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Stephen J. Ehrenberg
Stephen J. Ehrenberg

Real estate investment trusts: The wave of the future?

REITs flourish as investors look outside their traditional boundaries.

May 30, 2013
by Stephen J. Ehrenberg, CPA

As the U.S. economy recovers and corporate America returns to profitability, taxpayers have sought to reduce their tax bills. From tax credits to enhanced deductions such as the Sec. 199 domestic production activities deduction, Congress has provided tax benefits for qualifying corporate taxpayers.

Due to eligibility requirements, taxpayers may not qualify for or be able to maximize the tax benefits from these incentives. To even the playing field, a “new” wave of benefit is becoming more popular, offering advantages to eligible taxpayers through structuring alternatives. This “new” benefit, which has actually been available for decades, comes from establishing real estate investment trusts (REITs) in atypical industries.

What is a REIT?

A REIT is an entity formed to own and, in certain cases, manage or operate real estate ventures such as office buildings, hotels, and apartment complexes. REITs can be privately owned or held by the public at large. Many REITs are publicly traded enterprises with securities available for purchase on the various stock exchanges.

To qualify as a REIT, Sec. 856 stipulates that, among other requirements, the entity must:

  • Have at least 100 shareholders;
  • Have no more than 50% of its shares held by fewer than six individuals during the last half of the tax year;
  • Maintain an investment portfolio that meets all the following qualifications:
    1. At least 75% of the value of its total assets is represented by real estate assets, cash and cash items (including receivables), and government securities;
    2. Meets a two-part gross income test; and
    3. Maintains no more than a 25% interest in taxable REIT subsidiaries;
  • Distribute at least 90% of its income to shareholders as dividends.

 

Tax treatment of REITs

REITs are passthrough entities because they can avoid an entity-level tax by paying their income out to their investors and taking a deduction for those dividends paid (Sec. 857). (However, REITs cannot pass their losses through to the shareholders.) Even capital gains can be distributed to shareholders, and, if the REIT designates those distributions as capital gains, the shareholders pay tax on them at the reduced capital gain tax rate (Sec. 857(b)(3)). The REIT can also designate certain capital gains as undistributed and pay tax on them, but the shareholders then receive a tax credit for the tax the REIT pays on those gains.

REITs that fail to distribute 85% of their ordinary income and 95% of their capital gain income to shareholders are subject to a 4% excise tax under Sec. 4981.

Why invest in a REIT?

These types of investment vehicles, which bundle equity opportunities in real estate, offer investors access to large-scale ventures that otherwise might not be available to them. Furthermore, because REITs receive tax deductions for the dividends paid to shareholders, REIT investments give shareholders greater cash flows than their C-corporation counterparts, which are generally subject to the 35% maximum federal corporate income tax rate.

Today’s REIT

In today’s economy, as the cost of and access to capital return to normal levels, traditional REIT investments in rental properties and the like remain in favor with investors in the real estate market. However, as corporate America seeks to rebuild and strengthen its economic infrastructure, there also has been an increase in what many call “nontraditional” REIT investments.

Recently, taxpayers in nontraditional markets have sought permission from the IRS to restructure their existing entities into REITs. Entities operating in industries such as document storage, prisons, and cellphone towers have pursued the favorable tax status that traditional real estate entities have benefited from for years. These business operations, which often require an IRS letter ruling to operate as REITs, expand the spectrum of REIT investments to areas beyond traditional real estate by increasing the scope of what is considered real estate and rental income.

The prison companies, for instance, have successfully contended that housing prisoners is tantamount to the rental of real estate (i.e., the prison cells and the surrounding grounds) in exchange for compensation (Letter Ruling 201317001). The cellphone tower companies achieved REIT status by arguing that the receipt of revenue in exchange for the lease of space on their towers for the placement of equipment by mobile phone service providers amounted to rents from real property (Letter Ruling 201129007).

Conclusion

REITs are required to maintain minimum levels of real estate assets and are essentially required to pay most of their income to shareholders in the form of dividends. As the economy progresses, investors will continue to seek means to maximize their hard-earned dollars. While REITs have historically been focused strictly on traditional real estate ventures, there has been a recent rise in nontraditional REITs as corporate America and the taxpaying public diversify their portfolios to capitalize on these opportunities.

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Stephen J. Ehrenberg, CPA, MBT, is a tax principal in the Los Angeles office of Holthouse Carlin & Van Trigt LLP.