The use of real estate investment trusts ("REIT") in real estate private equity fund structures has long been advised as a prudent strategy. Specifically, tax-exempt and foreign investors have historically been the key driver behind fund managers implementing this structure because of the tax benefits that have been afforded to those investors. U.S. investors, however, were historically neutral, or even negatively biased, against the REIT entity due to the loss of pass-through losses and taxation at the highest tax rates.
As fund managers structure new funds and look to attract investors, they should understand and consider REITs, including new benefits created a few years ago by the Tax Cuts and Jobs Act (the "Tax Act"). Tax-exempt and foreign investors continue to enjoy the benefits they have historically had, and U.S. investors received new potential tax benefits through a REIT structure. Note that fund managers also have administrative and cost incentives for utilizing REITs.
Revisiting the Basic Rules of REITs
The legal and tax requirements for operating in REIT form are crucial to understand and implement because failure to do so can result in significant penalties and taxes including up to a 100% income tax. Care must be taken for a REIT to meet all requirements so that it can be allowed the deduction for dividends paid to shareholders. This deduction is the mechanism by which REITs avoid double taxation inherent in C corporations.
The most significant tests involve ownership, income, assets, and distributions.
- Ownership: A REIT must be owned by 100 or more shareholders. Also, five or fewer individuals cannot own more than 50% of a REIT.
- Income: 75% of a REIT’s gross income must be derived from real estate sources such as rents from real property and interest from real estate mortgages. 95% of a REIT’s gross income must consist of income from the 75% category as well as other passive income such as interest and dividends.
- Assets: For qualification purposes, the value of the REIT assets must be comprised of more than 75% in real estate assets and cash.
- Distributions: As a general rule, a REIT must distribute at least 90% of its REIT taxable income to its shareholders each year.
Certain types of income that a REIT may receive from tenants is considered impermissible tenant services income (income that derives from services that are generally provided for the convenience of a tenant and not customarily provided in connection with the rental of space). This impermissible income does not qualify for the income test noted above and, after a certain threshold, may taint all of the income from a particular property. The tax code allows a taxable REIT subsidiary (“TRS”), which is a C corporation that is generally wholly owned by a REIT, to provide such services to tenants which ultimately mitigates the negative tax impact which would exist if the services were performed directly by a REIT.
Understanding the Tax Benefits of REITs
Under the Tax Act, the use of REITs has the ability to provide significant tax benefits for not only tax-exempt and foreign investors, but now also U.S. investors.
- REITs as a Blocker of Unrelated Business Taxable Income ("UBTI") and Effectively Connected Income (“ECI”) with a U.S. Trade or Business
- Tax-exempt investors are subject to tax on UBTI. Real estate rental income is generally excluded from UBTI, however there is a major exception when real estate is financed with debt. Debt-financed income is generally subject to UBTI tax (an exception exists for certain qualified organizations). A REIT transforms rental income into dividends which are not treated as UBTI.
Under the Tax Act, REITs provide an additional benefit for tax-exempt investors. Historically, tax-exempt investors were able to net income and losses from various UBTI activities. Under the Tax Act, UBTI must be separately calculated by activity, and losses from one activity can no longer offset income from other activities. Since a REIT eliminates UBTI, this new restriction is irrelevant.
- Rental real estate generally produces income that is ECI for foreign investors trigging a tax liability and filing obligation. Through the REIT structure, rental income is converted into ordinary REIT dividends which are not factored in as ECI for foreign investors. There are certain tax liability and filing requirements for foreign investors even with a REIT structure which are outside the scope of this article.
- Section 199A Qualified Business Income 20% Deduction
- Section 199A under the Tax Act allows taxpayers a 20% deduction against certain types of qualified business income but is subject to wage and/or basis limitations. REIT dividends are also eligible for the 20% deduction but are not subject to the wage and/or basis limitations.
As an example, the Section 199A deduction for REIT dividends is a significant benefit for real estate debt investment funds. Without wages or depreciable basis, investors in these funds would generally not be eligible for the 20% deduction if operating in partnership form. Furthermore, the interest income would need to be considered as derived from a U.S. trade or business in order for the 20% deduction to apply. Utilizing the REIT structure removes these requirements and allows investors to utilize the deduction.
- State Filings
- In the partnership structure where a fund holds properties in several states, there exists a tax filing requirement at the partnership level in each state where a property is held and tax must generally be withheld on behalf of nonresident partners which can be a time-consuming and costly process. Furthermore, investors generally have to file tax returns (and pay income tax) in those states as well. A REIT files state tax returns for the states where the real estate is held. The dividends that are reported to U.S. investors are generally only taxable in an investor’s resident state so this eliminates the need for multiple state tax filings at the investor level as well as the onerous tax withholding requirements.
- Compliance Timing and Costs
- Fund managers are commonly subject to investor deadlines surrounding the distribution of Schedules K-1 to investors. Where fund investments are held directly or through other partnerships, it is common for K-1 delivery delays to arise because of the lack of complete information from the underlying investments. The use of a REIT significantly alleviates, if not eliminates, the possibility of these delays. A REIT only reports dividends to its shareholders (i.e., the fund partnership), and the determination of whether there are taxable dividends is made at the beginning of the year. Therefore, the fund partnership return, along with investor K-1s, can be prepared and distributed in a timely manner long before the underlying REIT tax return is finalized.
- Compliance costs for tax preparation are also a significant factor in evaluating the REIT structure. As there is an increase in the number of investors in a fund as well as the amount of states where investments are made (and therefore nonresident tax withholding), compliance costs for tax returns increase. Furthermore, investors have increases in personal compliance costs because of state filings. A REIT significantly reduces compliance costs for partnerships because the only activity flowing to investors consists of dividend income and tax withholding is not required on behalf of the investors. The investors themselves may recognize compliance cost savings as a result of filing in less states.
Summary
The formation and structure of a real estate fund relies upon the most efficient structure for its investors. With the large number of institutional, tax-exempt, and foreign investors looking to invest in real estate, the REIT entity choice proves itself to be a valuable option. While the loss of pass-through losses for U.S. investors continues to be an adverse aspect of REITs, benefits under the Tax Act provide significant mitigating tax incentives.
Fund sponsors should carefully understand and consider the REIT entity when structuring their funds because of the value that they can provide to investors. The most sophisticated investors may even expect and require the REIT structure to meet their own investment underwriting requirements.
An example of a REIT structure within a real estate private equity fund is presented in the following organizational chart:
