A Real Estate Investment Trust (REIT) is an entity, comparable to a mutual fund, that provides the opportunity for pooling of funds. It allows smaller investors to participate in larger investments, have expert management of assets, and allows for shares to be marketed.
There are significant tax advantages that a REIT provides under both the current law and President Biden’s tax proposal. REITs do not face double taxation if they distribute 100% of taxable income. A REIT can protect tax exempt shareholders from recognizing Unincorporated Business Taxable Income as well as foreign shareholders from tax on effectively connected income and FIRPTA in certain scenarios. Furthermore, shareholders that receive REIT dividends are eligible for a 20% deduction under Section 199A of the Internal Revenue Code (eligibility for this benefit would be somewhat curtailed under proposals by both the House Ways and Means Committee and Senator Wyden).
Two organizational requirements a REIT must comply with are: (1) ownership by 100 or more persons for 335 days out of the year and (2) not be closely held, often referred to as the “five-or-fewer” test. For the 100-shareholder requirement, one entity is considered one person. However, for the “five-or-fewer” test, entities are looked through until an individual is reached.
Both requirements are waived in the first year of formation, but you should remain cautious. If the decision is made to turn a real estate company into a REIT in the fourth quarter of any given year, by the following January 31, the 100-shareholder requirement must be met. Many more real estate companies would be REITs if it weren’t for the “five-or-fewer” test. Generally, ownership is too concentrated for this test to be met.
Quarterly asset tests must be met on the last day of each quarter. For example, suppose that on December 15 one of the asset tests was not passed. If that test is passed on December 31, the REIT meets this test.
Should one or more of the asset tests not be met, there is a 30-day grace period to cure the issue. In addition, there are relief provisions available which a REIT may follow to preserve its status.
A common misconception pertaining to the REIT income tests relates to personal property. When real and personal property are leased together, one must test to see whether more than 15% of the aggregate FMV of both the real and personal property represents personal property. If so, that percentage is reclassed as non-qualifying income. If not, all rents are deemed to be rents from real property. This 15% threshold applies only in situations when real and personal property are leased together. When the personal property is not leased together with the real property, the personal property rent does not qualify for the 75% income test as rents from real property.
There are two timing rules one should be aware of around a REIT’s 90% distribution test. The first is referred to as the “January dividend,” those dividends declared in October, November, or December that are paid by January 31 are treated as if paid on December 31. The other is commonly referred to as the “throwback rule” made by a formal election under which the REIT treats distributions declared and paid in the following year as paid on the prior December 31. Shareholders are taxed in the year paid rather than the year deducted by the REIT.
Additional tax considerations relate to “prohibited transactions,” which are defined as a disposition of property held primarily for sale to customers in the ordinary course of a trade or business. There is a 100% tax on gains from these transactions. However, if all elements of the safe harbor are met, this tax is avoided.
Also, taxable REIT subsidiaries (“TRS’”) should be considered during structuring. A TRS is a C-corporation that can engage in activities problematic for a REIT, although the TRS income is subject to double taxation, unlike the REIT. Through ownership of a TRS, a REIT can obtain the economic benefits of generating non-qualifying income and converting it into 95% qualifying gross income by means of a dividend for REIT income test purposes.
There are many intricacies in forming and maintaining REIT status. If you, or someone you know, has formed a REIT or is thinking of forming a REIT, please feel free to contact Mazars’ REIT Practice professionals for additional information.
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Bonni Zukof, Senior Manger
The information provided here is for general guidance only, and does not constitute the provision of tax advice, accounting services, investment advice, legal advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers.