With attributes that help mitigate tax and reporting obligations for individual, tax-exempt and foreign investors, real estate investment trusts (REITs) have historically been an attractive alternative to pass-through structures for certain real estate funds. Further, with the passing of the Tax Cuts and Jobs Act (TCJA), REITs have become an even more attractive investment vehicle as the ordinary dividends paid qualify for the new 20% pass-through deduction regardless of the wage and qualified basis limitation rules. This combined with other longstanding benefits of REITs has fueled growth in this sector and captured the attention of real estate owners and investors looking to reduce the overall tax burden on their real estate holdings. It should be noted that the TCJA did little to alter the myriad of rules and requirements that continue to serve as a barrier to entry and remain a concern for investors looking to incorporate and/or currently operating as a REIT. This article aims to highlight one such area of concern, namely the prohibited transaction tax, to present the prohibited transaction tax safe harbor rules and identify several disposition options that could help a REIT avoid such tax.
Background and the prohibited transaction safe harbor rules
A REIT will generally avoid paying federal income tax by distributing all of its REIT taxable income in the form of dividends annually. However, even though a REIT may distribute or pay out all its income, there are instances where a REIT may be liable for federal tax. For example, if a REIT engages in a prohibited transaction, any gains generated are subject to the 100% prohibited transaction tax, designed to discourage REITs from engaging in dealer transactions1.
A prohibited transaction does not include the sale of a real estate asset if the following safe harbor rules are satisfied:
- the property has been held by a REIT for at least two years for the production of rental income2
- the aggregate expenditures made by the REIT or any partner of the REIT during the two-year period preceding the date of sale that are includible in the basis of the property do not exceed 30% of the net selling price of the property (30% Rule)
- the REIT did not make more than seven sales of property during the year or either:
- the aggregate adjusted bases (as determined for purposes of computing earnings and profits) of property sold during the tax year does not exceed 10 % of the aggregate bases of all of the REIT’s assets as of the beginning of the year, or
- the fair market value of property sold during the year does not exceed 10 % of the fair market value of all of the REIT’s assets as of the beginning of the year; or
- the trust satisfies the requirements noted in i) above by substituting 20 %3 for 10 % and the three-year average adjusted bases percentage for the taxable year does not exceed 10 %; or
- the trust satisfies the requirements noted in ii) above by substituting 20 %4 for 10 % and the three-year average fair market value percentage for the taxable year does not exceed 10 %
- if the REIT did not satisfy the seven sales of property rule, substantially all of the marketing and development expenditures related to 3(b)(i)-(iv) were made through an independent contractor or taxable REIT subsidiary5 (TRS) from whom the REIT receives no income; and
- in the case of property, which consists of land or improvements, not acquired through foreclosure or lease termination, the REIT has held the property for at least two years for the production of income
Determination of dealer versus investment property
One position a REIT may use is that the property sold was not inventory and that the REIT is not a dealer in such property. In general, inventory or property held by a taxpayer primarily for sale to customers as part of its business is not considered a capital asset6. Accordingly, if a REIT were deemed to have sold dealer property, the sale would be considered a prohibited transaction. While the Internal Revenue Code (Code) contains no guidance in terms of distinguishing between inventory and investment property, there have been hundreds of cases analyzing the broader dealer vs. investor issue, each of which references certain factors (e.g., the frequency and number of sales). It is important to note that each sale must be evaluated separately, and some factors may be given more weight than others. When everything is taken into consideration, it really depends on the facts of the case.
Determining whether a sale is a prohibited transaction is performed on a year-by-year basis. Failure to meet all of the safe harbor requirements does not automatically mean that any sale was a prohibited transaction and that a REIT is left without options to mitigate. With proper planning and well-documented facts, the following options are available that should allow a REIT to dispose of multiple assets in a year, including:
Generally, when a REIT is winding down or nearing the end of its life cycle, its assets may be sold to several unrelated buyers over a period of time or in its final year of existence. In this scenario, it is quite possible that the REIT could conflict with the safe harbor rules noted herein. However, the IRS has ruled7 that a proposed sale of real estate properties by a REIT under a plan of liquidation will not constitute a prohibited transaction. Accordingly, a REIT's gains on sales, made pursuant to a plan of liquidation, will generally not be subject to the 100% prohibited transaction tax.
Like kind exchanges—section 1031
In PLR 201614009, the IRS ruled that a taxpayer’s like-kind exchanges were not treated as a sale for prohibited transaction purposes and would not be treated as a sale for purposes of the prohibited transactions limitation (i.e., 7 sales). However, to the extent that the REIT recognizes gain on boot8 received, that portion of the 1031 transaction may be treated as a sale for purposes of the safe harbor.
Negotiate sale of portfolio to single buyer or limited number of buyers
The sale of more than one property to a single buyer as part of a single transaction counts as only one sale9. For example, a REIT which owns 70 real estate assets (each of which was held for more than two years), may sell 10 of those assets each to seven different buyers and stay within the safe harbor.
Transfer property to a TRS
A REIT could transfer a property or multiple properties to a TRS, which could then sell the assets. While the TRS would be subject to tax on any gain, the tax would be capped at 21%. For REITs that are contemplating the sale of several properties and find they do not fit within the safe harbor provisions outlined herein, a 21% vs. 100% tax should be a trade-off its shareholders are willing to accept.
Before disposing or diversifying its property portfolio, REIT taxpayers should contact their tax advisors to discuss the prohibited transaction rules and options available to avoid a property sale characterized as, or deemed a prohibited transaction. As part of our REIT services, RSM can assist REITs with tracking, monitoring and substantiating its sales to help mitigate the 100% prohibited transactions tax on such assets sold.