REITs: Rules, Risks and Rewards

Real Estate Investment Trusts (REITs) are a special entity that pose some unique risks and rewards. Unlike regular C-Corporations, a REIT can deduct from taxable income the dividends paid to its shareholders. Usually, REITs dividend out all taxable income in order to avoid paying federal income tax. REITs also cleanse income so shareholders only receive and will need to report dividend income and will not need to deal with other complex tax issues that might arise in REIT investment structures when held as a partnership. REITs also provide foreign investors the opportunity to invest in U.S. real estate without being subjected to FIRPTA taxes. In order to generate these advantages, REIT owners must understand and be cautious of the potential pitfalls.

REIT rules become complex quickly. Particular REIT activities give rise to increased risk. In these circumstances, specialists can help verify that REIT rules are adequately considered.

REIT Rules: The Basics

Congress intended for REITs to help develop, construct, maintain, and revitalize the real estate infrastructure necessary for businesses to expand and to house the nation’s residents to The goal was to protect the long-term well-being of the areas in which REIT investments are made. Most REIT rules make sense once viewed through the lens of congressional intent. Following is a primer on some of the terms and key considerations of REITs.

Investment Term: Because Congress created REITs as a vehicle for making long-term improvements to our nation’s real estate, REITs cannot have any income from the sale of inventory. The tax benefits given to REITs cannot be attained by flipping properties. All REIT sales transactions are subject to prohibited transaction analysis. There is a prohibited transaction safe harbor if a REIT sells fewer than 7 properties in a year and holds each property for more than 2 years. All potential sales transactions should be reviewed in order to consider potential issues. If a transaction is determined to be prohibited, then there is a 100% tax on the gain.

Assets: A REIT must hold 75% of its assets in cash and real property. Cash accounts should be carefully reviewed since some money market accounts and accounts receivables may be considered securities subject to additional rules and not cash. Real estate should be analyzed on a property-by-property basis. A property with more than 15% personal ownership will cause REIT testing problems. Significant amounts of personal property should immediately raise a red flag. REIT testing is based on the REIT’s proportionate share of partnership assets.

Diversification Rules: REITs have additional security holding limitations. A REIT may not hold more than 5% of its assets in any single security, with the exception of holdings in Qualified REIT Subsidiaries (QRS), investments in other REITs, or Taxable REIT Subsidiaries (TRS). TRS investments may not exceed 20% of the REIT’s assets after January 1, 2018, and 25% prior to that date. A REIT may not own more than 10% of the vote or value of any of any individual security (excluding TRSs, QRSs, or other REITs). REIT investors are not intended to be sophisticated investors, and these rules help protect them from significant non-real estate risk.

Income: Gross income for a REIT must derive at least 75% from rental of real property, interest, and/or gains from the sale of real property. REITs must receive 95% of gross income from receipts qualifying for the 75% test and non-REIT dividends. Dividends from another REIT always qualify as rent from real property (the 75% test). Generally, the best way to avoid REIT income testing problems is to analyze sources of income from a property prior to purchase. It is also a good practice to analyze the sources of future income prior to the disposition of a significant portion of a portfolio.

Impermissible Tenant Service Income: REITs are not permitted to provide services to their tenants other than services that are ordinary and customary in the market for a particular property class. Impermissible tenant service income is generally a non-standard service rendered in a rental agreement for which there is no separate collection of income. Regulations require the REIT to reclassify a portion of its rental income as a receipt for impermissible services. If total imputed impermissible income for any particular property exceeds 1% of that property’s gross revenues, then all gross income from that property no longer qualifies for the 75% or 95% tests.

REIT Compliance Testing: REITs are required to test for asset compliance on a quarterly basis and income compliance on an annual basis. There is a 30-day grace period from the end of a quarter for a REIT to comply with asset testing. Income testing does not have a similar grace period. Once income is earned, its character cannot be changed. While income testing is only required once a year, a REIT should be cognizant of where it stands on income testing throughout the year. A single income test failure is much more difficult to correct than an asset test failure.

REITs: Navigating the Risks

The best way to protect REIT status is to recognize which transactions and which parts of the investment lifecycle face higher levels of risk and require REIT specialist involvement.

Acquisition Transactions: All acquisitions should be reviewed to vet potential complications. All leases should be reviewed to make sure there are no services required under the lease that would give rise to impermissible tenant service income. Also, all the balance sheet and gross income accounts should be reviewed to make sure the property qualifies for REIT purposes. The best way to manage REIT asset test risk is to confirm each property acquired will meet REIT test standards on a stand-alone basis. If a property would not qualify on a stand-alone basis, the REIT should engage a specialist to help.

Disposition Transactions: Prohibited transaction analysis must be considered (see above), and REITs need to confirm the remaining portfolio qualifies as a REIT after excluding the disposed asset. Generally, a single small sale transaction does not pose much risk to a large investment portfolio, but significant dispositions are inherently riskier.

Taking Assets Out of Service: If a REIT takes all or a significant portion of its assets out of service for a renovation or other purpose, special care must be taken. Significant improvements may change the holding period for prohibited transaction analysis purposes, and generally, when assets are out of service, gross receipts are very low. This means that just a little impermissible income can have a significant negative impact on a percentage basis.

Ramping Up Phase: When a REIT is ramping up its portfolio holdings, the REIT needs to take special care to make sure it does not overlook testing requirements. Often, REIT employees are trying to move as quickly as possible on a purchase transaction. If they are not careful to adequately analyze the existing leases and assets held during this phase, then they face the risk of a REIT test failure.

Winding Down Phase: The same considerations exist when a REIT is winding down as with a disposition transaction. However, there is heightened risk of asset test failure as the number of properties owned dwindle and previously insignificant accounts assume a much more significant portion of the REIT’s total assets.

REITs should never take chances with their tax status. Specialists should be involved throughout to confirm REIT test assertions. REITs should always complete testing on a timely basis. If timely REIT tests are not prepared, a failed asset test can mean losing REIT status. Specialists can help navigate the significant REIT rules, risks, and rewards.

If you have any further questions regarding REITs or their structure, please contact your Marcum Real Estate professional.