Do You Know Your REIT Ownership Requirements?
March 18, 2020
By Jeffrey Hess
While real estate investment trusts (“REITs”) have been utilized over the past 20 years as a vehicle to acquire and own real estate, recent tax law changes have expanded the attractiveness of REITs to additional investors and investments. Despite their attractiveness, REITs are subject to a variety of organizational, income, asset and distribution requirements. Let’s take a look at ownership requirements as they relate specifically to the investors owning a REIT.
100 Shareholder Test
A REIT must have at least 100 shareholders (the “100 shareholder test”) for at least 335 days of a 12-month taxable year or during a proportionate part of a taxable year that is less than 12 months. The days need not be consecutive. This requirement does not apply until the REIT’s second taxable year. The REIT must satisfy the 100 shareholder requirement starting no later than January 30 of its second taxable year. A problem can arise when a REIT forms late in the year. A REIT whose first taxable year is December 1 to December 31 only has approximately 60 days from the day it is formed to obtain its 100 shareholders, while a REIT whose first taxable year is February 1 to December 31 has approximately 365 days after formation to obtain its 100 shareholders.
No rules of attribution are applicable in determining whether the 100 shareholder test is satisfied. For example, assume that a partnership with 125 partners owns 100% of the REIT’s stock. For purposes of the 100 shareholder test, the REIT would be treated as having one shareholder, and it would fail the 100 shareholder test.
The 100 shareholder test is generally not a problem for actively traded public REITs or for non-traded REITs (REITs that are listed but are thinly traded). However, private REITs, which are often used in real estate private equity structures, would have a hard time meeting this test if not for the existence of REIT shareholder accommodation services that help secure shareholders for the REIT. The shareholders secured by shareholder accommodation service firms are typically preferred shareholders with no voting rights who receive an annual dividend coupon in exchange for their investment. This is allowed because there are no restrictions stating that a REIT can’t have more than one class of stock, and all shareholders are accounted for in the 100 shareholder test. A REIT that has 100 preferred shareholders who receive an annual dividend and a partnership owning 100% of the common stock of the REIT will pass the 100 shareholder test.
Transferable Shares or Certificates
A REIT must issue transferable shares or transferable certificates of beneficial interest as support for its ownership. This requirement must be satisfied at inception, unlike the 100 shareholder test. There are certain scenarios in which restrictions on transferability will not violate this rule. A few of those scenarios are:
- Restrictions pursuant to the Securities Act of 1933.
- Restrictions where the trustee or director believes that a failure to redeem shares or that a transfer of shares would result in the loss of REIT status.
- Restrictions that would cause a transferee to own shares in excess of a certain percentage in value of all of the outstanding REIT stock.
- Restricted stock issued to REIT employees that must be forfeited to the REIT if the employee terminates employment prior to becoming vested.
In the context of private equity real estate funds, this requirement is easily met when the REIT is primarily owned by the real estate fund, which is typically taxed as a partnership for federal income tax purposes.
Non-Closely Held REITS
After a REIT’s first taxable year, it cannot be closely held. A REIT will be closely held if five or fewer individuals directly, or indirectly via certain attribution rules, own more than 50% of the value of the REIT’s outstanding stock at any time during the last half of the REIT’s taxable year. This test is commonly known as the “five or fewer test.” The attribution rules for the five or fewer test require that a REIT look through partnerships, corporations, trusts and estates to the ultimate owner of the REIT stock. Each individual is deemed to own all shares owned by their spouse, siblings, ancestors and lineal descendants. The rules of attribution are complex and must be navigated cautiously.
The Importance of REIT Demand Letters
In order to ensure compliance with the aforementioned rules, REITs must issue an annual shareholder demand letter to a certain number of REIT shareholders of record. The number of demand letters that are required to be sent is based on how many shareholders the REIT has. These letters are required to be sent to shareholders within 30 days after the close of the REIT taxable year. The demand letter confirms the following from the shareholders:
- Actual owner of the stock registered in the shareholder’s name.
- Maximum number of shares that are constructively owned at any time during the second tax year, factoring in the aforementioned attribution rules.
While noncompliance of this requirement was formerly an event that could de-REIT a company, the penalty for non-compliance is currently $50,000.
REITs have long been valued due to their ability to obtain a deduction for dividends paid to shareholders to avoid the double taxation present with C corporations. The REIT structure has historically been favored by tax-exempt and foreign investors due to tax efficiencies for these types of investors. U.S. individuals were less inclined to be interested due to the loss of pass-through taxation available with partnerships. Due to recent changes in the tax law, REITs have become attractive investment vehicles and offer tax saving opportunities for individual investors as well. The demand for REITs in the marketplace is continually growing, with various investors even expecting and requiring them in certain structures. Nevertheless, due to the complex nature of the requirements, REITs must ensure continuous compliance to maintain REIT status and maximize the tax benefits that their investors may be eligible to receive.