[IMGCAP(1)]Real estate investment trusts were originally created to permit tax-efficient public investment in real estate, but REITs have also found wide use as private vehicles.
An entity becomes a REIT by making a tax election and satisfying certain requirements. In particular, a REIT’s assets must be primarily real estate and its income primarily derived from real estate. REITs must also satisfy certain ownership, operational and other tests. REITs are partial conduits. A REIT, unlike a “regular” corporation, deducts dividends paid. Its shareholders are taxed on dividends received. Based on a REIT’s long-term capital gains, its dividends may be taxed at long-term capital rates. The balance of a REIT’s dividends are taxed as ordinary income.
Limited partnerships and limited liability companies are generally preferable to REITs for private investment in real estate, because they are full conduits and are not subject to the substantial REIT qualification and compliance requirements. Thus, they are more flexible and less expensive.
However, a REIT may provide substantial comparative tax benefits in situations involving certain investors and assets. This article reviews the use of REITs as vehicles for private investment in real estate, and related issues and planning opportunities.
Foreign investors: A REIT can be a very good or very bad vehicle for foreign investment in U.S. real estate, depending on the asset and other factors.
Foreign persons are generally subject to U.S. income tax on gains from direct or indirect ownership interests in U.S. real estate. However, a foreign person is generally not subject to U.S. income tax on gains from sales of “domestically controlled” REITs (“DREITs”). Thus, a foreign person may pay no U.S. income tax on their exit from a U.S. real estate investment, if that exit can be structured as the sale of a DREIT.
DREIT qualification requires that less than 50 percent of the value of the REIT is held (directly or indirectly) by foreign persons. Indirect foreign ownership may present a practical issue for many private investment funds, which may have substantial foreign ownership or may not know the extent of their indirect foreign ownership. It may be possible to address this and other issues by obtaining representations and covenants from key investors.
DREITs do not solve all issues for foreign investors, however. For example, REITs are required to distribute substantially all of their taxable income as dividends. A 30 percent U.S. withholding tax applies to dividends paid to foreign investors, which may make a REIT a poor vehicle for foreign investment in properties generating substantial year-to-year income (as opposed to properties producing a return primarily due to capital appreciation).
As another example, a REIT may be a poor vehicle for foreign investment in U.S. mortgage loans, as (effectively) tax-free “portfolio interest” may be converted to taxable dividends. This issue is further complicated and may create cash flow issues for a REIT if the REIT has substantial non-cash interest income (e.g., original issue discount), as such income may compel the payment of dividends that are subject to withholding taxes which must be paid in cash.
U.S. tax-exempt investors: U.S. tax-exempt persons (such as churches, pension funds, charities and private foundations) generally are not subject to federal income tax on their investment income. However, they generally are subject to federal income tax on their “unrelated business taxable income,” including UBTI arising from debt-financed investment in real estate. One potential solution to this issue is to structure tax-exempt investment through a REIT. The REIT does not pay tax on its income (due to the dividends paid deduction), and the REIT’s UBTI generally does not flow through to its tax-exempt investors. In other words, the REIT “purges” the UBTI. This is potentially an easy and effective solution.
U.S. taxable investors: REITs may solve certain state tax issues. For example, a state may tax nonresidents on gain realized from the sale of real property located in that state, including gain realized through an investment in a partnership. However, general state conformity to the federal tax treatment of REITs may provide a planning opportunity. That is, if a REIT distributes its entire taxable income, its federal taxable income will be reduced to zero and (in a conforming state) its state taxable income will be reduced to zero. The REIT’s shareholders generally would be taxed on these dividends only by their state of residence, not the state in which the underlying property is located. Thus, it is possible that no state income tax will be imposed on a REIT’s earnings, even though the REIT’s properties are in high-tax states.
Many investments are not appropriate for REITs. REITs are subject to a number of limitations as to their permitted assets and income. Some of these limitations are simply prohibitions. For example, an entity will not qualify as a REIT unless at least 75 percent of its assets is real estate.
Less obviously, REITs generally cannot act as real estate developers or engage in condo conversions, due to the 100 percent tax penalty on inventory sales by REITs.
Many investments require special consideration or structuring. Some assets, such as commercial rental properties, may be relatively “easy” for REITs. However, even in “easy” cases, many issues require diligence, such as: Are any tenants related to the REIT or its beneficial owners? Is there on-site parking and, if so, who operates it and how is it operated? Do any tenants pay “percentage” rents? Are any non-customary services provided to tenants?
Other assets are “hard.” For example, REITs can own but cannot operate hotels. As a result, hotel REITs generally involve (at least) three parties: the REIT (which owns the hotel), a subsidiary of the REIT (which leases the hotel from the REIT), and an unrelated professional hotel manager.
Other assets may require special diligence or protections. For example, REIT investment in partnerships generally is tested on a look-through basis. If the REIT has a non-managing or non-controlling interest in a partnership, it could have qualification or penalty tax issues based on activities that it does not control. Ideally, a REIT will obtain some degree of contractual protection from these issues when it invests in a partnership.
REIT Investment in Debt
Debt instruments secured by real estate generally qualify as “real estate” for purposes of the REIT rules, and “mortgage REITs” are REITs that primarily invest in such assets.
Mortgage REITs may or may not be tax-efficient vehicles for foreign investors, as discussed earlier.
Mortgages require special diligence as a REIT asset class. For example, if the mortgage is secured by personal property in addition to real property, the mortgage may only partially qualify as a real estate asset. Mezzanine financing (i.e., loans secured by the equity of an entity that owns real estate) may also qualify as real estate assets, but the analysis is more complex and the status of such a loan may not be entirely clear. Special issues are raised by mortgages purchased at a discount, particularly in light of IRS Revenue Procedure 2011-16.
One or Multiple REITs?
For an investment in multiple real estate assets, a basic issue is whether to utilize one REIT to hold all of the assets or to use a separate REIT for each asset. U.S. taxable investors may prefer a single REIT, so that gains and losses from the various assets are pooled and the REIT distributes only the net taxable income of all assets.
Foreign investors may prefer a separate REIT for each asset as part of a DREIT structure, to permit the sale of each DREIT as an exit strategy.
State and Local Tax Planning for the REIT
State and local tax considerations may affect various aspects of REIT planning. For example, there may be benefits to forming the REIT as a limited partnership if it will own property in Texas and Pennsylvania. California’s rules relating to the dividends paid deduction may present particular issues.
REITs are not easy. REITs are expensive. REITs can be dangerous. In the right situation, however, a REIT may be the ideal vehicle for private real estate investments.
James McCann is a partner at Kleinberg, Kaplan, Wolff & Cohen, P.C. in New York, where he focuses his practice on domestic and international taxation. McCann counsels clients regarding all tax aspects of domestic and cross-border investments and business transactions. Representative clients include pooled investment funds and their managers, privately owned businesses and high net worth individuals. He can be reached at email@example.com.