Both real estate investors and real estate private equity fund sponsors must consider the organizational structures they use to hold their investments. Historically, partnerships and limited liability companies (“LLCs”) have been the top choice due to their flexibility and tax benefits. The REIT is another option to consider as there are significant benefits to both individual investors and property owners. REITs can avoid corporate income taxes (for the most part), while offering the ability to diversify a portfolio’s investment mix.
In the real estate sector, REITs are commonly identified by the type of real estate investments they hold. The following categories are the main types of REITs. Equity REITs primarily own and operate real estate related assets (multi-family, office, industrial, hospitality, data storage centers, etc.). Mortgage REITs generally provide financing directly to real estate owners and operators or hold mezzanine debt. And Hybrid REITS contain a mix of both equity and mortgage investment strategies.
While there are significant tax benefits through the use of REITs, these four requirements and tests are key considerations for an entity considering a REIT structure (a) ownership requirements; (b) asset tests; (c) income tests; and (d) distribution requirements.
Ownership Requirements
In order to qualify as a REIT, the following rules apply:
- Legal formation as a corporation, trust or association (although LLCs may elect to be treated as a corporation under the tax code).
- Management must be by one or more trustees or directors.
- Ownership by at least 100 shareholders starting with the second taxable year (100 shareholders must exist at least 335 days of each year).
- Greater than 50% in value of entity’s stock cannot be owned by five or fewer individuals during the last half of each tax year.
Within the provisions of the REIT and related structures, it is a common practice to limit the amount of ownership an individual may maintain to less than the 10% of the total shares to ensure a REIT maintains the provisions of the “5 or fewer” test.
Asset Tests
Under the asset tests in Section 856(c)(4), 75% of the value of the total assets of a REIT at the close of each quarter of a taxable year must consist of qualifying assets. The term “total assets” means gross assets of the REIT determined according to U.S. GAAP. Qualifying assets of the REIT are represented by one or more of (a) real estate assets; (b) government securities; and (c) cash and cash items, including receivables.
The term “real estate assets” includes tangible real property, interests in real property, and interests in mortgages. These items would include property such as land, land improvements, buildings or structures as well interests in real property such as co-ops, timeshares, and so forth for equity REITs and would include interests in mortgage and mezzanine debt.
While the 75% testing is the main asset test, there are also other limitations that exist with regard to the ownership of assets:
- No more than 20% of a REIT’s total assets may consist of securities of taxable REIT subsidiaries (TRSs), and not more than 5% of its total assets can be of any one issuer, except for securities qualifying for the 75% test and for securities of TRSs.
- No more than 25% of a REIT’s total assets can consist of securities.
- No more than 10% of the outstanding value of the securities of any one issuer may be held by a REIT, except with respect to TRSs.
If a REIT is not in compliance with the asset test at the end of a quarter, the REIT has the ability to cure the failures/non-compliance generally within a one-month period. As a result, it is very important that a REIT closes its books and analyzes these items on a timely basis.
Also related to the asset tests are services and activities that REITs are prohibited from performing. Services that are non-customary or rendered primarily for a tenant’s behalf (i.e., rather than those services normally performed in connection with the rental of space) such as special cleaning services (e.g., maid services) would not be able to be performed by REITs. In order to ensure compliance with this rule, a REIT can establish a TRS, which is not subject to the same restrictions. However, it should be noted that a TRS is taxed on its net income as a regular corporation.
Income Tests
A REIT must have gross income the character of which meets certain percentage requirements each taxable year. There is a 75% test as well as a 95% test under code Sections 856(c)(2) and (3). In order to meet the 75% test, at least 75% of a REIT’s gross income must be derived from the following:
- Rents from real property.
- Interest on obligations secured by mortgages on real property or on interests in real property.
- Gain from the sale or other disposition of real property.
- Dividends and gains from the sale or other disposition of other REITs.
- Abatements and refunds of taxes on real property.
- Income and gain derived from foreclosure property.
- Amounts received or accrued as consideration for entering into agreements (a) to make loans secured by mortgages on real property or on interests in real property; or (b) to purchase or lease real property.
- Gain from the sale or other disposition of a real estate asset that is not a prohibited transaction.
- Qualified temporary investment income.
In order to meet the 95% test, at least 95% of a REIT’s gross income must be derived from sources described in the 75% test as well as from earnings from certain types of portfolio income such as interest, dividends and gains from sales of securities.
To ensure compliance, REITs may create a TRS to hold property or receive income that does not qualify under various tests.
Qualifying income included in the category of rents from real property includes not only basic rent, but also includes rental escalations, charges for taxes, common-area maintenance charges (“CAMs”), etc. Rents that are based in whole or in part on the gross receipts of a tenant may qualify, but rents contingent on profits would not.
Noncompliance with the annual income testing requirements can either result in a 100% tax on disqualifying (bad income) or can result in the REIT losing its REIT qualification and thus subject it to corporate income tax on all of its income. Therefore, it is crucial that the annual income test be analyzed each year. Furthermore, REITs generally review year-to-date income on a quarterly basis to identify any potential issues while having sufficient time to cure any problems.
Distribution Requirements
In order to maintain REIT status, a REIT must distribute at least 90% of its taxable income in a tax year. In conjunction with the distribution, a REIT is entitled to a deduction for such dividends paid and therefore REITs will generally distribute at least 100% of its taxable income to avoid entity-level tax.
Due to the large amount of depreciation expense usually incurred by equity REITs, this requirement is generally not an issue as long as a REIT has sufficient cash flow. There is a mechanism in the tax code where a lack of sufficient cash flow to pay distributions will not cause a failure in the REIT’s status as a REIT, however, the election does require the shareholders to agree to recognize the income reported on the tax returns.
Form 972 is used by a shareholder who agrees to recognize a consent dividend as taxable income in the form of a dividend on the shareholder’s own tax return, even though the shareholder receives no actual cash distribution of the consented amounts.
Other REIT Election Considerations
Before deciding to form a REIT, it is important to consider an entity’s business plan and the makeup of the investors and their related preferences. If the business plan calls for short-term income from flipping both commercial and residential property, this would not be appropriate for the REIT structure. A 100% tax is imposed on the net income from prohibited transactions that include the sale of property held for sale by an entity in the ordinary course of business (e.g., property held as inventory or short-term flipping of real estate).
However, if investors are looking for long-term capital appreciation, a REIT could be a structure worth considering due to the tax advantages of being entitled to the dividend paid deduction. Upon making the election, it is important to also decide on an Umbrella Partnership REIT (“UPREIT”) or DownREIT structure.
An UPREIT is a structure in which the REIT owns its required real estate investment through an operating partnership.
A DownREIT structure is typically used by existing REITs where a REIT owns properties directly in addition to its investment in an operating partnership.
The UPREIT structure permits deferral of a gain upon contribution of properties while allowing the contributing partner to obtain liquidity and diversification. If an owner were to contribute appreciated real property directly to a REIT, gain or loss would generally be recognized. Using an UPREIT structure would be an ideal way for a real estate owner to transfer his or her property to a REIT without recognizing a gain. There are provisions to consider with an UPREIT structure that include the following:
- If property that is contributed has appreciated, the partnership agreement must provide that the contributing partner be allocated certain amounts of income, gain, loss, deductions, or credits not based on his/her partnership interest, but rather adjusted to take into account his/her basis in the property transferred. This generally will mean that the contributing partner will receive less depreciation deductions and will recognize a gain on any sale of the property, taking into consideration the original basis in the property.
- If property has a mortgage or other partnership-related debt, reduction of the debt may result in a deemed distribution (which may be taxable) to the contributing partner.
- If the contributing partner receives cash or marketable securities from the partnership at the time of transfer or within a time period thereafter (within two years), the partner may be treated as having sold his/her property, in whole or in part, rather than having contributed it the partnership and will recognize gain.
- The contributing partners remain subject to all the usual rules restricting use of losses, including passive losses and at-risk limitations.
- The partnership agreement generally includes provisions to protect the REIT partner, including that the partnership is required to make specified distributions to ensure the REIT can meet the 90% distribution test mentioned above.
REITs in the Future
Absent any significant changes to the tax code, it is expected that REITs should continue to be favored in the industry as a form of organizational structure. As noted, there are many complex qualification requirements. As such, it is imperative you speak with your trusted business advisor. Nevertheless, the REIT structure can be an advantageous component of a real estate enterprise. Click here to see a discussion about the benefits of REITs in the real estate private equity sector.
