Real Estate Investment Trusts

<div class="Section1">In addition to meeting the asset-based tests described in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7986">7986</a>, a REIT must satisfy several diversification tests with respect to its assets in order to qualify for pass-through tax treatment as a REIT.&nbsp;The following diversification tests are applied at the close of each quarter of each taxable year of a REIT&rsquo;s existence:<br /> <ol><br /> <li>No more than five percent of the value of a REIT&rsquo;s total assets may consist of securities of any one issuer (except with respect to taxable REIT subsidiaries (TRS) and securities permitted under the 75 percent test).</li><br /> <li>A REIT may not hold securities that represent more than 10 percent of the voting power of the outstanding securities of any one issuer.</li><br /> <li>A REIT may not hold securities that represent more than 10 percent of the total value of the outstanding securities of any one issuer.<a href="#_ftn1" name="_ftnref1">¹</a></li><br /> </ol><br /> The IRC recognizes that the value of securities may fluctuate between quarters. As such, Section&nbsp;856 provides that if a REIT meets the diversification requirements at the close of any given quarter, it will not fail to meet the requirements in the subsequent quarter unless the failure is due to the acquisition of securities or property and is wholly or partially the result of that acquisition. If a REIT fails to meet the diversification tests at the close of a quarter as a result of an acquisition of securities made during that quarter, it has a 30-day period in which to correct the discrepancy. If the discrepancy is corrected within that 30-day period, the REIT will be treated as having satisfied the diversification test for the quarter.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;856(c)(4)(B)(iii).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&nbsp;856(c)(4).<br /> <br /> </div></div><br />

<div class="Section1">A qualified REIT subsidiary is a corporation in which the REIT owns 100 percent of the interests&mdash;e.g., it is a wholly owned subsidiary of a REIT. A qualified REIT subsidiary is not treated as an entity separate from the parent-REIT, so that all of the income and assets of the subsidiary are considered along with the REIT&rsquo;s for purposes of the REIT income and asset tests.<a href="#_ftn1" name="_ftnref1">¹</a><div class="Section1"><br /> <br /> A subsidiary that has elected to be treated as a taxable REIT subsidiary (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7999">7999</a>) cannot qualify as a qualified REIT subsidiary.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> If a qualified REIT subsidiary ceases to be 100 percent wholly-owned by the parent-REIT, its status as a qualified REIT subsidiary is terminated and it is treated as a new corporation that acquired all of its assets from the parent-REIT in exchange for its stock.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;856(i)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&nbsp;856(i)(2).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; IRC &sect;&nbsp;856(i)(3).<br /> <br /> </div></div><br />

<div class="Section1">An important aspect of REITs is their pass-through income tax treatment. Like partnerships, REITs are not taxed at the entity level, but at the shareholder level.&nbsp;Thus, annual taxable income is allocated pro-rata to all shareholders, and these amounts are included in the shareholders&rsquo; individual returns and will be taxed at their level.<div class="Section1"><br /> <br /> The amount of income determined at the entity level and passed through to REIT shareholders is usually less than the actual cash distributions received for the same year. In most instances this is due to the fact that taxable income is reduced by depreciation, a deductible expense that does not reduce distributable cash flow. Since REIT distributions differ from REIT income allocations, and the information reported to shareholders on a Form&nbsp;1099, this can cause confusion that, in some cases, may cause investors to avoid investing in REITs. <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7977">7977</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7980">7980</a> for a discussion of how REIT shareholders are taxed.<br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> Shareholders use Form&nbsp;1120-REIT (<em>U.S. Income&nbsp;Tax Return for Real Estate Investment&nbsp;Trusts</em>) to report the income, gains, losses, deductions, credits and to figure the income tax liability of real estate investment trusts.<br /> <br /> <hr><br /> <br /> </div></div><br />

<div class="Section1">REIT dividends ordinarily do not create tax preferences. However, real estate investment trusts do pass through, and each shareholder must report a proportionate share of the REIT&rsquo;s own tax preference items.<a href="#_ftn1" name="_ftnref1">¹</a><div class="Section1"><br /> <br /> For an explanation of the alternative minimum tax, <em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="777">777</a>.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;59(d).<br /> <br /> </div></div><br />

<div class="Section1">REITs can be broken down into three basic classes: equity, mortgage and hybrid.</div><br /> <div class="Section1"><br /> <br /> An equity REIT will actually acquire and take ownership of real property. Most equity REITs buy and hold properties for their net rental income. Others seek profits through appreciation in property values. These often try to add value through increasing occupancy levels or by making physical improvements to the property. Equity REITs can be sub-classified by the type of real estate in which they invest. For example, investments may be confined to (or predominantly focused on) office buildings, apartments, shopping centers, warehouses, or medical care facilities, etc. Some equity REITs may diversify their holdings among several different types of real estate.<br /> <br /> Mortgage REITs do not actually own real estate, but rather, they hold mortgages on income-producing commercial properties. Mortgage REITs generally provide a higher current yield than equity REITS, but they lack the opportunity for capital appreciation through increases in property values. Instead, their market valuations will be affected by fluctuations in the prevailing market interest rates.<br /> <br /> Hybrid REITs are simply REITs that invest in both direct property ownership and in mortgages.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  <em>Lagreide v. Comm</em>., 23 TC 508 (1954).<br /> <br /> </div>

<div class="Section1">In order to qualify as a REIT, at least 75 percent of the REIT&rsquo;s assets must consist of certain defined assets, including real estate assets (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7986">7986</a>). &ldquo;Land&rdquo; is a type of real property asset that qualifies as a real estate asset for this purpose.<a href="#_ftn1" name="_ftnref1">¹</a>&nbsp;The IRS has recently clarified what types of property constitute &ldquo;land&rdquo; in the context of REITs.<div class="Section1"><br /> <br /> Land includes any water or air space that is adjacent to the physical land itself, and also includes any natural products (such as crops growing on the land) and deposits that remain physically attached to the land. However, once a product is severed from the land (such as when crops are harvested or minerals are extracted) it no longer qualifies as land and is no longer treated as a real estate asset.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> The IRS regulations clarify that if crops, minerals or other products that were previously physically attached to the land are stored upon the land after they are severed, such storage does not serve to recharacterize the stored property as &ldquo;land&rdquo; for REIT asset testing purposes.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;856(c).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.856-10(c).<br /> <br /> </div></div><br />

<div class="Section1">A REIT may own interests in a partnership and participate in that partnership as a partner much in the same way as any other taxpayer-entity. For purposes of the asset and income tests applicable to REITs, the REIT will be deemed to own its proportionate share of each of the underlying partnership assets.&nbsp;The characterization given to any partnership asset for partnership purposes is controlling in determining the character of the asset for purposes of applying the REIT asset tests (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7990">7990</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7992">7992</a>).<a href="#_ftn1" name="_ftnref1">¹</a><div class="Section1"><br /> <br /> Under the regulations, the REIT&rsquo;s proportionate interest in a partnership is determined based upon its capital interest in the partnership.&nbsp;The IRS has found that, because a partner&rsquo;s capital account typically reflects its net investment in the partnership, a REIT&rsquo;s capital interest in a partnership is determined by dividing the REIT&rsquo;s capital account balance by the sum of all of the partners&rsquo; capital account balances.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> For purposes of the income tests applicable to REITs, any income realized when a REIT-partner sells its interest in the partnership will be attributable to real property to the extent that the underlying assets of the partnership constitute real property.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.856-3(g).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; See Let. Rul. 200310014.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.856-3(g).<br /> <br /> </div></div><br />

<div class="Section1">If a REIT fails to meet either of the two income tests for any given tax year, and the failure is due to reasonable cause (rather than willful neglect),<a href="#_ftn1" name="_ftnref1">¹</a> the REIT will continue to qualify as a REIT for that year, but will be subject to an excise tax equal to 100 percent of the unqualified income. The tax is calculated by dividing 95 percent or 75 percent of the total gross income of the REIT (depending upon which test is failed) by the amount of REIT income that would qualify for the particular test.<a href="#_ftn2" name="_ftnref2">²</a></div><br /> <div class="Section1"><br /> <br /> Once the REIT has determined that it has failed one or both of the income tests for the year, it is required to file a schedule describing each item of its gross income that would qualify for the failed test (or tests) in order to avoid disqualification.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> If the failure is due to willful neglect, the REIT will be disqualified and will be taxed as a regular corporation the tax year, and for four years following the year of disqualification.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 856(c)(6).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 857(b)(5).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 856(c)(6)(A).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.  IRC § 856(g).<br /> <br /> </div>

<div class="Section1">In order to ensure that REITs continue to further the legislative intent that their income should primarily be derived passively from real estate activities, a REIT must satisfy both of the following income tests in order to qualify as a REIT:<a href="#_ftn1" name="_ftnref1">¹</a></div><br /> <div class="Section1"><br /> <blockquote><em>75 Percent Income Test</em>: At least 75 percent of the REIT’s gross income each tax year must be derived from rents, mortgage interest, gain from the sale of real property, dividends received from other qualified REITs and certain other income derived from real estate sources.<br /> <br /> <em>The 95 Percent Income Test</em>: At least 95 percent of the REIT’s gross income must be derived from (a) items that qualify for the 75 percent income test and (b) income from interest, dividends, gain from the sale of stocks or other securities and certain mineral royalty income.</blockquote><br /> Unlike in the case of the asset-based qualification tests, the income-related qualification tests must only be satisfied at the close of each tax year (rather than on a quarterly basis).<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 856(c)(2) and (c)(3).<br /> <br /> </div>

<div class="Section1">A taxable REIT subsidiary (TRS) is a corporation in which the REIT owns interests, whether directly or indirectly, if both the REIT and the corporation agree to elect that the corporation will be treated as a TRS.<a href="#_ftn1" name="_ftnref1">¹</a> A corporation will automatically become a TRS if another TRS owns either (a) securities representing 35 percent or more of the voting power of the corporation or (b) securities representing 35 percent or more of the total value of the corporation.<a href="#_ftn2" name="_ftnref2">²</a></div><br /> <div class="Section1"><br /> <br /> Corporations that own or manage lodging or health care facilities cannot qualify as a TRS.<a href="#_ftn3" name="_ftnref3">³</a>Other than this limitation, a TRS is permitted to provide many of the services that a REIT might otherwise be restricted from providing because of the asset and income tests required to maintain REIT qualification.<br /> <br /> For example, a REIT that owned residential apartment buildings was permitted to use a TRS in order to provide housekeeping services to its tenants without risking disqualification. The services provided by the TRS did not cause the rental income received by the REIT to fail to qualify as income derived from real property even though the REIT itself would have been unable to provide the housekeeping services in question.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 856(l)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 856(l)(2).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 856(l)(3).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.  Rev. Rul. 2002-38, 2002-26 IRB 4.<br /> <br /> </div>