Ditto JBG Cos.' proposed acquisition of New York REIT, which is already under fire from one of New York REIT's shareholders.

Willens doesn't think that the Treasury Department has the authority to add to a regulation in this manner. “I think the IRS is overreaching but then that is what I thought about the Treasury's rules on inversion deals as well.”

A company could challenge the rule in Tax Court, he said, but that process takes years. Shareholders, whether they are for or against a deal, are not inclined to wait around for a case to wind its way through the court system.

WASHINGTON, DC--The Internal Revenue Service published regulations Tuesday morning updating REIT spinoff rule changes that were made by Congress in December of 2015 as part of the larger Consolidated Appropriations Act passed by Congress. PATH requires companies who elected a REIT status for assets that have been spin off within 10 years of that event to recognize the gain as though the assets had been sold at their fair market value on the sale date.

The regulation, however, said nothing about a company engaging in a REIT conversion after a spin off, such as by merging with an existing REIT. This is where the IRS stepped in, updating the rules to include conversions and making it effective immediately.

The IRS, as it often does in such surprise rule changes, explained that there were companies trying to get around the intent of the law with the conversion loophole. It said in its notice in the Federal Register:

A conversion transaction could result in elimination of the corporate level of gain in the converted property, including gain from the sale of the property, because RICs [regulated investment company] and REITs generally are not subject to tax on income that is distributed to their shareholders.

Essentially what the IRS has done is make it impossible for a company that spin off its asset to merge with an existing REIT, tax expert Robert Willens of Robert Willens LLC wrote in a client note.

The problem is that Congress wrote Sec. 856(c)(8) sloppily. That section prevents a corporation involved in a tax-free spin-off from "electing" to become a REIT until the 10th anniversary of the spin-off. However, Sec. 856(c)(8) does not prevent such a corporation (involved in a tax-free spin-off) from engaging in a "conversion" transaction, including, for example, merging (in a tax-free reorganization) with and into an existing REIT. We looked at the language of Sec. 856(c)(8), which bars only "elections," and not "conversions," and thought we had a very useful loophole.

Some Very Disappointed Shareholders

The new rules will stop a few recent proposed transactions in their tracks, Willens told GlobeSt.com. It appears that the Colony Capital, NorthStar Realty Finance and NorthStar Asset Management's $58 billion proposed equity REIT, fit the criteria described in the rule, he said.

Ditto JBG Cos.' proposed acquisition of New York REIT, which is already under fire from one of New York REIT's shareholders.

Willens doesn't think that the Treasury Department has the authority to add to a regulation in this manner. “I think the IRS is overreaching but then that is what I thought about the Treasury's rules on inversion deals as well.”

A company could challenge the rule in Tax Court, he said, but that process takes years. Shareholders, whether they are for or against a deal, are not inclined to wait around for a case to wind its way through the court system.