REITs: an attractive investment vehicle. (real estate investment trusts)(includes related article) (2024)

Changes in the tax law have made REITs more appealing for investorsinterested in real estate. Here's how REITs are taxed and what to lookfor when investing in REITs.

Before TRA 86, investments in real estate provided a tax shelter forhigh income taxpayers by generating losses to offset income from othersources. TRA 86 amended IRC Sec. 469 limiting the amount of lossdeductible from such activities to the income derived from passiveactivities. As a result, real estate limited partnerships were virtuallyeliminated as tax shelters. Real estate losses could only be used tooffset ordinary or portfolio income upon the disposition of the entireinterest in the passive activity. These changes shifted the focus ofinvestors to another form of real estate investment--real estateinvestment trusts (REITs).

REITs have been around since the early 1960s, but volatile interestrates and risky investments by some of the trusts kept the focus of mostinvestors on limited partnerships. Several newer REITs offer solidcapital structures, better management, and greater geographic diversity,lowering their risk and making them more appealing toinvestors.

1992 was a banner year for REITs, as evidenced by increased stockprices. In addition to TRA 86, TAMRA 88 eased many of the restrictionsfor qualifying and maintaining REIT status, thus enabling REITs toattract investors seeking replacements for lost tax shelters.

Characteristics of a REIT

REITs are an excellent way for small investors to pool their resourcesand invest in real estate properties without the major commitment oftime and capital required for direct ownership of real estate. REITinvestments offer greater liquidity (especially if publicly traded) anddiversification can be easily achieved through allocation of investmentsin mixed portfolios of properties and geographic areas. Long-term growthin share values is possible through increases in property values, andREIT income, sheltered through depreciation deductions, can bereinvested in additional property. As the bulk of their investments isin real estate, the price of REIT shares is affected by swings in thereal estate market. As a result they tend to be less volatile than otherequity stocks. There is also a greater liquidity to the shares than adirect investment in real estate.

Types of REITs

REITs are divided into three categories based on their source of income:1) equity REITs simply own and rent properties; 2) mortgage REITs makeloans; and 3) hybrid REITs do both. Equity REITs are considered superiorfor the long run because they earn dividends from rental income as wellas capital gains from the sale of properties. Mortgage REITs are a goodspeculative investment if interest rates are expected drop. They reactmore sharply to interest rate movements than equity REITs because theirdividends are from interest payments. Some REITs may be organized for asingle development project. Others, called finite-life REITs, are set upfor a specified number of years, after which they are liquidated and theproceeds are distributed to the shareholders. Another type ofclassification for REITs involves the ability to issue additionalshares. Closed-end REITs can issue shares to the public only once andcannot issue additional shares (causing dilution) unless approval isgiven by current shareholders. Open-ended REITs may issue new shares andredeem shares at their fair market value at any time.

Taxation of REITs

With some exception, REITs are not taxed on the income they distributeto shareholders. This avoids the double-taxation problem of regularcorporations. One of the requirements for REITs is that they distributenearly all of their income to shareholders annually to avoid a penaltytax.

Investors are assured that annual dividends will be forthcoming if theREIT is profitable. Except in the case of capital gain distributions,the dividends are normally considered portfolio income, and they cannotbe used to offset passive losses from limited partnerships.

Qualifying To Be A REIT

To apply for REIT status, an organization must be a corporation, trust,or association whose main investments are in real estate and mortgagesand which otherwise would be taxable as a domestic corporation. It mustbe managed by one or more directors or trustees who hold legal title tothe property of the trust and who have the rights and authority tocontrol the trust as would a centralized corporate management. Thetrustee may be an officer, employee, or shareholder of an independentcontractor that provides services to the REIT, such as handling realestate mortgages owned by the trust. A wholly-owned subsidiary of acorporate investment advisor to the REIT can also serve as anindependent contractor to manage the trust's property. The shareholdersmay review and re-elect the trustees annually, so their performance isnot above scrutiny and criticism.

Ownership Requirements. The beneficial ownership of the trust must beevidenced by transferable shares or certificates and held by at least100 persons. For purposes of the 100-person test, shares held by relatedparties of an individual are not attributed to thatindividual.

Additional Tests. Other requirements for REIT status include anextensive three-fold income test, designed to ensure that the income ofthe REIT is primarily derived from real estate investments, and a strictasset test, which must be met at the end of each quarter of the REIT'stax year. Prohibited transactions trigger a 100% penalty tax on the netincome from the transaction, unless the criteria are met for a "safeharbor" exclusion. Gross income, for purposes of the tests, includesonly recognized income which is determined in accordance with thetrust's method of accounting. It includes only the gross profit, and notgross receipts, on the sale or other disposition of assets.

The Three-fold Income Test. Seventy-five percent of the REIT's grossincome (excluding gross income from prohibited transactions) must comefrom the following sources:

* Rents from real property;

* Tenants' reimbursem*nts for property tax abatements and refunds;

* Interest on real estate mortgages;

* Distributions from other REITs;

* Gains on the sale of real estate and real estate mortgages not heldprimarily for sale to customers;

* Income from shared appreciation mortgages;

* Commitment fees; and

* Qualified temporary investment income.

In addition to the 75% test, the REIT must also derive 95% of its grossincome (excluding gross income from prohibited transactions) from thesources which meet the 75 percent test, plus dividends, interest, andgains from the sale or other disposition of stocks and securities. Thesetwo tests are to ensure that income is from investments and principallyreal estate investments.

The last part of the income test restricts the REIT's gross income toless than 30% from the sale of stocks and securities held short-term,prohibited transactions, real property held less than four years (otherthan foreclosure property and property involuntarily converted), andinterests in mortgages on real property held less than four years.

Investment Diversification Requirements. In addition to the incometests, the electing trust must also satisfy a two-fold asset test. Forpurposes of this test, total or gross assets of the trust are TABULARDATA OMITTED determined in accordance with GAAP.

For the first part of the test, at least 75% of the value of the REIT'stotal assets must be in cash and cash items, real estate, and governmentsecurities at the end of each quarter of the REIT's tax year. Cashincludes cash on hand and time or demand deposits with financialinstitutions. Cash items include receivables which arise in the ordinarycourse of the REIT's operation.

Long-term installment obligations from the sale of REIT property areconsidered as a real estate asset if secured by a mortgage on realproperty, and are not included in receivables for purposes of this test.Government securities may include securities issued by the FHA, FHLB,Federal Land Bank, Federal Intermediate Credit Bank, Public HousingAdministration, U.S. Postal Service, and the Small BusinessAdministration.

Real estate assets for this test are defined as real property, includinginterests in real property and interests in mortgages of real propertyand shares in other qualified REITs. For shares held in other REITs toqualify, the issuing REIT must have been a qualified REIT for the entiretaxable year of the shareholder REIT. A regular or residual interest ina real estate mortgage investment conduit (REMIC) is also treated as areal estate asset, but if less than 95% of the REMIC's assets are realestate assets, the REIT is treated as holding directly its proportionateshare of the assets and income of the REMIC.

The second part of the asset test provides that not more than 25% of thevalue of the REIT's total assets be invested in securities (other thanthe securities included in the 75% test). Of the 25%, no more than 5% oftotal assets may be from one issuer, and that 5% cannot exceed 10% ofthe issuer's outstanding voting securities. The 25% test is redundant,since it is automatically met if the 75% test is fulfilled. However, thefive and ten percent limitations provide significant limitations oninvestments. Congress' intent was to ensure adequate diversification ofthe REIT's assets, thereby reducing the overall risk of the portfoliothrough regulation.

Prohibited Transactions

REITs are subject to a 100% tax on net income from "prohibitedtransactions," unless certain safe harbor rules apply. A prohibitedtransaction is the sale or other disposition of property held primarilyfor sale to customers in the ordinary course of a trade or business,with the exclusion of foreclosure property. Since it may be unclearwhether property is being held by a REIT primarily for sale, safe harborrules are available for determining when a particular sale does notconstitute a prohibited transaction. These requirements include that:

* The property sold must be a real estate asset;

* The REIT must have held the property at least four years;

* The total expenditures made by the REIT toward the property duringthe prior four-year period must not exceed 30% of net sales;

* The REIT must have no more than seven sales of property during thetaxable year, excluding foreclosure property; and

* If the property consists of land or improvements, it must have beenheld by the REIT for the production of rental income for at least fouryears, with the exception of foreclosure or leased property.

If a particular sale falls under the prohibited transaction category,the net income from that sale is excluded from REIT taxable income anddoes not affect the REIT's distribution requirement.

Foreclosure Property

Several IRC Secs. related to REITs make reference to foreclosureproperty, usually as an exception or exclusion to a requirement or test.The distinction made for foreclosure property was in recognition of manyinvoluntarily acquired holdings of REITs in the mid-seventies. Ingeneral, foreclosure provisions apply during a two-year period (at theelection of the REIT) following acquisition of the property. Foreclosureproperty includes real property and personal property such as attachedfixtures that are acquired by the REIT as a result of a bid atforeclosure proceedings, or as a result of an agreement by process oflaw after a default on leased property or indebtedness secured by theproperty. Election to treat property as foreclosure property isvoluntary and irrevocable and applies to all such property acquired in ataxable year. Subsequent leases and completion of construction causeadditional rules to apply to foreclosure property. All income fromforeclosure property is qualified income for the 75% and 95% incometests. If the REIT sells the property, the net income from the sale ismultiplied by the highest corporate tax rate to compute the tax.

Tax Computations

A qualified, electing REIT may deduct dividends paid to its shareholdersin computing its taxable income. The determination of a REIT's taxliability involves six separate computations, including the following:

* REIT taxable income, including capital gains and loss distributionsto shareholders, with adjustments for net income from foreclosureproperty, to which the usual corporate tax rate is applied;

* The effect of a net capital gain is taxable dependent upon theamount of the gain distribution to shareholders as compared to thetaxable income;

* The alternative minimum tax based on tax preference items;

* The tax on the net income from foreclosure property computed at thehighest corporate rate;

* The tax on prohibited transactions at the 100% penalty rate; and

* A 100% penalty tax on any income attributable to the gross incomewhich caused the REIT to fail the income tests. Any income resultingfrom a change in accounting methods (from cash to accrual basis) isincluded in REIT taxable income, usually prorated over a ten-yearperiod.

Dividends Paid Deduction

A REIT's main purpose is to provide a conduit through which shareholderscan receive the income from passive investments in real estate withoutbeing taxed at the corporate level. For this reason, the REIT is alloweda deduction for dividends paid, both for ordinary income and capitalgains, to reduce the amount of taxable income to the trust. Dividendsmay be paid in cash or property valued at the adjusted basis to the REITat the time of distribution. If a determination is made that the REITincorrectly calculated its taxable income and did not meet thedistribution requirements for qualification as a REIT, a deficiencydividend may be appropriate.

Prior to 1974, the IRS automatically disqualified the trust and imposedthe corporate tax on all of its income, regardless of the amountpreviously distributed. The deficiency dividend now allows the REIT tomake the additional distribution within 90 days of the determination andretain qualifying status without the additional tax penalty, althoughinterest charges do apply. The REIT must also file a claim for adeficiency dividend deduction within 120 days of thedetermination.

An excise tax equal to four percent of the excess of the requireddistribution over the distributed amount for the year is imposed onREITs that fail to distribute 85% of ordinary income and 95% of capital-gain net income by year end. This is to penalize REITs that manipulatethe timing of dividends to defer recognition of income by certainshareholders, and to restrict income timing advantages of non-calendaryear REITs.

Taxation of the REIT Shareholder

The shareholder treats a REIT distribution as ordinary income, unless ithas been designated as a capital gain dividend. A capital gain dividendis a long-term capital gain to the shareholder, even if the sale of hisREIT shares would not result in a long-term capital gain or loss. Thedetermination of what portion of a distribution is taxable as a dividendand what portion is a return of invested capital is based on the REIT'searnings and profits, rather than its taxable income. If the REIT'sdistribution to its shareholders exceeds the trust's earnings andprofits, the distribution is treated as a return of capital. Suchdistributions are tax free to the shareholder and reduce the adjustedbasis. They are taxable as a capital gain if they exceed theshareholder's adjusted basis. Dividends received from a qualified REITare not eligible for the dividend received credit, the dividend receivedexclusion, or the intercorporate dividend deduction as provided for inthe Code.

Under IRC Sec. 501, tax-exempt organizations may invest indirectly inreal estate through REITs without being subject to the tax on unrelatedbusiness taxable income (UBIT). The distributions from the earnings andprofits of a REIT qualify as dividends and thus escape the UBIT tax.

Evaluating the REIT as an Investment

Investments in REITs involve several key evaluation factors. Investorsshould diversify their holdings in REITs as they would with anyportfolio. Past performance of a REIT is a good assessment of managementability, and at least three years of operating results should beevaluated. Total management fees exceeding one percent of gross assetsper year would be considered high. Self-administered REITs will havelower fees since the property managers are employed by the trust.Information on publicly traded REITs is readily available in SEC filingsand should be used for evaluation purposes.

Leverage Status of the REIT. The less leverage a REIT has, the safer itshould be, and the greater its ability to take advantage of fallinginterest rates by borrowing to expand its portfolio. Total debt of theREIT should be less than five percent of the market value, calculated bymultiplying share price by the number of shares outstanding.

Dividend Payments. Dividend growth of 9-10% is considered good, anddividends should constitute the bulk of the return. Excessive capital-gain distributions may indicate the REIT's income is from nonrecurringevents and cannot be sustained over the long run. If the trust isselling off its properties to provide income, it will not have thefuture rental income needed for continuity.

Finite REITs do not provide the liquidity and dividend income of regularREITs, and the recent emergence of the finite form has not providedenough information for evaluating their appreciation potential. REITsare not usually a preferable investment for someone who has unusedpassive losses, since the REIT income cannot offset these losses. If aninvestor is subject to the alternative minimum tax, no benefit will beobtained for the passive losses with REIT income.

Evaluating the Investor's Needs. REITs can satisfy a need for currentincome or long-term appreciation. If one or the other is preferred,looking at how the management and trustees of the REIT are compensatedto determine the direction of the REIT has importance. If compensationis based solely on asset values, the management will likely concentrateon investing in additional properties and capital appreciation. If thebasis for determining compensation includes dividends or currentearnings, the management may be motivated to increase dividend yield,possibly at the expense of long-term appreciation.

The market's valuation of the REIT should be compared to the actualmarket value of the underlying assets. Generally, share prices for REITsare under-valued, but a large valuation difference could reflectinformation in the market that is unfavorable to the REIT. Using outsidevaluations for such comparisons is advisable, and the method of thevaluation is important. As with any financial instrument, the betterinformed the investor, the greater the chances are of locating sound,quality investments.

Risk is Relative

The riskiness of any real estate investment is directly related to theeconomic conditions which affect the entire economy, but the choiceamong the various forms of real estate ventures is tempered by theinvestor's desire for current income, capital appreciation, andliquidity. REITs have gained some favor over traditional real estatepartnerships due to the TRA 86 and the TAMRA 88 tax law changes. Inorder to take advantage of the newer regulations, investors must weighthe importance of their investments in terms of return, risk, and othertaxation factors. Overall, the REIT provides a sound real estateinvestment for those who want a current return as well as long-runappreciation without the time and capital investment requirements oftraditional ownership forms.

COMPARING PUBLICLY TRADED PARTNERSHIPS

One notable alternative to a REIT is a publicly traded partnership(PTP). "Master limited partnerships" (MLPs) were forerunners of PTPs.The Revenue Act of 1987 sanctioned real estate PTPs. The label MLP isstill often used as a synonym for PTP. Major tax benefits shared by PTPsand REITs relate to their flow-through nature. The double-taxationproblem associated with corporate earnings distributed to shareholdersas dividends is avoided because PTPs and REITs generally are not subjectto an entity-level tax on their earnings. Moreover, the maximum tax rateapplied to the distributed income in the hands of individual investorsof 31% is lower than the maximum corporate-tax rate of 34%.

The principal advantage of PTPs is flexibility. This flexibility comesfrom the virtual nonexistence of statutory controls imposed by tax lawon the manner in which PTPs are organized and managed and the way inwhich they conduct their business activities--with the exception of a90% income test.

As a general partner, a corporation may be eligible to receive specialallocations of most or all depreciation deductions. In contrast, REITsare not permitted to make special allocations of depreciation or otherdeductions. The special allocations of a PTP are dictated by profit andloss sharing ratios and are subject to the requirements of IRC Sec.704(b). The amount of depreciation allocated to the corporate partnerdepends, in part, on its adjusted basis in its partnership interest.

No Mandatory Distributions

There are no statutory requirements with respect to distributions to PTPpartners. Thus, PTPs can retain earnings for reinvestment or for otherpurposes. They are also free to distribute earnings pro rata ordifferentially among partners depending upon the partnership agreement.

Although PTPs do not have statutory distribution requirements, themarket may effectively limit the freedom of PTPs in this regard. Marketconsiderations seem to dictate that PTPs pay out most of their operatingcash flows. PTPs and REITs trade largely on current yields, whichgenerally permit little or no cash retention. Another factor is thatinvestors (limited partners) in a PTP are taxed on their share ofpartnership income whether or not it is distributed. Thus, investorshave a clear preference for current distributions of part or all of theearnings in order to pay the taxes on these earnings.

To avoid being taxed as corporations, PTPs must derive 90% or more ofgross income from the following sources: Interest, dividends, oil andgas, commodities, real property rents, and gains from sales ordispositions of real property, capital assets, or IRC Sec. 1231 assets.For both PTPs and REITs, the term "real property rents" means rents frominterests in real property, charges for services customarily furnishedin connection with real property rentals, and rent attributable topersonal property leased in connection with real estate to the extentsuch rent does not exceed 15% of total rent. Amounts contingent on"income or profits" are not treated as rents from real property.However, rent can be based on a fixed percentage or group of percentagesof receipts or sales, which would permit some types of percentage rentalclauses. For PTPs (but not REITs), the term "real property rents" alsoincludes income from furnishing services to tenants or managing realproperties.

Net income from PTPs is treated as portfolio income at the investor-partner level. The only way PTP investors can benefit from PTP losses isto carry them forward and offset them against future PTP income (fromthe same investment) or sell their PTP shares.

Losing the PTP Status

PTPs can lose PTP status by failing to meet the 90% income test. If thistest is not met, the partnership would be treated as a regularcorporation. This would trigger a deemed transfer of all partnershipsassets (subject to liabilities) to a newly formed corporation inexchange for stock under IRC Sec. 351. The individual investors areregarded as having received the stock in complete liquidation of theirpartnership interests. PTP liquidating distribution rules are governedby IRC Secs. 731 and 732, which may cause income recognition to thepartnership under certain conditions--generally pertaining to recaptureof previously claimed tax benefits. IRC Sec. 7704(e) contains rules topreclude inadvertent PTP terminations. PTPs that no longer have theirpartnership interests publicly traded become regular partnerships andare not subject to PTP rules.

PTPs are considered riskier investments than REITs. The market does nothave the same long-term experience with PTPs as it has with REITs. PTPswere officially sanctioned in the Revenue Act of 1987 for real estateand a limited number of other activities. Although master limitedpartnerships have existed since 1981, prior to 1987 there had been arisk the IRS would reclassify and tax all large publicly tradedpartnerships as corporations. A second reason for the market's lack offamiliarity with PTPs is that there are relatively few security analystswho provide information about PTP investments. The market's relativeunfamiliarity with PTPs results in investor caution, and as aconsequence, PTPs must offer yield premiums to attract investors. Nowthat legislation has clarified the status of PTPs, the market may devotemore time and energy to PTP investments.

Less Regulation Bust Also Less Liquidity

There is far less regulation of the organization and operation of PTPsthan REITs. In particular, the lack of statutory requirements forindependent directorships and minimum distributions out of earningsgives rise to a greater risk of conflicts-of-interest. PTP investors donot have the guarantees that their REIT counterparts enjoy, andtherefore, they (or their advisors) must spend considerable effortreviewing PTP prospectuses and partnership agreements.

Partially as a result of these reasons, many non-publicly traded masterlimited partnership investors have had difficulty selling their shares.One analyst stated that master limited partnerships "trade almost byappointment." Sales of PTB shares could be at a sharp discount from thevalue of the underlying real estate assets due to the market'sskepticism about public partnerships. This lack of liquidity reduces theattractiveness of PTP shares, which results in an additional yieldpremium.

Ray A. Knight, JD, CPA, and Lee G. Knight, PhD, are professors at MiddleTennessee State University. They have published numerous articles inprofessional publications, including the CPA Journal.