If you have a real estate investment trust (REIT), a taxable REIT subsidiary (TRS) may play a critical function in supporting its commercial success while safeguarding the favorable tax status it enjoys. Here, we answer common questions about REITs and discuss how to leverage transfer pricing and protect your REIT income in certain scenarios.
How can a REIT help protect income?
Under Internal Revenue Code (IRC) Section 856, REITs retain their tax status only if, among other conditions, they meet various gross income tests relating to real estate and portfolio-related income and other non-real estate-related income. Real estate and portfolio-related income is often referred to as good income, while other non-real estate-related income is considered bad income.
By forming a TRS, bad income may be kept separate from that of the REIT and allow it to pass the gross income tests of IRC Section 856.
Because TRSs are treated as C corporations for U.S. tax purposes, transactions between REITs and their taxable subsidiaries should be at arm’s length, priced as if between third parties. Transfer pricing rules exist to ensure that an appropriate amount of taxable income is reflected at different entities within a controlled group. IRC Section 482 provides the U.S. transfer pricing rules.
By following and demonstrating that it follows the transfer pricing rules with respect to transactions between the REIT and its TRSs, a REIT can mitigate a threat to its tax status.
Is the IRS placing increased focus on REIT-TRS transactions?
Yes. In recent years, the IRS has increasingly scrutinized and challenged REIT-TRS transfer pricing arrangements.
If the REIT-TRS group undertakes intercompany transactions not at arm’s length — for example, excessive rent to the REIT or excessive deductions for the TRS — a 100% excise tax could be applied to the resulting income or deductions.
What are some examples of the IRS' increased focus?
Ashford Hospitality
The IRS asserted that the REIT overcharged rent to the TRS, and imposed a 100% federal excise tax on the amount by which the rent was held to be greater than the arm’s length rate — namely, $3.3 million for 2008 and a TRS adjustment of $1.6 million for agreeing to be party to the REIT’s bank loan agreement.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.