Understanding REIT tax: FAQs
Want to get smart on REIT tax? These investment vehicles are rising in popularity, but potential investors may not know where to start. Below, we answer some frequently asked questions about the changing REIT tax landscape, from basic definitions to potential benefits.
Q. What is a REIT?
A. A real estate investment trust (REIT) is essentially a mutual fund for real estate. As a corporate matter, it is typically organized as a Delaware or Maryland corporation, a Delaware limited liability company, or a Maryland real estate investment trust. As a tax matter, a REIT election is made upon filing of a tax return on Form 1120-REIT.
Q. Why were REITs created?
A. Congress created REITs in 1960 to make income-producing real estate investments accessible to retail investors. Today, publicly traded REITs are popular among retail investors. In addition to publicly traded REITs, there are public non-listed REITs (ie, REITs that are registered with the SEC but do not trade on national stock exchanges) and private REITs (ie, REITs that are exempt from SEC registration and do not trade on national stock exchanges). Private REITs are often used as private investment vehicles by private funds, sovereign wealth funds, foreign pension funds, US pension funds and other tax-sensitive investors.
Q. What are some of the tax benefits of a REIT?
A. In some ways, a REIT combines the best tax attributes of a partnership and a corporation. Like a partnership, a REIT is typically not subject to an entity-level tax. Unlike partnerships which are flow-through entities for tax purposes, REITs generally avoid entity-level tax by virtue of receiving a dividends paid deduction and by effectively being required to distribute all of their earnings and profits each year. However, like a corporation, REITs provide investors with simplified tax compliance (ie, Form 1099 instead of a Schedule K-1).
Q. Are there special REIT tax benefits for foreign investors?
A. A REIT can be an attractive investment vehicle for sovereign wealth funds, foreign pension funds, and certain income tax treaty eligible foreign investors. In some instances, these investments can be structured to have zero US federal income tax leakage and no US federal income tax return filing requirements.
Q. Are there special REIT tax benefits for US tax-exempt investors?
A. A REIT is also an attractive investment vehicle for many types of US tax-exempt investors. Some tax-exempt investors are sensitive to generating unrelated business taxable income (UBTI). A REIT can be an effective UBTI blocker for tax-exempt investors and may be an appropriate alternative to the “fractions rule,” which may be burdensome.
Q. How do you qualify as a REIT?
A. In addition to electing REIT status upon filing of a tax return on Form 1120-REIT, a REIT must comply with various organizational and operational requirements under the Internal Revenue Code, including certain distribution requirements. REITs typically engage a REIT tax advisor to perform quarterly and annual REIT testing to assist with REIT compliance matters.
Q. What types of assets do REITs typically invest in?
A. REITs are typically in the rental business or the mortgage business. This includes office, residential, hotels, senior housing, and self-storage, among others.
Q. Can a REIT build and sell luxury condos?
A. In general, a REIT cannot be a dealer in real property. If a REIT engages in dealer activity, it is penalized with a 100-percent excise tax on gains from such activities. Activities such as building luxury condos for the purpose of flipping such condos would be outside the scope of activities in which a REIT can engage. However, in certain circumstances, and with appropriate tax planning, a REIT may develop and ultimately sell real property.
Q. Do I need to drastically change how I operate my real estate rental business if I decide to become a REIT?
A. A REIT is required to operate in compliance with the REIT tax rules in order to maintain its REIT status. With the help of a REIT tax advisor, REITs can generally structure their real estate operations to fall within the REIT tax rules (usually without too much pain from a business perspective).
Q. What is a taxable REIT subsidiary?
A. A taxable REIT subsidiary (TRS) is a subsidiary of the REIT that is a taxable corporation. It is a more flexible vehicle that can be used to perform certain activities that the REIT is not permitted to perform under the REIT tax rules. For example, a TRS is often engaged by the REIT to perform services for tenants (so-called “impermissible tenant services”) that the REIT is not permitted to perform directly for tenants under the REIT tax rules. A TRS is also often used in senior housing and hotel REITs.
About DLA Piper’s National REIT Tax practice
DLA Piper’s National REIT Tax practice has in-depth knowledge and experience with US-listed public REITs, Singapore-listed public REITs, non-traded public NAV REITs, and private REITs. We advise on the acquisition, disposition, and operation of real estate assets through fund, REIT, and joint venture vehicles. Our attorneys are recognized as industry leaders and regularly publish articles in legal and trade publications and actively participate in real estate and REIT industry organizations.
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