Real Estate Investment Trusts (REITs) were created in the 1960s by Congress to allow average individuals to participate in large-scale, professionally managed property investments. The REIT industry can be broadly grouped into two categories: Equity REITs, which own and operate real estate through professional managers, and Mortgage REITs, which lend money to real estate owners or invest in mortgage-backed securities. Though they’re different groupings, all REITs are structured as C-corporations for tax purposes that are allowed a special tax deduction for dividends paid from taxable income. For a REIT to receive a dividend paid deduction (DPD), they are required to make an election and adhere to certain rules and compliance.
If you are considering investing in a REIT, it’s important to know about the fundamentals of this investment.
In summary, REIT requirements are as follows:
- Entity must have at least 100 shareholders
- Five or fewer shareholders can’t control more than 50% of the stock
- Must pass annual income and quarterly asset tests, and
- Must distribute 90% of its REIT taxable income each year.
Ownership
REITs must establish and maintain a corporate governance framework. This includes having a board of directors with appropriate expertise and independence, maintaining proper accounting practicesand adhering to regulatory reporting obligations. Failure to comply with governance and management requirements can result in penalties, finesor even the revocation of REIT status.
A REIT cannot be a financial institute or an insurance company. Ownership in a real estate investment trust must be held by at least 100 shareholders for 335 days of a 365-day calendar year or during a proportionate part of a taxable year of less than 12 months. The days need not be consecutive, and the requirement does not need to be met in the first year of existence. Look through requirements (to determine the next level of ownership) or attribution rules are disregarded for this shareholder requirement. A shareholder can be an individual or entity. For example, a pension plan or profit-sharing trust would count as a single shareholder of the REIT, and there are no look throughs to the owners/beneficiaries of the plan or trust.
During a REIT’s second year, the entity requires that five or fewer investors may not own or control, directly or indirectly, more than 50% of a REIT (the 5/50 test). Unlike the rules for the number of shareholders, the REIT will look through to the owners of an entity or pension plan to determine if the 5/50 test is met and is required to maintain a list of its shareholders. To ensure that the REIT is complying with the 5/50 test, written Shareholder Demand Letters must be sent to shareholders within 30 days of the close of the REIT’s tax year; for REITs with at least 2,000 shareholders, anyone who owns more than 5% receives a letter.
Non-compliance with sending a demand letter could result in a fine of $25,000 for each tax year a REIT does not comply, and the fine is increased to $50,000 if the failure is intentional. There is no penalty for the REIT if it does not receive a response from the shareholder.
Asset and Income Tests
The asset test must be passed on a quarterly basis, and the income test on an annual basis, including the first taxable year for which a REIT election is in place. If an entity does not pass the REIT asset test in the first quarter of its first year, it can’t take advantage of the remedies available and, therefore, cannot make a REIT election for that year. It is recommended that the asset and income tests are performed quarterly to ensure compliance and allow the REIT to make changes if needed. For the asset test, 75% of the REIT’s assets must be in real estate, cash and cash equivalents and selected government securities. Accounts receivable arising from operations are included in the cash equivalent.
In addition, a REIT must pass other quarterly asset tests:
- A REIT may not own securities of a single issuer that exceed 5% of the REIT’s gross assets except securities that qualify for the 75% test.
- A REIT cannot own by vote or value more than 10% of a corporation’s outstanding securities.
- A REIT’s taxable REIT subsidiary stock may not have value exceeding 20% of the REITs gross assets.
These asset tests are intended primarily to limit the Company’s ownership of securities issued by C corporations. These asset tests do not apply to qualifying assets for the 75% test, stock, or debt of a Taxable REIT Subsidiary (“TRS”) or Qualified REIT Subsidiary and ownership in an entity that qualifies as a partnership for tax purposes.
There are two income tests that a REIT must pass. The first is that 75% of the REIT’s gross income must be rent from real property used in the asset test. The second is that 95% of the REIT’s gross income must include income in the 75% test plus interest and dividends from securities not included in the 75% test, such as non-REIT dividends and TRS dividends. REITs should project and monitor their income throughout the year to ensure they will pass the annual test.
Distribution Test
A REIT must distribute at least 90% of its taxable income annually to maintain its REIT status. A REIT can declare dividends in October, November or December to be paid in January of the following year, and the DPD will be claimed in the year declared. Failure to meet this test will result in an imposition of corporate income tax and an excise tax.
Other Reporting
REITs are subject to regular reporting requirements to ensure transparency and provide investors with accurate and timely information. These reports include financial statements, property valuations, asset composition breakdowns and other relevant disclosures. Compliance with reporting obligations is crucial to maintain investor trust and confidence in the REIT sector.
Investing in REITs can be a worthwhile opportunity for investors wanting to participate in the real estate market. However, compliance with regulatory requirements is essential for the smooth operation and success of REITs. By understanding and adhering to these requirements, REIT managers can maintain tax advantages and provide shareholders with a transparent and trustworthy investment platform.
For more information on the potential tax benefits of a REIT or additional information about forming and structuring a REIT, please contact us.
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