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Real estate investment trusts, or Reits, are a vehicle through which investors can own real estate and related assets without the imposition of entity-level federal and, in many cases, state income taxes. The mechanism that achieves this is a dividends-paid deduction. Thus, if a Reit distributes all its income to its shareholders, the shareholders are taxed on the income, but the Reit itself is not. The tax rates imposed on the shareholders are the ordinary rates, which go up to 35% for both individuals and regular corporations. While, under fairly recent law, the tax on individuals for dividends from regular corporations is capped at 15%, and the tax on corporate shareholders receiving such dividends can be 10% or lower, taking into account the taxation at both the entity and investor levels, Reits still produce the lowest combined level of taxation.

The original rationale for this favoured treatment is that wealthy investors have traditionally been able to invest in real estate through partnerships, which are not subject to entity-level tax, and that the Reit regime merely levels the playing field for aggregations of small investors, much as mutual funds permit them to invest on an aggregate basis in securities without having to pay an additional corporate tax. This rationale still rings true, and yet, the usefulness of the Reit vehicle has gone considerably beyond the original model. As shown below, Reits can also accommodate private transactions and in certain respects have considerable advantages over partnerships.

It is worth noting that partnerships, unless they are publicly traded, remain available as a vehicle for avoiding entity-level tax. In a partnership, there is no tax on the partnership itself, but the partners report the partnership’s income and deduction as if they were themselves directly engaged in the partnership’s operations. Thus, unlike Reits, partnerships can pass losses and tax credits through to the partners, which, of course, can be advantageous, even though the partnership regime does result in much more complicated tax returns for partners. Further, although the tax treatment of partnerships and partners is filled with complexities, partnerships do not have the burden that if they somehow run foul of the rules (except for the rules on publicly traded partnerships) they will become subject to entity-level tax. Nevertheless, for transactions involving raising money from the public, and for certain private transactions where the Reit rules are more favourable than partnership rules, Reits are the preferred entity.

The point that most aspects of a Reit’s organization and operation are subject to extensive, complex, and often petty, rules whose violation can be punished by a loss of Reit status (de-Reiting) is a central feature of the tax laws governing Reits. The basic theme of this pervasive set of qualification requirements is that Congress intended to exempt from the corporate tax only businesses that were primarily engaged passively in real estate activities. Over the years, though, Congress has expanded the allowable range of Reit activities, while maintaining the basic set of intricate qualification tests and prohibitions. Not surprisingly when complex statutory provisions meet reality, the basic policy objective becomes indiscernible, and the overall result is a minefield to which Reits must adapt themselves.

What follows is a selective distillation of the principal Reit qualification requirements, along with observations about how these requirements are typically dealt with as a practical matter. The focus is on federal income taxation. Most states have income taxes that follow the federal pattern and do not tax Reits, but some impose other kinds of taxes, such as gross receipts taxes, which do apply. All section references, unless otherwise indicated, are to the Internal Revenue Code of 1986, as amended, or to the regulations thereunder.

Ownership and organizational requirements

A Reit must be a corporation, trust, or association taxable as a domestic corporation, other than a life insurance company or a bank.

It is customary for a Reit to be a corporation or a business trust, although technically it could even be a partnership or a limited company, provided that it has elected to be taxed as a corporation under the regulations under section 7701. For public Reits, perhaps the most common jurisdiction of organization is Maryland, which is viewed as having corporate rules friendly to management.

A Reit’s shares must be transferable, and there must be at least 100 shareholders (not by attribution).

Publicly held Reits would of course have no trouble with the shareholder requirement. Closely held Reits (private Reits) typically issue 100-plus shares of preferred stock, which end up in the hands of 100-plus different employees, friends and family, and/or charities. The most common denomination is $1,000 a share, although there is little guidance and more thrifty taxpayers have gotten comfortable with $100 a share or less.

Five or fewer individuals (determined using complex attribution rules) cannot own by value more than 50% of a Reit’s outstanding stock.

This restriction prevents, for example, ownership by a single person or a single family, but it does not impede majority ownership by an entity that is itself not closely held by individuals. A public company could thus own all of a Reit’s stock (apart from what is needed to satisfy the 100-shareholder rule). It should be noted that tax ownership, which looks to economic benefits, is different from ownership as reported for SEC purposes, which tends to look to control. To prevent inadvertent violations of this requirement, it is customary for public entities to provide in their charter that no person can own more than, say, 9.5% of the equity of the entity; violations of this prohibition are declared invalid and punished by somewhat confiscatory mechanisms. An unexpected effect of this limitation, from the management perspective, is that hostile takeovers are much more difficult.

A Reit has to elect Reit status, and the election cannot have been terminated or revoked. If there is a termination or revocation, there cannot be a new election for five years unless the Internal Revenue Service (IRS), which administers the federal tax laws, consents to a shorter period.

The possibility of a termination, and its catastrophic effect, are intended to keep Reits focused on compliance.

Gross income tests

At least 75% of a Reit’s gross income must consist of the following:

1. Rents from real property, which includes incidental rental of personal property which constitutes less than 15% of total rent, and charges for customarily furnished services, but excludes

1. Rents based in whole or in part on profits, except that fixed percentages of gross receipts are OK;
2. Rents from related persons, that is, persons who have 10% or more common or cross-ownership determined by applying complex attribution rules, unless the tenant is a taxable Reit subsidiary (TRS)(explained below) and either (i) the premises is part of a property at least 90% of which is leased to unrelated persons at comparable rents or (ii) the premises is a qualified lodging facility managed by an eligible independent contractor; and
3. Rents from a property where the income from furnishing certain impermissible services directly to tenants exceeds 1% of all amounts received by the Reit from the property, though it is OK to furnish the services through an independent contractor or a TRS.

At least 95% of a Reit’s gross income consist of the following:

1. Anything which qualifies as good income under the 75% gross income test.
2. Non-Reit dividends.
3. Non-mortgage interest.
4. Gain from the sale of non-Reit stock and securities.
5. Income from transactions incurred to hedge against debt incurred to purchase or carry real estate, provided that certain identification requirements are met.

The above two gross income tests force Reits primarily into the rental real estate business (equity Reits) and holding mortgages on real estate (mortgage Reits). In some ways the participation in real estate can be active (Reits can, for example, develop their own properties) but fees from being a developer for third parties are not good income, and gains from sales to customers of property held as inventory are not only not good income but are also subject to a confiscatory tax. A few years ago Congress loosened some of these constrictions by permitting a Reit to own some or all of a TRS, which can engage in all but a few specified activities, on the theory that since the TRS is itself subject to corporate tax, and thus the income it generates does not get the Reit benefit of no entity-level tax, it should not be subject to the Reit restrictions. For a corporation to be treated as a TRS, the corporation and the Reit have to make a joint election, although an election automatically applies to 35%-or-more-owned subsidiaries of a TRS to avoid possible avoidance of rules designed to prevent non-arm’s length transactions from diverting income from the TRS (where it would be subject to corporate tax) to the Reit.

Note that both income tests are based upon gross income, so that even an unprofitable activity can be a problem for a Reit.

But for questions about the application of these rules in specific fact situations, it is not difficult for an enterprise that is in fact in the real estate business to meet the gross income tests. The 95% gross income test permits what is generally called a 5% basket for bad income, which is intended to cover minor foot faults in categorizing income as well as a small amount of income which is clearly bad. However, as a practical matter it is often difficult to apply these rules. For example, it can be difficult to determine whether rent is from a related person or whether certain services furnished directly to a tenant are improper, and so the 5% basket can frequently appear quite small.

Gross assets requirements

At least 75% of a Reit’s gross assets must consist of real estate assets, cash and cash items, and government securities.

Not more than 20% of the value of a Reit’s gross assets may be represented by securities in one or more TRSs.

Except for TRS securities and assets which meet the 75% gross assets test,

1. Not more than 5% of the value of a Reit’s gross assets may be represented by the securities of any one issuer.
2. The Reit may not hold securities possessing more than 10% of the voting power of any one issuer.
3. With a number of important exceptions, a Reit may not hold securities having a value of more than 10% of an issuer.

The 75% gross assets test is intended to provide backup to the income tests in motivating a Reit to invest primarily in real estate. The 20% test with respect to TRSs puts a cap on the extent to which a Reit can use TRSs to conduct non-Reit-friendly activities. Clearly the most controversy in the past several years has involved the 10% of value test, since it has been possible for a relatively insignificant asset (for example, debt of a small issuer where the debt makes up a large portion of the issuer’s securities) to cause a big problem for a Reit. A number of publicly traded Reits have needed to approach the IRS hat in hand so that the IRS would, by closing agreement with the Reit, agree to overlook violations, and have had to pay significant penalties as part of that arrangement. Otherwise, these violations would have caused the Reits to be de-Reited, subjecting them to years’ worth of corporate tax on their net income determined as if they were regular corporations. Legislation enacted in 2004 provided more exceptions to the prohibition and also made certain violations punishable only by fines and not by de-Reiting.

Distribution requirements

A Reit must distribute 90% of its Reit taxable income for the taxable year, except that it may retain capital gains and pay the resulting tax on the gains (in which case the dividends are deemed to be distributed, but the shareholders get a credit for the tax paid). To count as distributions for this purpose, the distributions must not be considered preferential; they must scrupulously follow the rights of various classes of stock and must be on the same a share basis within each class.

This basic distribution requirement forces a Reit to make distributions. That is, the dividend-paid deduction is a benefit but not an optional one. Public Reits typically distribute 100% of their taxable income, and frequently in excess of that, with the result that some of the distribution represents a return of capital to shareholders. High levels of distributions have historically been a significant attraction to potential investors, but do deprive Reits of one source from which they could otherwise finance new acquisitions, having to rely instead on issuances of equity and debt.

A Reit must distribute out within the taxable year all regular corporation earnings and profits to which the Reit has succeeded in the taxable year.

This requirement applies when a regular corporation with prior earnings itself elects Reit status and when a regular corporation merges into an existing Reit. This latter transaction is an increasingly common way for Reits to obtain a portfolio of properties without causing the stockholders of the target entity to recognize gain.

Definitions and relief provisions

For purposes of the asset tests, real estate assets includes real property, interests in real property, interests in mortgages on real property, and the shares of other Reits.

The application of this definition is usually clear-cut but not always so. For example, mezzanine financing frequently takes the form of junior debt secured by the ownership interests in an entity, so that the senior debt, which is directly secured by the entity’s real estate, cannot be disturbed by a default on the junior debt. The IRS has issued guidelines for determining when debt secured by an interest in an entity which owns real estate is considered for Reit purposes to constitute a mortgage on real property.

Interests in real property include fee ownership and co-ownership of land and improvements, leaseholds of land or improvements, options on or options on leaseholds of land or improvements, but not mineral, oil, or gas rights.

If a Reit fails to meet either or both of the gross income tests due to reasonable cause and not willful neglect, it will not be de-Reited but will be subject to a tax on the amount of the deficiency.

Unfortunately, there is little guidance as to what constitutes reasonable cause and not willful neglect. There are regulations under this provision that state that the test requires the exercise of ordinary business care and prudence in attempting to satisfy the gross income requirements. One example of reasonable cause is where the Reit relied on the written opinion of a tax professional. It is not, however, practical for a Reit to have a tax professional document and opine on its every move.

If a Reit fails to meet a gross asset test and the failure is de minimis (the bad asset is the lessor of 1% of the Reit’s assets or $10 million), the Reit has to dispose of the offending asset. For failures that are not de minimis but are due to reasonable cause and not willful neglect, the Reit must dispose of the offending asset and, in addition, must pay a tax of the greater of the regular corporate tax on all income from the asset, or $50,000.

This relief provision and the one below were enacted by legislation in 2004. There is therefore even less guidance as to the reasonable cause/not willful neglect issue in this context. Also, it is typically the case that when a Reit has an asset test failure, it is not because it owns an asset that it had reason to believe was permissible. Rather, the typical situation is that whoever at the Reit acquired or created the asset was simply unaware of the legal issues or incorrectly assumed that some necessary action was taken when in fact it was not. For example, as noted earlier, it is necessary for elections to be made for a corporation to be treated as a TRS; on occasion such elections have fallen through the cracks.

For other failures of the Reit requirements, if the failures are due to reasonable cause and not to willful neglect, a Reit can avoid being de-Reited if it pays a $50,000 fine for each failure.

Reit shareholders

As noted earlier, a Reit’s shareholders are taxed on distributions of its earnings. Because these earnings generally have not been subject to corporate tax, they do not qualify for the special capital gains rates in the hands of individual shareholders or for the dividends-received deduction in the hands of corporate shareholders.

However, if and to the extent the distributions correspond to capital gains the Reit has realized, the Reit can so designate them, and they are taxable to shareholders as capital gains. Tax-exempt shareholders are generally not taxable on Reit dividends, thus giving Reits an edge over partnerships, in that most tax-exempt partners would be taxable on income from leveraged real estate assets, whereas they are not taxable on Reit dividends generated by leveraged real estate assets. Reits also possess certain advantages over partnerships for non-US shareholders. A non-US partner is taxable on his share of partnership earnings from US real property, and he would also be taxable on gain from the sale of the property as well as on gain from the sale of his partnership interest. A non-US shareholder of a Reit will be subject to a withholding tax on regular dividends from a Reit, but (i) the tax rate may be reduced by treaty to less than the usual 30%, (ii) a non-US shareholder who owns less than 5% of a class of publicly traded Reit stock will not be subject to tax either on gain from the sale of the stock or on distributions which correspond to the Reit’s capital gains, and (iii) a non-US shareholder of a Reit which is majority-owned by US persons is not subject to tax on gain from the sale of the Reit stock. These tax rules help explain what attracts certain investors to Reits, despite the sizable compliance burden of satisfying the Reit qualification requirements.

Charles Temkin is a partner at Shaw Pittman LLP in Washington, DC.