REIT Conversions: Good For Wall Street. Not Good For America

wall_street_sign_nycWhenever one company or a small group of companies is able to wriggle free of the corporate tax, economists face a dilemma. On the one hand, there is some comfort in the fact that the impact of the corporate tax – our most economically damaging tax – has been lessened. On the other hand, there is the economic inefficiency that results from the unfairness of allowing a lucky few to escape the tax while others are left bearing the burden.

For example, suppose Congress passed a law randomly granting one out of every 10 corporations complete exemption from corporate tax. If the damage of the tax is large relative to the harm of an uneven playing field within the corporate sector, this new law could be a net plus for the economy. Alternatively, if the distortions of favoring one group of firms over another are too costly, the new law hurts economic growth.

Of course, in the real world tax breaks are not assigned randomly. They go to astute lobbyers and to those with skilled tax planners. Nevertheless, although our hypothetical random assignment of tax benefits may seem silly and politically unsound, it would probably result in better economic outcomes than the way tax breaks actually come into existence.

Why?

First, random assignment of tax benefits would not require the beneficiaries to act differently than they would otherwise. For a company to qualify for a legislated tax benefit, it usually must satisfy requirements that may cause it to change its business practices.

When businesses choose to convert to a real estate investment trust, they put themselves in a real estate straitjacket. So it is common to find statements like the following one, from Corrections Corporation of America, in Forms 10-K of businesses that have elected REIT status: “In order to meet [REIT requirements], we may be required to forgo investments we might otherwise make or to liquidate otherwise attractive investments.”

Second, large-scale random assignment of benefits would distribute them evenly over the economy so no one industry would be particularly favored. In contrast, tax planning and legislated tax breaks usually concentrate tax benefits in some industries and leave others out. Unless there is some clear reason to try to second-guess the free market, a tax code that favors one industry over another slows economic growth.

Third, random assignment of tax benefits would not entail the costs of planning and compliance that often significantly reduce the direct tax benefits companies enjoy. These costs come in a variety of forms. There are the out-of-pocket costs of professional fees paid to lawyers, accountants, lobbyists, and consultants. And there are the distractions to management and the drain of time to employees who must attend to compliance and planning issues.

Companies that have converted into REITs face substantial planning and compliance costs, which often negate a significant percentage of the tax benefits received. Here are some examples:

  • Iron Mountain, Inc., the document storage company, became a REIT earlier this year. The company estimates its total cost of conversion to REIT status will be between $185 and $200 million.
  • Equinix Inc. runs large-scale data centers and expects to become a REIT in 2015. It estimates its total conversion costs will be $84 million.
  • Gaming and Leisure Properties Inc. owns casinos and until just recently was part of Penn National Gaming Inc. Its election to REIT status began in November 2014. CEO Peter Carlino explained the process of creating a new REIT this way: “The pain was unimaginable, and I really do not overstate that. It was the most difficult thing we have ever done . . . I can’t overemphasize the complexity.”

The textbooks and the blue ribbon commissions that study tax reform tell us that our tax system should be simple (low compliance costs) and neutral (not interfere with free market business practices). REIT conversions move us in the opposite direction. But in a market where investors are desperate for yield, REITs have become extremely popular. Hedge funds unceasingly prowl for conversion candidates. Bankers, lawyers, and accountants are generating huge fees. Congress will have a heck of a time taking the punch bowl away from this party.

Perhaps, you may say, REITs provide benefits to the economy that make all the costs worthwhile. The usual policy justification is that REITs allow small investors the opportunity to diversify into well-managed real estate. But most large converted REITs were already publicly traded before, so it is hard to see how REIT status improves small investor access to the stock of these companies.

If the R and E in REIT stood for research and experimentation — that is, if tax-favored entities were doing science and developing new technology — tax privileges might be justified by positive externalities these activities generate. But what policy justification is there for subsidizing commercial real estate? In fact, regarding casino REITs it is easy to make the case that the associated externalities (like gambling addiction) are negative. If we really wanted to help middle-income taxpayers with their investments and promote their financial security, we would not be building more gambling houses.

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