As real estate investment trusts (REITs) proliferate in both public and private real estate sectors, there’s a growing list of benefits they can provide when compared with partnerships. Today’s changing landscape for owning and operating real estate is bringing new, and renewed, awareness for the key tax benefits for REIT structures — and their tips, tactics and pitfalls.
REITs, as corporations for income tax purposes, must own predominantly rental real estate assets or debt secured by real estate that’s held for enjoyment of income and long-term appreciation. Dividends are tax deductible. At least 90 percent of net ordinary taxable income must be distributed and 100 percent is required to avoid REIT-level tax.
REITs can’t be closely held, as defined, and must have at least 100 shareholders. A vast and nuanced array of organizational, operational, asset and income tests must be met. Shareholder impact is generally straightforward. A dividend, documented on a 1099 and consisting of ordinary income and sales gains, represents their proportional share of the REIT operation for the year.
Despite the complexities, REITs can be highly efficient and useful vehicles for real estate assets and debt. Note that in a fund setting, captive REITs with the common stock owned by a fund above it plus 100 direct preferred shareholders, are common structures.
REITs require high levels of administration and technical precision. Though potential downsides exist compared with partnerships, the benefits they provide can be significant, for U.S. and non-U.S. investors alike. Overall REIT benefits include:
- Provides investor simplicity through dividends or K-1 with only a dividend rather than complex K-1, K-2 or K-3
- Doesn’t require additional investor state tax returns or withholdings
- Provides permanent benefits to individual investors domiciled in zero or low-tax states
- Provides pass-through deductions per IRS section 199A, with all ordinary REIT dividends qualifying, including domestic and global equity and debt
- Preferred by many U.S.-based tax-exempt organizations to block unrelated business taxable income (UBTI); dividends generally not subject to UBTI
- Permits look-through rule for carry gain allocations at fund/shareholder level from REIT dividends, providing favorable treatment for direct real estate gains
- Reduces audit adjustment complexities from Bipartisan Budinet Act partnership regime as REITs themselves aren’t subject to it
Among the benefits for non-U.S. investors are:
- Preferred by qualified foreign pension funds over taxable blockers
- Provide monetization benefits through domestically controlled REIT provisions that allow tax-free sale of REIT stock or fund units
- Provide tax efficiency through levered REIT feeders
Among the benefits for non-U.S. investments are:
- Allows favorable interest expense elections without burdening non-U.S. local entities
- Net ordinary income outside the United States qualifies for pass-through deduction
- Condenses complex disclosures to investors into a dividend or K-1 with a dividend
The Inflation Reduction Act has a vast number of tax incentives for investing in clean energy, including tax credits. Though REITs generally don’t bear income tax, the Inflation Reduction Act provides for credit monetization via selling credits to unrelated parties. Gain on sale of the credits isn’t considered gross income to the REIT. The IRA provides numerous new categories for REITs to enjoy benefits from investing in clean energy.
This article was excerpted from a report written by Lillian Chen, a partner and CPA in the Moss Adams real estate practice group. Read the full report here.