U.S. Real Estate Investment Trusts: REIT

Presented by:

Kate Fishers, CPA

Chastang, Ferrell, Sims & Eiserman, LLC

REIT

REIT – Requirements:■ Organizational ■ Operational

REIT Taxation REIT Shareholder Taxation

To qualify as a REIT, any entity must:

■ Be organized as a corporation, trust, or an association

■ Be managed by one or more trustees or directors

■ Have transferable shares or certificates ■ Be taxable as a domestic corporation “but

for the REIT regulations” ■ Not be financial institution or insurance

company ■ Be owned by 100 or more persons ■ Not be closely held ■ Make an election to be taxed as a REIT

Ongoing requirements to remain in REIT

status:

■ Quarterly assets tests

■ Annual income tests

REIT

Must be organized:■ Corporation ■ Trust■ Association Foreign corporations, trusts or associations do

notqualify:■ Even if qualifying under other sections of the

code.■ Requirement: Both a corporation and domestic. ■ Domestic: Organized under the U.S. Law.

Management of REITs

■ Must be professionally managed ■ One or more trustees or directors ■ Must not be required to seek shareholder

ratification for their business decisions ■ Rights and powers of trustees must satisfy

the “centralization of management” test ■ Exclusive authority

Management of REITs

■Congress intended that REIT’s income should be “passive” in nature and not derived from the active operation of business.■The Code requires the trustees to delegate certain management of the REIT’s rental properties to an independent contractor. ■The independent contractor’s employees rather that the REIT’s employees provide certain services furnished to REIT tenants.

Independent contractors

35% - Private REIT5% - public REIT ■ Contractors do not own directly/indirectly

35% of REIT ■ REIT shareholder owning 35% or more of

REIT cannot own more than 35% of independent contractor

A trustee CAN:■ Establish rental terms ■ Choose tenants■ Enter into and renew leases ■ Deal with taxes, interest, and insurance ■ Make capital expenditures ■ Make decisions as to repairs of trust

property

Transferability of shares/certificates

Trust documents can include stock transfer restrictions if provisions prevent:

■ Violation of “closely held” prohibition ■Disqualifying as a domestically controlled REIT

■ Must have at least 100 shareholders

■ Each at least purchase $10 worth of shares

Closely held provision

An entity will not qualify as a REIT if is closely held

If during the last half of the taxable year more than 50% of the value of its outstanding stock is owned directly or indirectly by five or fewer individuals

Election to be Taxed as a REIT

■ Must make an Election ■ Election, once made, continues until

revoked or terminated by the entity’s failure to qualify as a REIT for a taxable year

■ Cannot re-elect REIT until the fifth year after initial revocation

Accounting period for a REIT

Must be the calendar year!

REIT Qualification

Congress intended that REITs be holders of real estate assets in a “portfolio type” manner.

While the original REIT provisions have been relaxed to allow REITs to become integrated real estate operating companies, the REIT qualifications tests still provide for significant operational constrains.

Assets tests

A REIT must satisfy six interacting assets tests at the close of each quarter of the taxable year:

1.At least 75% of the value of its total assets must consist of real estate assets, cash and cash items (operating A/R), and government securities

2.Not more than 25 % of the values of its total assets may consist of securities, other than those includible under the 75% test

3.Not more than 20% of the value of its total assets may consist of securities of one or more “taxable REIT subsidiaries”

Assets tests

4. Not more than 5% of the value of its total assets may consist of securities of anyone issuer, except with respect to a taxable REIT subsidiary and those securities includible under the 75% test

5. Not more than 10% of the outstanding total voting power of the outstanding securities of anyone issuer may be held, except with respect to a taxable REIT subsidiary and those securities includible under the 75% test

Assets tests

6.Not more than 10% of the outstanding total value of the outstanding securities of any one issuer may be held, except with respect to a taxable REIT subsidiary and those securities includible under the 75% test.

Assets tests

Failure to meet tests could disqualify REIT unless due to:■ Reasonable cause not willful neglect ■ Correct failure within certain time frame ■Pay penalties

Income Tests

Applied on annual basis – evaluating gross income

■ 75% gross income test ■ 95% gross income test

75% must be derived from:

Rents from real property Interest on obligations secured by

mortgages on real property Abatements and real property tax refunds Income gain derived from foreclosure

property

Income Tests

95% of a REIT’s gross income must be from the following sources: Sources mentioned under the 75% testDividendsInterest andGain from the sale or other disposition of stocks or securities

Failure of the income tests

If a REIT fails one or two of the income tests in any year, it may be disqualified from the REIT status. The REIT may still qualify for REIT status provided that the failure to meet income tests was due to reasonable cause and not willful neglect.

If it fails the tests, it is subject to a penalty tax.

Operations of a REIT

Minimum distribution requirements

■90% of the REITs taxable income■Can deduct the dividends paid

Distributions and cash flows

Taxable income is less than cash flow

■Depreciation ■Amortization

If distributions are greater than minimum distribution

The distribution could provide the shareholder with a return on capital (non-taxable) distribution

Taxable income is greater than cash flow

■Non-cash income (phantom income)

Subtracted from amount that would otherwise be distributable (not all non-cash income can be adjusted)

Distribution of its stock may qualify for dividend paid deduction and is treated as a distribution of property

“Subsequent year dividend procedure”

Dividends actually paid during the taxable year are

taken into account Dividends declaredOctoberNovember December But paid in January the following tax year

Will be deemed paid by the REIT and received byshareholders on December 31 of that year.

Dividend declared prior to October and paid following January will NOT qualify

A shareholder includes the amount in income only in the year the dividends are received.

4% excise tax on certain undistributed income -4% x (“required distribution”- distributed amount).

Purpose : Prevent REITS from making excessive use of the subsequent year dividend procedure to defer recognition of income by REIT shareholders

Tax of the REIT and its shareholders

REIT’s taxable income■ Similar to other domestic corporations■ Except: A REIT is entitled to a dividend

paid deduction A REIT is potentially subject to entity level

tax if allREIT taxable income is not distributed

Special capital gain rules

■ The net capital gain is not included in the REIT TI from which the 90% minimum distribution requirement is calculated

■ Not include in the deduction for dividends paid

for purposes of determining if the REIT satisfies the 90% distribution requirement.

■ A REIT is subject to Corporate tax on any recognized capital gain unless it is distributed as capital gain divided that same year

Calculation of minimum dividend

distribution■ REIT’s taxable income before dividend

paid deduction: Net Capital gains $20Other net income 100Total taxable REIT income $120before divided paid deduction

Calculation of minimum dividend

distributionBasis for calculation minimum distribution:

REIT Taxable $120Less net capital gain <20> Basis for calculation 90% $100minimum distribution 90% <90>Retained income 10Capital gain 20Potential taxable income 30

at REIT level

Calculation of minimum dividend

distribution1. Must distribute $90 ordinary dividend

2. May distribute $20 capital gain dividends

3. May distribute $10 addition ordinary dividends

■ If taxed and retained at REIT level, the shareholder must include their proportionate share of undistributed long term capital gains will be deemed to have paid REIT level taxes on that reportable/taxable gain (impact on a basis of shareholder stock)

■ Undistributed capital gains lose its long term capital gain character

Shareholders

REIT distribution of ordinary income ■ Taxed in same manner as other corporate

distributions ■ Net capital gain distributions taxed at

long-term capital gains rates (15%)

Qualified dividends

15% reduced rate for certain individual shareholders – applies to: Dividends paid by a corporation that is subject to tax at the corporate level REIT distributions will therefore generally not qualify for the reduced capital gains rate

Taxation of REIT shareholders

■ Dividends treated as ordinary dividends to extent of current or accumulated earnings and profits (E&P)

■ Dividends in excess of E&P are non-taxable return of capital to extent of the shareholders basis in the shares

■ Any dividends in excess of basis is treated as taxable gain from the sale of shareholders shares

Foreign Shareholder -

Taxation■ Complex withholding requirements when

distributing to foreign shareholders

■ Taxed as ordinary dividend or capital gains dividend

Ordinary dividends: •30% (or lesser treaty rate)

Foreign Shareholder -

Taxation

Treaty considerations: - No 15% unless one the following three

conditions is met: - Shareholder owns not more than 10% or - REIT publicly traded and shareholder owns

not more than 5% or - REIT is “diversified’’ and shareholder owns

not more than 10%

Foreign Shareholder -

TaxationWhy treaty restrictions?

Example:Individual resident in Denmark holds U.S. real property: - 30% tax gross receipts - Or net at graduated rates

Placing real estate in a REIT:Real estate income dividend income (5/15%)(Significantly reducing the U.S. tax)

Foreign Shareholder -

TaxationCapital gain distributions:FIRPTA (Foreign Investment Real Property Tax Act) Treated as gain realized from the taxable sale or exchange of USRPI taxed as effectively connected income – graduated rates

Capital gains distributions:

- Subject to a withholding rate of 35% (or 15% to the extent provided for in regulations)

Foreign Shareholder -

TaxationCapital gain distributions subject to U.S. Tax ■October 22, 2004■Capital gain distributions made by a REIT to a foreign owner is not treated as income effectively connected with a U.S. trade or business

Result

Treated a as REIT dividend that is not a capital

gain distributions if1. REIT publicly traded

2. Foreign investor owns less than 5% of

the stock on date of distribution

Foreign Shareholder – Sale of REIT shares

Domestically controlled REIT: ■ 50% or less of value of the REIT’s

outstanding stock is held, directly or indirectly, by the foreign persons

■ If domestically controlled, its stock is excluded from the definition of U.S. real property interest and sale of stocks by foreign shareholders generally escape U.S. tax

■ If considered foreign controlled, it most likely will be considered a U.S. Real Property Holding Company (if 50% or more of the value of its assets is U.S. real estate)

■ Sale of stock subject to U.S. taxation

CHASTANG, FERELL, SIMS & EISERMAN,L.L.C.Certified Public Accountants & Consultants

Kate Fishers, CPAk-fishers@cfsecpa.com

1400 W. Fairbanks Ave. Suite 102Winter Park, Florida 32789

Tel.: 407.629.1944 *Fax: 407.740.0671

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