Why Real Estate Companies Should Consider REIT Structures to Attract Domestic and Foreign Investor Capital by Arkadiy (Eric) Green, CPA
Posted on September 12, 2018
Investors around the world continue to view U.S. commercial real estate as an attractive asset to diversify their portfolios, minimize exposure to market volatility and build wealth. However, most of these projects require more capital than the average individual has to invest. In response, a growing number of businesses that own, operate or finance commercial properties are pooling their assets into public and private real estate investment trusts (REITs) to attract capital from individuals and institutional investors and yield preferential tax treatment. Understanding the nuances of qualifying for this type of real estate holding structure and adhering to a maze of complex regulatory requirements for structuring and negotiation REIT-related transactions requires the assistance of experienced tax professionals.
What is a REIT?
A REIT is a company that owns and operates income-producing real-estate assets, such as office buildings, shopping malls, multi-family properties, and warehouses, or that invests in mortgages secured by real estate. It typically includes a portfolio of real estate investments and is comparable to a mutual fund in that it allows a significant number of investors to own a share of large-scale real estate projects and receive dividend income without requiring them to invest significant dollars up front or exposing them to liquidity risks.
REITs may be traded publicly in the equity markets or a group of investors may hold them privately. They generally come in three forms:
- Equity REITs own and operate income-producing real estate,
- Mortgage REITs provide money to real estate owners through mortgages or mortgage-backed securities,
- Hybrid REITs are a combination of equity and mortgage REITs
What are the Tax Benefits of REITs?
For tax purposes, REITs are treated as C Corporations, similar to mutual funds, they receive the benefit of a tax deduction for the dividends they pay to their shareholders. As a result, REITs typically do not pay income tax at the corporate level. Instead, they enjoy a lower effective tax rate than typical C Corporations, which, beginning in 2018 is a 21 percent flat federal income tax rate.
Investors who own shares in REITs must pay taxes on the dividends they receive, which can be either ordinary or capital gains dividends. Indirectly, REIT shareholders get the benefit of the deductions that are usually available to real estate owners. These include interest payments, depreciation, and operating expenses taken at the REIT level. In addition, beginning in 2018, the Tax Cuts and Jobs Act (TCJA) introduces a substantial benefit for individual REIT shareholders by establishing a deduction equal to 20 percent of the shareholder’s ordinary REIT dividend income. Unlike a similar deduction for flow-through entities, REIT shareholders are not subject to limitations on this deduction based on the wages paid and the basis of qualified property.
REITs can also provide significant benefits to foreign investors, who may use REITs as “blockers” to help minimize their U.S. federal and state tax filing obligations. In addition, domestically controlled REITs, in which U.S. persons own more than 50 percent of the value of its stock directly or indirectly, can be structured to allow foreign investors to sell their stock of the domestically controlled REIT without incurring U.S. tax.
How can a Real Estate Holding Company Qualify as a REIT?
In exchange for preferential tax treatment, REITs must meet a number of burdensome organizational and operational requirements, including the following:
- REITS must be organized as corporations, trusts or associations, and managed by one or more trustees or directors;
- Beneficial ownership must be evidenced by transferable shares;
- There must be a minimum of 100 shareholders; and
- More than 50 percent of REIT shares cannot be held by five or fewer individuals.
Quarterly Asset Tests
- At least 75 percent of the value of total assets at the end of each quarter must consist of cash or cash items, government securities and real estate assets, including real property, mortgages on real property, shares in other REITs, and certain personal property leased with real property (that does not exceed 15 percent of combined real and personal property value);
- No more than 20 percent of the value of REIT may consist of securities of one or more Taxable REIT Subsidiary (TRS);
- No more than 25 percent of the value of the REIT assets may be represented by non-qualified publicly offered REIT debt instruments;
- Investment in securities of any one issuer (except for securities qualifying for the 75% asset test and securities of a TRS) cannot 1) exceed 5% of the value of the REITs total assets, 2) represent more than 10% of the total voting power of any one issuer’s securities, or 3) represent more than 10% of the value of the securities of any one issuer.
At least 75 percent of the REIT’s gross income for the taxable year must be derived from the following items:
- rents from real property,
- interest from mortgage obligations,
- gain from the sale of real property and mortgages on real property,
- other specified real estate source income,
- dividends from other REITs,
- abatements or refunds from real property tax,
- income and gain from “foreclosure property,”
- certain commitment fees, and
- income from certain temporary investments of new capital.
In addition, at least 95 percent of the REIT’s gross income must be from income items that qualify for the 75 percent income test, and other interest, dividends and gain from the sale of stock or securities.
For income-test purposes, rents that REITs receive from real property may include 1) amounts received for the right to use real property; 2) additional amounts collected from tenants for their share of real estate taxes or operating expenses and utilities; 3) rent attributed to personal property leased under a lease for real property if personal property rent does not exceed 15 percent of the total rent; and 4) charges for “customary” services rendered in connection with rental or real property.
Rents from real property generally exclude 1) rent based on net income or profits of any person (however, rents based on gross income are generally permissible), 2) related party rents (if the REIT owns 10% or more interest in the tenant, determined by applying specific attribution rules), and 3) impermissible tenant services income. If impermissible service income from a property exceeds 1% of total revenue derived from the property, then all income from the property is “tainted” as non-qualifying income (however, a TRS can generally provide impermissible services income to REIT’s tenants without tainting rents).
REITs must distribute 90 percent of their real estate investment trust taxable income (REITTI). The deduction they receive for dividends paid to shareholders in a taxable year must generally equal or exceed 90 percent of REITTI (excluding capital gain and without regard to the dividends paid deduction).
Failing to meet any of the REIT qualification requirements can lead to significant fines, treatment as a regular C corporation (i.e., losing the dividends paid deduction) and a loss of REIT status for five years.
Forming a private or public REIT structure can be a tax-efficient way for real estate businesses to attract capital from a wide variety of domestic and foreign investment sources, especially under the new U.S. tax laws. While REITs can raise capital and hold assets directly, most use more complicated structures in order to take advantage of certain tax benefits and the additional flexibility that these structures may provide. Structuring and managing this type of REIT structure is a complex, time consuming and potentially costly undertaking for which experienced real estate tax advisors should be engaged early on in the planning process.
About the Author: Arkadiy (Eric) Green, CPA, is a director of Tax Services with Berkowitz Pollack Brant, where he works with real estate companies, commercial and residential developers, property management companies, real estate investors and high-net-worth individuals to structure investments and complex transactions for maximum tax efficiency. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or via email at firstname.lastname@example.org.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.