An Introduction to REITs

A real estate investment trust (REIT) is an investment vehicle that enables small investors to invest in large-scale income-producing real estate. Congress decided that the only way for average investors to invest in large-scale commercial properties was through pooling arrangements, in which small investors pool their capital and share in the benefits of real estate ownership. As a result, REITs were created by the Real Estate Investment Trust Act of 1960.

The REIT legislation was intended to provide substantially the same tax treatment for REITs that existed for regulated investment companies (RICs). Similar to RICs, REITs are treated as conduits through which "qualified" income distributed to shareholders is not subject to a corporate-level tax. In the context of a REIT, qualified income is generally passive income from real estate investments (as opposed to income from the active operation of a trade or business). REITs, like RICs, may deduct from their taxable income dividends distributed to shareholders, thus avoiding a Federal income tax at the entity level.

REITs played a limited role in real estate investment until the 1990s. In the early years, REITs were constrained, because they were only permitted to own real estate and not to operate or manage it. This was consistent with the view that REITs were passive investment conduits for holding real estate. The Tax Reform Act of 1986 permitted REITs, for the first time, not only to own, but also to operate and manage, most types of income-producing commercial properties. Today, there are about 300 REITs operating in the U.S., with total assets in excess of $300 billion; about two-thirds of these trade on the national stock exchanges.

REITs are subject to a myriad of technical and complex rules.

A REIT is a corporation, trust or association that meets the requirements of Sec. 856 and elects to be treated as a REIT. There are two basic REIT structures in use today. In the DownREIT structure, a property owner contributes property to a REIT in exchange for REIT stock. This is generally a taxable transaction. DownREIT contributions are taxable under Sec. 351(e), which excludes contributions of appreciated property to corporations that are considered investment companies from the nonrecognition of gain provisions. An alternative to the Down REIT is the umbrella partnership REIT (UPREIT) structure, which was first used in 1992. An UPREIT is a REIT that holds all or substantially all of its properties through a single operating partnership with the REIT as the general partner and others as limited partners. The principal benefit of the UPREIT structure is that it permits real estate investors to defer built-in gains that would be recognized if appreciated properties were contributed directly to a REIT in exchange for its stock.

The basic provisions for REITs appear in Secs. 856–859; other Code sections contain special rules for REITs. A REIT is subject to certain organizational requirements and operational rules. Under the operational requirements of Sec. 856, an entity qualifies as a REIT only if it satisfies tests of annual income, quarterly asset and annual distribution. While the operational tests ensure operational passivity of a REIT, the organizational and structural requirements satisfy the congressional intent that REIT shares be widely held.

To qualify as a REIT, an entity must elect to be taxed as a REIT or have in effect such an election from a previous tax year. In addition, an entity must:

1. Be organized as a corporation, trust or association;

2. Be managed by one or more trustees or directors;

3. Have transferable shares or certificates;

4. Be taxable as a domestic corporation but for the operation of Secs. 856–859;

5. Not be a financial institution or an insurance company;

6. Be owned by 100 or more persons; and

7. Not be closely held.

Requirements 1–5 must be met for the entire tax year, while requirement 6 must be met for 335 days of a tax year of 12 months (or a proportionate number of days for a tax year of fewer than 12 months). The seventh requirement must be met during the last half of each tax year, with the exception of the first tax year for which a REIT election is made. A REIT must use a calendar-year ac-counting period for its first year of qualification.

75% Test

A REIT must satisfy two source-of-income tests on an annual basis, designed to ensure that it derives the majority of its income from passive sources (e.g., rents, interest, dividends and occasional real estate sales). These are the 75% test and the 95% test. First, the REIT must derive at least 75% of its "gross income" (exclusive of gross income from "prohibited transactions") from the following sources:

1. Rents from real property;

2. Interest on obligations secured by mortgages on real property or interests in real property (i.e., mortgage interest);

3. Gains from the sale or other disposition of real property other than property held primarily for sale to customers in the ordinary course of business (i.e., Sec. 1221(1) property);

4. Abatements and refunds of real property taxes;

5. Dividends or other distributions on shares of other qualified REITs and gains arising from the sale or disposition of such interests;

6. Income and gain from foreclosure property (defined below);

7. Certain commitment fees;

8. Gain from the sale or other disposition of a real estate asset that is not a prohibited transaction solely by reason of Sec. 857(b)(6); and

9. Qualified temporary investment income.

For purposes of the REIT income tests, the term "gross income" has the same meaning as defined under Sec. 61 and the regulations thereunder. The term "prohibited transaction" means a sale or other disposition of property held for sale in the ordinary course of the taxpayer's trade or business that is not foreclosure property.

The term "rents from real property" is defined as rents from interests in real property, charges for services customarily furnished or rendered in connection with rental of real property (whether or not such charges are separately stated) and rents attributable to incidental personal property. In general, there must be a landlord-tenant type relationship. The Code specifically excludes rents (1) that depend in whole or in part on any person's income or profit from the property; (2) received (directly or indirectly) from a related-party tenant; and (3) from real property if the REIT furnishes or renders more than a de minimis amount of certain services to tenants or manages or operates such property other than through an independent contractor from which the REIT receives no income. A tenant is considered a related party if the REIT owns, directly or indirectly, either (1) 10% or more of the combined voting power of all voting classes of stock or 10% or more of the total value of a corporate tenant or (2) 10% or more of the assets or net profits of a noncorporate tenant.

The de minimis exclusion listed above, added by the Taxpayer Relief Act of 1997, allows REITs to provide a small amount of noncustomary services to tenants or to undertake certain management activities. Services are "customary" if, in the geographic market in which the property is located, tenants in buildings of a similar class are customarily provided with the service. Thus, services rendered in one region may be customary but the same services rendered in another region may not. Examples of customary services contained in the regulations include the "furnishing of water, heat, light and air conditioning, the cleaning of windows, public entrances, and lobbies, the performance of general maintenance and the furnishing of telephone answering services or laundry equipment." If the REIT provides more than a de minimis amount (generally more than one percent of all amounts derived during the tax year by the REIT with respect to the property) of certain noncustomary services to tenants of a property, any amount received with respect to such property is excluded from the definition of "rents from real property."

95% Test

Under the 95% income test, at least 95% of a REIT's gross income (exclusive of gross income from "prohibited transactions") must be derived from:

1. Sources that qualify for the 75% test;

2. Dividends or interest from any source; and

3. Gain from the sale or other disposition of stock or securities.

In addition, income qualifying for the 95% test includes income from all hedges that reduce the interest rate risk of REIT liabilities.

To ensure that a REIT's assets consist primarily of real estate, Congress imposed a series of asset tests with which a REIT must comply. The 75% asset test requires that on the last day of each calendar quarter of the REIT's tax year, at least 75% of the value of a REIT's total assets consist of real estate, cash and cash items and government securities. In general, "real estate assets" include real property, mortgages on real property and shares in other qualified REITs. Though seemingly redundant, another asset test (the 25% test) requires that not more than 25% of a REIT's total assets constitute securities (other than governmental securities or shares of a qualified REIT subsidiary). If the REIT satisfies the 75% asset test, it must satisfy the 25% test. Further, no more than 20% of the value of a REIT's total assets can be represented by securities in a taxable REIT subsidiary (TRS).

"Total assets" for purposes of the 75% asset test means the gross assets of the REIT determined in accordance with generally accepted accounting principles. The value of marketable securities is their market value as of the valuation date (i.e., the last day of the calendar quarter). The value of real estate assets and securities for which quotations are not readily available is as determined in good faith by the trustees/board. To perform the 75% test, the REIT must revalue its assets at the end of any quarter in which property was acquired. A revaluation of assets is not required at the end of any quarter during which there has been no acquisition of property; the mere change in market value of property held by a REIT does not, by itself, affect REIT status.

The asset tests also generally prohibit a REIT from owning 10% or more of the total value of the outstanding voting securities of any corporation. (Note: The 10% value test applies to tax years beginning after 2000.) Recent legislation has eased the limits imposed on REITs and allowed them to more effectively compete with other real estate owners. The Tax Relief Extension Act of 1999 (TREA) contains provisions allowing REITs to own up to 100% of a TRS. A TRS is a C corporation that is subject to tax. However, a TRS may generally provide any type of noncustomary tenant services without the use of an independent contractor and can enter into any type of business activity that it chooses. To ensure that a TRS's income is subject to taxation, the TREA restricts the amount of debt and rental payments a TRS can make to its affiliated REIT (i.e., earnings-stripping limits). The cost of violating these earnings-stripping rules is a 100% tax levied on "redetermined rents" and excess interest.

In general, if a REIT fails the asset tests, it is disqualified. However, if a REIT initially meets the asset test, a subsequent failure due solely to changes in REIT asset values will not cause a disqualification. Also, if the REIT fails the asset test due to an acquisition of assets, it will not be disqualified if it corrects the problem within 30 days following the close of the relevant quarter.

REITs are also required to distribute a percentage of their income. For purposes of this requirement, only distributions that qualify for the deduction for dividends paid are included. A REIT's deduction for dividends paid (computed without regard to capital gain dividends) must equal or exceed (1) the sum of 90% (95% for tax years beginning before 2001) of the REIT's taxable income for the tax year (determined without regard to the dividends-paid deduction and excluding any net capital gain) and 90% (95% for tax years beginning before 2001) of the excess of the net income from foreclosure property over the tax imposed on such income, less (2) any excess noncash income. "Excess noncash income" includes certain types of noncash income. The deduction from the required minimum distribution amount of excess noncash income was intended to alleviate the compliance problem resulting from the inclusion in taxable income of amounts that will not be received by the REIT until one or more years in the future. "Foreclosure property" means real property (including real property interests) and any personal property incident to such real property, acquired by the REIT in a foreclosure or by a deed in lieu of foreclosure following a default of a debt obligation or after termination of a defaulted lease. The dividends-paid deduction is not allowed for "preferential dividends." A preferential dividend is a distribution that treats shareholders in the same class of stock differently or treats a class of stock other than in accordance with its dividend rights as a class.

Conclusion

As discussed, the Code provides special tax treatment for entities that qualify and elect to be taxed as REITs. A REIT is still a means by which numerous small investors can have a practical opportunity to invest in a diversified portfolio of real estate assets and have the benefit of professional management. Similar to mutual funds, REITs provide an opportunity to invest in large assets on a small scale. It is obvious that, based on the significant growth of REITs in recent years, the technical constraints are a small price to pay and the REIT is here to stay.

From Bryan I. Pukoff, CPA, J.D., Rehmann Robson, PC, Farmington Hills, MI