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Why REITs?

Mar 10, 2015

The purpose of this article is to explore the use of the Real Estate Investment Trust (“REIT”) as a vehicle to facilitate the investment in real estate.  Although REITs were created in 1960, it was not until the early 1990s that REITs gained market credibility when a slew of self-managed real estate companies went public. Even though REITs are essentially corporations, they are afforded a significant tax advantage: only one level of tax on its earnings.  This is due to a special rule under IRC Sec. 857(b) which allows a REIT to take a deduction from its taxable income on any dividends paid to its shareholders.
To receive this special tax treatment, REITs need to meet a number of technical requirements, many of which adhere to the reason for their creation in the first place – so that the average investors could invest in a managed portfolio of real estate assets.  To this end, REITs need to have a minimum of 100 shareholders and must not be closely held,* and must own predominately real estate and derive predominately all of their income from the real estate as stated in IRC Sec. 856(a). 

Because the earnings of a REIT are only taxed at the shareholder level,   REITs became a popular way for real estate companies to recapitalize their companies in a tax efficient manner.  Furthermore, REITs can also provide liquidity to the owners by going public. With the advent of the UPREIT structure, many real estate owners were able to roll up their real estate into an operating partnership on a tax-deferred basis and thereafter admit the public REIT shareholders as a partner.  The public shareholders invested through the REIT, while the former property owners remained in the partnership.  However, the former property owners, while not direct shareholders in the public REIT, nonetheless acquired an option to convert their partnership interest into public REIT stock at the then-current trading price of the REIT.
While there have been major legislative changes in the REIT rules since 1960, with the second wave of REITs in full swing during the 1990s, the most significant tax legislation occurred in 1999 with the advent of the Taxable REIT Subsidiary (“TRS”) as defined in IRC Sec. 856(i).  The TRS allowed REITs to truly compete with all other property owners as they could become truly full service.  However, this legislation also carried with it a heavy administrative burden of ensuring that transactions between the REIT and the TRS were arm’s length.

Over the past few years, due to the attractive nature of the REIT tax regime along with the establishment of the TRS, many non-traditional real estate businesses have been converting the real estate portion of their businesses to operate through the REIT structure.  The primary issues faced by these companies are the taxability of reorganizing as well as structuring the business objectives to meet the REIT rules. While REITs can manage their own portfolio, there are a number of rules dealing with service income and limits on how much income a REIT can earn from revenues not directly connected to the real estate.
The types of companies that have successfully reorganized include prisons, cell towers, data centers, document storage, billboards, electrical transmission infrastructure, gas pipelines, telecommunications networks and gaming.   Entities in each of these industries face issues in complying with the REIT rules; and there has been much debate as to whether these non-traditional real estate companies should be permitted to operate through a REIT.  

The REIT as an investment vehicle has distinct advantages over operating in other structures, but also carries some heavy administrative burdens. As REITs are a creature of the tax code, there are a litany of rules and tests that a REIT must meet under IRC Sec. 856(c).  But since it has so many advantages, many investors are drawn to using it. 

Domestic institutional Investors usually prefer the REIT structure due to the fact that, if it is structured properly, it can be a way to own real estate without the worry of the unrelated business income tax rules.

Foreign investors are also drawn to the REIT as a properly structured REIT could afford these investors a lower tax cost than if they invested directly or in a partnership or through a corporation.  Typically, though, the foreign investors do not own more than 50% of these entities.

The REIT has also been considered an option for companies who want to raise capital and diversify their investor base.  By utilizing the broker-dealer network, they can raise money in the secondary market.  Some of these companies are listed public companies, but since they are typically on the smaller side, they do not trade regularly as companies that are listed on the major stock exchanges.   But many of these companies utilize the REIT structure as it can be the beginning of a true liquidity event if and when the market is right and they go raise a more significant amount of capital.

While the REIT can be an effective structure to accommodate a variety of investors and property owners, care needs to be taken in their use.  What may be beneficial to one set of investors may be detrimental to others. As with structuring any investment, the first goal is to understand the business plan and thereafter complement the plan with an efficient tax structure for all parties.

*More than 5 individuals cannot own more than 50% of the value of REIT as defined under IRC Sec. 856(h)(1)(A).

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