The ABCs of REITs
A real estate investment trust (REIT) is a complex entity designed to provide all investors the opportunity to invest in commercial real estate in a tax efficient manner. REITs have become a popular investment vehicle around the world.
The REIT industry has a diverse profile and can be broadly grouped into two categories:
- Equity REITs predominantly own and operate real estate
- Mortgage REITs generally lend money directly to real estate owners and operators
While REITs differentiate themselves through various characteristics, all REITs must follow the same regulations under federal tax law.
To qualify as a REIT, an organization must be a corporation, trust or association. A REIT cannot be a financial institution or an insurance company and it must be managed by one or more trustees or directors. The REIT’s ownership (which must be proven by transferable shares or by transferable certificates of beneficial interest) must be held by at least 100 shareholders for at least 335 days of a 365-day calendar year (or equivalent thereof for a short tax year) for the second taxable year and beyond.
A REIT cannot be closely held. At any time during the last half of the taxable year, more than 50 percent in value of its outstanding stock can be owned, directly or indirectly, by no more than five individuals, (this is commonly referred to as the 5/50 test). Spouses and certain other family members are aggregated and count as one individual for this purpose.
A REIT is required to pay a dividend of at least 90 percent of its taxable income each year. A dividend is any distribution of cash or property made by a corporation to its shareholders out of its earnings and profits from the current taxable year and then from accumulated earnings and profits from prior years. If there are no earnings and profits available for a distribution, the distribution is considered a return of capital for the shareholder and is therefore nontaxable to the extent the shareholder has basis in the REIT shares.
Asset and income tests
A REIT is subject to different income and asset tests. These tests, in conjunction with all of the other REIT rules, mean that only certain assets can be held in a REIT.
Asset tests are completed on a quarterly basis; 75 percent of the value of a REIT’s total assets must be represented by real estate assets, cash, cash items and government securities. Real estate assets specifically include real property, interests in mortgages on real property or real estate mortgage investment conduits.
Diversification is also required as part of the asset test. No more than:
- 5 percent of the value of the REIT’s total assets may consist of securities of any one issuer, except with respect to a taxable REIT subsidiary
- 10 percent of the outstanding vote or value of the securities of any one issuer may be held (again, a taxable REIT subsidiary is an exception to this requirement)
- 25 percent of the total assets can be securities
- 25 percent of the REIT’s total assets may consist of one or more taxable REIT subsidiaries (the Protecting Americans from Tax Hikes Act reduces this requirement to 20 percent as of Jan. 1, 2018)
Along with the asset tests, REITs must also comply with annual income tests. For practical purposes, it is in the REIT’s best interest to test income on a quarterly basis in conjunction with the asset tests. These income tests are based on the gross income from the various properties that the REIT owns. There are two income tests: the 75 percent test and the 95 percent test.
The 75 percent test is comprised solely of real estate income. At least 75 percent of a REIT’s gross income must be derived from rents from real property, interest on obligations secured by mortgages on real property, dividends from other REITs, and gain from the sale or other disposition of real property. Rents from real property is defined to include rents; charges for services customarily furnished in connection with rental of real property; and generally rent attributable to personal property which is leased in connection with a lease of real property. Impermissible tenant service income is excluded from rents from real property. A taxable REIT subsidiary (TRS) is primarily used to allow the REIT to provide otherwise non-qualifying services.
REITs must also comply with the 95 percent test. While this test has less margin for error, it also allows for a greater variety of sources of income. This test includes both real estate and portfolio income. All of the real estate income from the 75 percent test is included in the 95 percent test. Interest income, dividend income, and gain from the sale or disposition of stock and securities are also included.
A prohibited transaction is a sale or other disposition of property that is held primarily for sale to customers in the ordinary course of a trade or business. Net income from prohibited transactions is taxed at 100 percent for REITs. There are certain safe harbors to follow in order to avoid a sale being deemed a prohibited transaction. Prohibited transactions are a common issue about which REIT stakeholders must be aware because the penalties can be severe. Proper documentation and planning before a REIT acquires and disposes of a property, however, can diminish the REIT’s exposure.
To REIT or not to REIT?
Whether or not a REIT makes sense for your company depends heavily on the makeup of your investors and their preferences. As noted, a REIT distributes earnings to shareholders in the form of a dividend. At the same time, the REIT is entitled to a dividends-paid deduction. From a tax perspective, this holds a significant benefit. Although a REIT is generally taxed as a corporation, the REIT can avoid paying entity-level federal income tax through the use of the dividends-paid deduction to offset its otherwise taxable income.
Tax-exempt or foreign investors:
The presence of a REIT is very attractive to tax-exempt investors. While these investors are generally exempt from paying federal tax by definition, many may still be subject to unrelated business income tax on their share of debt-financed real estate income.
On the contrary, dividends issued by REITs are generally excluded from unrelated business taxable income. Similar benefits can also apply to foreign investors who may be able to use a REIT vehicle to mitigate US reporting and tax withholding on dividend income and ultimate disposition of REIT stock.
REITs offer exciting opportunities to the average taxable investor as well. REITs offer diversification by investing in many different property types across all parts of the world. REITs provide yield in the form of dividends.
As noted earlier, REITs are required to distribute at least 90 percent of their taxable income to shareholders. REITs simplify state tax reporting for individuals since the state income tax consequences and filing requirements of multistate real estate portfolios do not pass through the REIT to the investor. The shareholders simply recognize dividend income and pay tax in their state of residence.
If the property is directly owned by an individual:
While the allure of not paying taxes is attractive, REITs may not be the best vehicle for an individual who directly owns property. The general organization requirements are significant hurdles.
While the 100 shareholder test can be easily administered, the 5/50 test requires a significant diversification of ownership that often deters owners that own a majority stake in real estate.
An attractive option, with rules
REITs are becoming an increasingly popular option in real estate. But along with the many valuable benefits come strict compliance rules that must be considered. Ignoring or misinterpreting these rules can significantly affect a REIT and its owners. With proper structuring and ongoing monitoring, the utilization of a REIT may be an attractive implementation for your next real estate investment.
Real estate funds considering setting up a real estate investment trust should also consider the impact of a REIT on taxable investors.
Real estate investment trusts can provide numerous benefits to a variety of investors looking to invest in real estate, but there rules.
Explore the prohibited transaction tax safe harbor rules and identify several disposition options that could help a REIT avoid such tax.