A REIT allows investors to pool capital to participate in real estate ownership—think of it as a mutual fund for real estate. Investors receive tax advantages that are more commonly associated with larger and more sophisticated investors and businesses, yet also benefit from professional management of a diversified portfolio of real estate assets. But setting up a REIT is not without challenges. A REIT must meet various organizational, operational, income, and asset requirements. Taxation as a REIT entitles the entity to a dividends-paid deduction so that a REIT may not be required to pay any corporate-level income tax, rather than the normal double taxation applicable to “normal” US corporations. Although shareholders of a REIT must pay tax on the dividend income received (subject to certain exceptions), this results in a single level of tax payable by shareholders. Given these advantages, REITs are highly regulated, with their asset ownership, income, and activities scrutinized closely. Unsurprisingly, the administrative burden of maintaining REIT compliance can be costly.
This article aims to provide an overview of the wonderful world of REITs, including organizational requirements, distribution requirements, taxation, and certain nuanced complexities facing REITs, while also briefly addressing notable recently proposed rule changes. This article discusses certain US federal income tax considerations applicable to REITs but does not comprehensively discuss all tax considerations; for example, state and local taxes, indirect taxes, and payroll taxes are not covered.
Requirements to Be a REIT
The Internal Revenue Code defines a REIT as a corporation, trust, or association (i) that is managed by one or more trustees or directors, (ii) the beneficial ownership of which is evidenced by transferable shares or by transferable certificates of beneficial interest, (iii) that (but for the REIT provisions) would be taxable as a domestic corporation, (iv) that is neither a financial institution nor an insurance company, (v) the beneficial ownership of which is held by 100 or more persons, (vi) that may not be closely held, and (vii) that must meet certain income and asset requirements. A REIT must elect to be taxed as a REIT for US federal income tax purposes.
A REIT must have at least 100 or more shareholders for at least 335 days of a 12-month taxable year. The days do not need to be consecutive. This rule applies to the second taxable year and subsequent taxable years thereafter. The closely held requirement means that five or fewer individuals may not own more than 50 percent of the REIT. Generally, ownership attribution rules are applicable (e.g., a corporation would be deemed to own its subsidiaries’ shares in the REIT along with its own shares for purposes of this requirement). Each tax year, a REIT generally will demand a written statement from its larger shareholders disclosing their direct or indirect ownership. These ownership rules ensure that a REIT is not just used as an investment vehicle for a closely held group and instead, is
A REIT must also satisfy two income tests every year and certain asset tests every quarter of every year.
At least 75 percent of the gross income for each taxable year must be derived from (i) rents from real property, (ii) interest on obligations secured by mortgages on real property, (iii) dividends received on shares of other REITs, (iv) gain from the sale or other disposition of real property, including gain from the sale of shares of other REITs, and (v) other specified real estate–related items. Additionally, at least 95 percent of the gross income for each taxable year must be derived from (i) income that qualifies for the 75 percent gross income test, (ii) dividends (other than from other REITs), (iii) interest income from obligations not secured by real property, and (iv) gain from the sale or disposition of stock or securities (other than stock of other REITs or interests in partnerships).
Rents from real property are a broad category and include amounts received for the right to use real property, including charges for services customarily rendered in connection with the rental of real property. This also includes real estate taxes, late charges, and tenants’ obligations towards certain operating expenses and utilities. (Rent attributable to personal property leased under, or in connection with, a lease of real property is included as rent from real property provided that the personal property portion does not exceed 15 percent.) Rents from real property do not include any related-party rent, certain contingent rent, amounts derived from impermissible tenant services, and rents from personal property if they do not meet the 15 percent rule described above.
Although a REIT may provide services to its tenant such as security services, maintenance, and cleaning, such services must be incidental to the rental of the property. This is a vital distinction because impermissible tenant services can actually cause all the rent from a property to be treated as income other than rents from real property. Accordingly, services income generally is reviewed closely by REITs to ensure they are not running afoul of any applicable rules.
So, what happens if a REIT fails to satisfy its income tests? In the worst-case scenario, an entity may lose its REIT status entirely and be treated like a “normal” US corporation. If, however, a failure occurs due to reasonable cause and not by willful neglect, and if the REIT discloses such failure to the IRS, the entity can maintain its REIT status, which, in some cases, may require the REIT to cure the failure. A REIT must also pay a tax equal to the greater of the amount by which it failed the 95 percent income test or the 75 percent income test multiplied by a fraction the numerator of which is generally the REIT’s taxable income for the year of the failure (determined without regard to the dividends-paid deduction and without regard to the deduction for taxes paid by the REIT) and the denominator of which is generally the REIT’s gross income for the year of the failure (subject to certain exclusions).
Reasonable cause may be construed broadly, but a REIT should exercise ordinary business care and prudence in attempting to satisfy the requirements of the gross income tests. Generally, reliance on a “reasoned, written opinion” constitutes reasonable cause, but the absence of such a reasoned, written opinion with respect to the transaction does not, by itself, give rise to any inference that the failure to meet a percentage-of-income requirement was without reasonable cause. Of course, reliance on an opinion is not reasonable if the REIT has reason to believe that the opinion is incorrect (e.g., if the REIT withholds facts from the party rendering the opinion). An opinion is not “reasoned” if it does nothing more than recite the facts and express a conclusion, without any sort of analysis.
Apart from making sure that a REIT is generating “good” income, at the close of each quarter of the taxable year, at least 75 percent of the REIT’s total assets must consist of real estate, cash and cash items, and government securities. Real estate assets include real property interests, and also generally include personal property (to the extent that such property complies with the 15 percent rule described above), debt secured by real property and debt instruments issued by publicly traded REITs, shares of other REITs, and other specified assets.
In addition to the aforementioned 75 percent test, the asset test also includes five additional requirements:
- No more than 25 percent of a REIT’s assets may be represented by assets that do not count towards the 75 percent asset test;
- No more than 20 percent of a REIT’s assets may be represented by stock or other securities of taxable REIT subsidiaries (TRSs);
- The value of securities of any one issuer owned by the REIT may not exceed 5 percent of the aggregate value of the REIT’s assets (except for TRSs);
- The REIT may not own securities constituting more than 10 percent of the total value or voting power of the outstanding securities of any one issuer (except for TRSs); and
- No more than 25 percent of a REIT’s assets may be represented by specified debt instruments issued by publicly traded REITs.
So, what happens if a REIT fails to satisfy its asset tests? Similar to the consequences of failing the income test, a failure of the asset test may result in the loss of REIT status, as well as penalties and taxes. Generally, a REIT has a 30-day period to cure failures after the end of each quarter, provided that all requirements were satisfied in the previous quarter and the failure is not related to the 5 percent or 10 percent securities tests (mentioned above).
A REIT must also (i) demonstrate that the failure was due to reasonable cause rather than willful neglect, (ii) file a description of each asset that caused the REIT to fail the requirements, (iii) dispose of the nonqualified assets (or otherwise satisfy the tests) within six months, and (iv) pay a penalty equal to the greater of $50,000 or the tax computed on a specified amount of net income generated by the “bad” asset.
REITs may have subsidiaries, generally referred to as either a qualified REIT subsidiary (QRS) or a taxable REIT subsidiary (TRS).
A QRS can be any corporation for which 100 percent of the stock is held by the REIT (or other QRSs) and the corporation has not made a TRS election. (This may also include what tax practitioners refer to as “disregarded entities” for US federal income tax purposes.) All of the assets, liabilities, and items of income, deduction, and credit are treated for REIT purposes as if they were part of the REIT (i.e., the QRS is effectively ignored). Treatment as a QRS is automatic, and the corporation does not need to make an election. A QRS cannot elect to be treated as a REIT.
Alternatively, a TRS is a subsidiary of a REIT that may perform certain management services not customarily rendered in connection with the rental of space. The TRS may be 100 percent owned by a REIT, but such ownership is not required. Because a TRS must pay corporate-level federal income taxes (currently at a rate of 21 percent), a TRS allows a REIT effectively to “cleanse” non-qualifying REIT income (under the income tests described above) if directly earned by a REIT and convert it to qualifying income in the hands of the REIT. Rents received by a REIT from tenants also receiving non-customary services from a TRS will not be disqualified as “rents from real property.”
To be treated as a TRS, both the TRS and the REIT must sign an election statement to be submitted to the IRS. The TRS election automatically applies to any corporate subsidiaries of the TRS of which the TRS directly or indirectly owns a greater-than-35 percent interest in the voting power or value of the subsidiary. Once the TRS election has been made, however, it is irrevocable unless both the REIT and the TRS consent to the revocation.
Although a TRS must pay tax on its activities, certain restrictions apply. A TRS does not include any corporation that, directly or indirectly, engages in either (i) operating or managing a lodging or health care facility or (ii) providing rights (under a franchise, license, or other arrangement) to operate or manage a lodging or health care facility under a brand name. But a REIT may lease property to a TRS, and the TRS may hire an eligible independent contractor to undertake such services.
REIT Distributions and Taxes
Each tax year, a REIT must distribute as a dividend at least 90 percent of its REIT taxable income, although most REITs will distribute 100 percent of their taxable income. Tax at the corporate income tax rate, levied at 21 percent, is owed by the REIT on the taxable income that is not distributed. Capital gains may be retained by the REIT, in which case the REIT pays the 21 percent corporate income tax, and amounts are deemed distributed and then recontributed by each shareholder, respectively. Shareholders receive a credit for the tax paid by the REIT in respect of such capital gains.
A REIT can deduct dividends paid on its US federal income tax return, to the extent it has current and accumulated earnings and profits. The dividends-paid deduction can be claimed for the year the dividend is declared, and the dividend can actually be distributed within the 12-month period following the close of the taxable year. Shareholders are required to take dividends into account as taxable income in the year received.
Although maintenance of a REIT can be costly and complicated, and may not allow the flexibility that other investment vehicle alternatives may provide, REITs remain a preferred real estate investment vehicle because of this single layer of tax. Using a simple example, assume a domestic corporation invests in real estate and receives $100 of rental income. The corporation would owe $21 of tax (with a 21 percent corporate income tax rate) and then distribute the remaining $79 to its shareholders. The shareholders would owe tax on the income received. Assuming a 35 percent personal income tax rate for all shareholders, that leaves them with $51.35 remaining. That is a whopping 48.65 percent effective tax rate, without even factoring in any state and local taxes.
On the other hand, the same income earned through a REIT would not suffer the corporate income tax “leakage” because the REIT would receive a dividends-paid deduction on the entire $100 distributed. Shareholders would then receive the $100, subject to our assumed tax rate of 35 percent, leaving them with $65 remaining. This is a difference of $13.65. This example shows that investing through a REIT can potentially lead to a significant amount of tax savings. (A REIT dividend is ordinary income and is generally not “qualified dividend income,” which, for individuals, is taxed at capital gains rates. This calculation also does not include the net investment income tax of 3.8 percent.)
Foreign Investment in Real Property Tax Act
No discussion regarding REITs would be complete without a mention of the Foreign Investment in Real Property Tax Act (FIRPTA).
Generally, the tax code treats gain from the sale of stock by a foreign corporation as foreign source income and therefore not subject to US federal income tax. FIRPTA, however, provides that gain derived from dispositions of stock of certain “US real property holding corporations” (USRPHC) is treated as income that is effectively connected with a US trade or business and therefore subject to US federal income tax.
The disposition of a US real property interest (USRPI) by a foreign person is subject to income tax withholding in the United States. A USRPI includes any interest in a US corporation unless it is established that at no time during the five-year period immediately preceding the date of the disposition was the US corporation a USRPHC. A corporation is a USRPHC if the fair market value of its USRPIs equals at least 50 percent of the fair market value of the company’s USRPIs, its interest in real property located outside the United States, and any other assets the corporation used in the US trade or business. Most direct interests in US real property, such as land, improvements on the land, buildings, and other “inherently permanent structures,” are USRPIs.
To the extent that a US corporation is a USRPHC, a sale of stock would be treated as a sale of a USRPI and subject to FIRPTA. Upon disposition of a USRPI, FIRPTA rules require that the buyer withhold 15 percent of the amount realized on the disposition and remit such amount to the IRS. The 15 percent is on the gross amount of the consideration, not just the seller’s profit on the USRPI. Tax treaties generally do not provide any exemption from FIRPTA.
A foreign investor that disposes of a USRPI is required to file a US tax return with respect to the income arising from the disposition. Any tax withheld shall be credited against the amount of any income tax due.
Application to REITs
A REIT generally acts as a “blocker” corporation in respect to the underlying investments (i.e., the activities of a REIT, including its income, are not attributed to the owners of a REIT). REITs are generally USRPHCs, which means that FIRPTA taxes and tax filing obligations may apply to (i) gains from dispositions of REIT shares because such shares are considered USRPIs and (ii) REIT capital gain distributions, which are treated as if the foreign shareholder disposed of the USRPI itself.
Shares in a domestically controlled REIT, however, do not constitute USRPIs. As a result, any gain on the disposition of a domestically controlled REIT should not be subject to FIRPTA. A REIT is treated as domestically controlled if at all times during the past five years, less than 50 percent in value of the stock was held directly or indirectly by non-US persons (the DC-REIT Exception). The DC-REIT Exception can be tax favorable to non-US shareholders upon disposition of their investment.
Proposed Changes to DC-REIT Exception
The Department of the Treasury released proposed regulations (the Proposed Regulations) on December 29, 2022, that address (among other things) the determination of whether a REIT is domestically controlled, and, therefore, whether its non-US shareholders are eligible for an exemption from FIRPTA. The Proposed Regulations provide that the following nonpublicly traded entities should be “looked through” to their underlying owners: (i) domestic and foreign partnerships, (ii) REITs, (iii) regulated investment companies, and (iv) domestic corporations formed under subchapter C of the Code (C corporations) that are owned 25 percent or more directly or indirectly by foreign persons. See Proposed Treas. Reg. § 1.897-1(c)(3)(ii).
A foreign-owned domestic corporation is any nonpublic domestic corporation in which foreign persons hold directly or indirectly 25 percent or more of the fair market value of the corporation’s stock. This look-through approach with respect to C corporations is a significant departure from the well-established tax norm of not looking through a C corporation for the domestically controlled determination. The preamble to the Proposed Regulations provides that that purpose of this look-through rule is to “prevent the use of intermediary domestic C corporations by foreign investors to create domestically controlled [REITs]” that would be exempt from the application of FIRPTA for stock held directly by those or other foreign investors. Essentially, Treasury is worried that the DC-REIT Exception is being taken advantage of by certain fund sponsors and non-US investors.
Many real estate funds invest through REITs and currently use an investment structure for their non-US investors in which the REIT’s US ownership is 50 percent or higher in order to permit non-US investors to benefit from the DC-REIT Exception. This US ownership is maintained through a C corporation that is typically 100 percent owned by non-US investors. (The remaining less-than-50 percent interest may be held directly by non-US investors.) Under the Proposed Regulations, the C corporation would now be a “foreign-owned domestic corporation” and would be looked through for purposes of the DC-REIT Exception.
These new rules may result in real estate fund sponsors and other non-US investors re-evaluating their existing investment strategies and structures and potentially considering other alternatives to satisfy the DC-REIT Exception under the new rules. However, the Proposed Regulations may be updated as a result of comments received, and it is expected that the IRS will receive various comments opposing these new look-through rules. Additional guidance is expected in the near future.
There are various tax considerations that must be considered when making a US real estate investment. Although REITs have very stringent rules with respect to organizational requirements, income earned, assets owned, and required distributions, they are generally a suitable investment vehicle for a variety of investors. US investors may prefer investing through a REIT because of its tax-efficient nature, and non-US investors may prefer a REIT because it serves as a blocker (which may also be preferred for certain tax-exempt organizations). Although there is no “one size fits all” approach to investing in real estate, most will agree that REITs are all right.