests, including that (a) at least 75 percent of the value of its assets must be real property, mortgages secured by real property, cash, cash items (including receivables) and government securities and (b) not more than 25 percent of its assets can be securities.

In the case of the Corporation, it can satisfy the 100-shareholder rule by issuing to 100 or so investors non-voting preferred stock that is limited and preferred as to dividends and on liquidation. Given that the Corporation's sole asset is the real estate, it should have no difficulty satisfying the above-described income and asset tests. While there are some costs associated with transforming a C corporation into and administering a REIT, our services-oriented economy has already developed a number of REIT administrative service providers that for modest fees can handle most of the administrative aspects of REIT qualification, including providing 100 or so "accredited investors" that will each purchase one share of preferred stock in the REIT. Therefore, with some patience (and perhaps some considerable foresight), the shareholders of the Corporation can create a tax vehicle to permanently avoid a large federal income tax liability on the BIG inherent in the real estate.

Howard Solodky is a Washington, D.C.-based member of Womble Carlyle Sandridge & Rice and head of the firm's tax practice group.