What Hospitality REITs Should Know About Taxable REIT Subsidiaries
December 14, 2022
Chris Stoop and Arthur Khaimov
As noted in a previous article on understanding the basic of REITS, certain REIT’s will be required to use a Taxable REIT Subsidiary (TRS) in conjunction with their operations. This brings about different reporting requirements that companies must consider, but before getting into this detail, let’s first start with defining TRS and the breakdown why they are used.
What are Taxable REIT Subsidiaries?
A TRS is a corporation that is owned either directly or indirectly by a REIT and has made an election jointly with the REIT to be a TRS for tax purposes. A TRS is subject to regular corporate income tax, which stands currently at 21% because of the Tax Cuts and Jobs Act.
Generally, a REIT’s investments/income must come from passive real estate investments, so the TRS was created to perform activities that cannot be performed by the REIT itself, all while not threatening REIT qualification status.
Under Internal Revenue Code of 1986, as amended, (“IRC”) Sec. 856, REITs retain their tax status if, among other conditions, the REIT meets various gross income tests related to real estate and portfolio related income (good income) and other non-real estate related income (bad income). By forming and electing TRS status, the bad income may be kept separate from the REIT and allow the REIT to pass the gross income test under IRC Sec. 856.
A REIT can hold many TRSs, however, this ownership interest is limited to a 20 percent cap to be complied with quarterly. The limitation provides that the combined value of all the REIT’s TRSs cannot exceed 20% of the value of the REIT’s total assets.
How do TRS vary for a Hospitality REIT?
Although a TRS can typically perform services and generate income that a REIT is not allowed to without jeopardizing the REIT’s status, there are special rules regarding a TRS being used in conjunction with hospitality-REITs. For instance, a multifamily property which collects rent from the tenants would generally be considered a passive investment, while a hotel would not be considered passive because of a high amount of tenant services required based on the number of operations occurring at the property. In order to work around this, the REIT would lease the hotel property to a TRS which is required to have an “eligible independent contractor” (as defined under IRC Sec. 856(d)(9)) to manage the daily operations of the hotel. This nuance in the hotel lease arrangement between a REIT and its TRS is commonly referred to as the qualified lodging exception under IRC Sec. 856(d)(8)(B).
It is important for the owner/operator to ensure that the independent contractors selected to manage the daily operations have the expertise associated with these properties to ensure maintaining compliance with the provisions for the TRS rules as well as to ensure successful operations occurring at the underlying property. This rental structure would allow for the rental income between the REIT and the TRS to qualify for the related party rent exception under IRC Sec. 856(d)(8)(B) and therefore will be treated as good income for purposes of IRC Sec. 856(c)(2) & 856(c)(3).
Proper diligence is required in order to determine the arm’s-length rental charges between the REIT and TRS entities. There are risks associated with the REIT charging an inappropriate rent (shadowing losses to the taxable subsidiary) which could subject the REIT to a 100% tax. In the current market as the hospitality industry is still recovering from the impact of the COVID-19 Pandemic this is especially significant. In order to ensure the REIT is maintaining compliance with the arm’s-length rental charges, a REIT should consider the use of a transfer pricing study to fully ensure compliance which may avoid the most severe penalties or loss of REIT tax status.
Overall, the use of TRS entities provides additional flexibility to REITs as they continue to expand their base of operations, all while also ensuring that the REIT itself maintains compliance with their REIT Status (quarterly asset testing and annual income testing). A REIT should consult with a REIT specialist to so that all applicable provisions are being followed and maintained.