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Article

Tax benefits of REITs for real estate firms, sponsors, and investors

July 26, 2023 · Authored by Lillian Chen

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  • Real Estate

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 to partnerships, including REIT real estate investments.

REIT tax overview

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% of net ordinary taxable income must be distributed and 100% 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 rule set 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.

REIT benefits

REITs require high levels of administration and technical precision. Though potential downsides exist compared to partnerships, the benefits they provide can be significant, for U.S. and non-U.S. investors alike.

Overview of REIT benefits

Chart detailing overall REIT Benefits

A more in-depth look into REIT benefits follows.

State tax blocker

The REIT may have properties located in several states. It may have tax returns filed in each state, but an individual or trust shareholder would receive the dividends that are generally only taxable in the shareholder’s state of domicile with no added investor state filings or liabilities.

Baker Tilly Professional

Lillian Chen

Principal

Related sections

  • Real Estate

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.

When a fund-owned REIT operates properties, the fund receives the dividend. The outcome for its partners is the same as described above, except that the investor gets a K-1 reporting dividend income.

There’s also no state withholding tax on REIT dividends and none for a fund owning the REIT, which reduces administrative upkeep while improving cash flow.

For shareholders or partners domiciled in zero- or low-income tax states, REIT benefits compared to partnerships can be substantial, as they avoid income taxes in other, higher tax rate, states — all or part of which would be a permanent cost.

Tax-exempt investor tax blocker

Leveraged rental real estate can produce UBTI for tax-exempt partners of a partnership operator. Real estate debt funds needing leverage in financing their loans could also produce UBTI.

REITs, assuming they’re not closely held by pensions, can solve this issue, as the dividend from a REIT isn’t taxable to tax-exempt owners. This can be a particular benefit for individual retirement accounts), foundations, and certain other tax-exempt investors in leveraged real estate funds.

Pass-through tax deduction (IRC section 199A)

Rental real estate and certain debt funds may produce qualified business income for their partners, which would produce a 20% partner-level deduction for individual investors. This provision is scheduled to sunset after 2025 unless extended by congress.

Limitations depend on sufficient partnership allocations of wages and the unadjusted basis immediately after acquisition (UBIA) as it relates to tangible property. Many debt funds have no wages or tangible property, and instead pay a fee to a sponsor or manager.

Rental real estate funds may also have no wages, and the tangible property, if highly appreciated and of older vintage, may not produce sufficient UBIA metrics.

REITs, with wage and UBIA limits inapplicable, produce ordinary dividends which categorically qualify for the 20% deduction — subject to further shareholder or partner level limitations. Locating real estate rental and debt assets into or beneath a REIT, even if below a fund, can produce simplification and tax benefits for investors. See below for additional benefits for non-U.S. operations.

Qualified foreign pension funds (QFPFs) achieve tax-free appreciation

The complex Foreign Investment in Real Property Tax Act (FIRPTA) regime generally taxes non-U.S. investors on indirect U.S. real estate gains. In addition, all non-U.S. taxpayers are taxable on U.S. business income or gains directly beneath a partnership interest.

A QFPF can use a REIT to enjoy tax-free real estate appreciation and gain on exit.

For a QFPF the following are untaxed, including where REIT shares are held indirectly through a fund:

  • REIT dividends consisting of gain on a real estate asset sale
  • Sale of REIT shares generating a gain
  • Sale or redemption of fund units where the fund owns only REIT shares

The special rules applying to QFPFs are intended to increase capital flows into the United States and REITs are the key to a successful structure. It should be noted that ordinary REIT dividends paid to QFPFs are subject to U.S.-source withholding, net of treaty benefits.

Domestically controlled REITs in funds

REITs may facilitate tax-efficient monetization for non-U.S. investors other than QFPFs.

In a fund setting, a domestically controlled REIT is more than 50% owned by U.S. persons. It falls outside of the FIRPTA regime, allowing non-U.S. owners to sell REIT shares, or potentially partnership units holding REIT shares free of U.S. tax.

This scenario can provide an efficient path for investor monetization if they can either sell REIT shares, sell partnership units above such REIT, or, in certain cases, be redeemed of either prior to a gain on sale dividend, which would attract FIRPTA withholding.

By contrast, there’s no comparable exception for interests in partnerships owning real estate directly.

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REITs may facilitate tax-efficient monetization for non-U.S. investors other than QFPFs.

Blocked structures — levered captive REIT feeders for non-U.S.. Investors

In some cases, non-U.S. investors can’t tolerate direct fund investments, including those with a REIT beneath the fund due to the potential of dividends being subject to significant withholding taxes, particularly where there is limited or no treaty relief.

A taxable C-corp blocker — a regular taxable corporation — with mezzanine debt leverage from its investors or feeder fund, can be efficient. Generally, interest expense deductibility is limited to 30% of adjusted taxable income for the year.

The 30% interest expense limitation can be turned off for an electing real property trade or business (RPTOB). The blocker, depending on its share of the main REIT in the fund, may not enjoy that exception.

In some cases, the leverage could be placed into a captive feeder REIT, where the common stock is owned by the C-corp blocker. The captive feeder REIT would own a proportion of the main REIT shares. The levered captive REIT, using a REIT safe harbor, could elect RPTOB status to obtain unlimited interest expense deductions.

If the lending feeder fund investor base is sufficiently dispersed, the interest payments may enjoy a portfolio interest exception to withholding. Many alternatives are available depending on the facts.

The takeaway is that a captive REIT may be an effective levered feeder into the main REIT materially owned by other investors.

Outbound non-U.S.. Rental real estate operations

REITS can facilitate reporting simplification, interest expense efficiencies, and produce IRC Section 199A tax deductions.

Funds investing in rental real estate located outside the United States can enjoy several benefits by placing rental real estate assets beneath a U.S. REIT, particularly where the structure produces nominal local income taxes.

Perhaps most importantly, complex partnership investor reporting — including voluminous and detailed information required in the new Schedules K-2 and K-3 — can be reduced and condensed into simple dividend reporting.

A REIT may facilitate greater control over favorable elections to eliminate interest expense limitations. In many cases, rental real estate operating in a non-U.S. entity is treated as a partnership for U.S. purposes, where filing U.S. tax returns and required elections can be burdensome, especially where unwilling local sponsors are involved. By using favorable safe harbor rules, a REIT could make favorable interest expense elections without lower-level tax compliance and elections.

The IRC Section 199A deduction described above isn’t generally available for partnership activity outside the United States. However, U.S. REIT ordinary dividends are categorically qualified for the 20% deduction regardless of the geography of the operations.

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REITs can facilitate reporting simplification, interest expense efficiencies, and produce IRC Section 199A tax deductions.

Real estate fund sponsor promote carry allocations

Carry allocations above a REIT get favorable treatment.

Before proposed and final carry regulations were issued, it was unclear whether carry allocations consisting of REIT capital gain dividends could qualify as long-term gains for sponsors.

In addition, it was unclear whether REIT capital gain dividends attributable to gains on direct sale of rental real estate assets that are classified as IRC Section 1231 assets and held for more than one year were exempt from the general three-year holding period rule for carry capital gains.

Regulations favorably concluded that for IRC Section 1231 assets the holding periods and character of gains within the REIT flow up to the shareholders for purposes of applying carry rules.

Carry allocations of REIT long-term capital gain dividends produce the following outcomes:

  • If the gain is sourced from direct real estate that qualify as IRC Section 1231 asset sale gains, it’s excluded from the three-year holding-period rule
  • The gain is taxed only in the state of domicile of the partner receiving the carry allocation

Note that REIT capital gain dividends are subject to net investment income tax of 3.8%. This should be considered in determining where to locate carry allocations in the fund structure.

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Carry allocations above a REIT get favorable treatment.

BBA partnership audit rules

REITs may insulate or mitigate impact on investors.

In 2018, the BBA partnership audit regime dramatically altered how partnership audits are conducted, how adjustments and assessments are made, and how the impact is shared by the partners. The complexity and variability of potential outcomes can be vast.

Where the assets and operations of a fund are beneath a REIT, the direct impact of this regime upon the investors would be confined to the fund, with REIT dividends as the primary tax content. The resulting direct impact of the BBA partnership audit rules upon investors could be greatly simplified.

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REITs may insulate or mitigate impact on investors.

Inflation Reduction Act REIT-friendly provisions

The Inflation Reduction Act was enacted on Aug. 16, 2022, and includes large investments in energy security and climate change.

The two primary revenue raisers — alternative minimum tax based on book income and an excise tax on stock buybacks — don’t apply to REITs.

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.

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