Is it Time for Your Company to Consider Becoming a Real Estate Investment Trust?
As the US tax code continues to maintain one of the highest corporate marginal tax rates in the world, at 35%, it may be time for certain companies to consider reorganizing their qualifying business structure as a Real Estate Investment Trust (REIT).A REIT is generally not subject to corporate-level tax on income distributed to its shareholders, making it an attractive entity structure in which to own income-producing real estate.Although a company must meet a series of stringent requirements to qualify as a REIT, the effort may be worthwhile for certain companies, particularly companies that may have exhausted or may have expiring net operating loss carryforwards. It is estimated that companies such as American Tower and Iron Mountain will save $400 million and $150 million a year, respectively, by converting from an ordinary C corporation to a REIT.
Hardly a week goes by without a major company announcing it is restructuring as a REIT. In the last month, both Sears Holding Corp. and Darden Restaurants Inc. announced that they intend to spin off some of the real estate assets containing their retail operations into REITs. In addition, the IRS in recent years has allowed certain companies that have applied for a ruling to classify certain assets as real estate. In many cases, these assets may not have been thought of as meeting the traditional definition of real estate or the IRS' long-time definition of “real estate assets.”
“Real estate assets,” per the Internal Revenue Code, have been defined as real property (including interests in real property and interests in mortgages on real property) and shares of other real estate investment trusts. The IRS did issue new proposed regulations in the spring of 2014 which expanded upon this traditional definition to include land, inherently permanent structures and structural components, as defined. The proposed regulations include a series of facts and circumstance tests by which assets may qualify as inherently permanent structures and structural components.
Companies continue to be innovative in how they operate their businesses to realize the maximum possible benefits available under the tax code. In recent years and after IRS approval, many companies have transferred certain non-traditional real estate assets as qualifying assets into a REIT structure. Such asset holdings have included outdoor advertising billboards, cellular phone towers, self-storage facilities, casinos, prisons, ski lift towers and copper and fiber optic lines.
Critics of recent REIT conversions state that the definition of real property has been inappropriately expanded to accommodate industries and assets that should not be eligible for REIT status, that REITs were intended to be passive entities and now are too active, and that REIT expansion threatens to diminish the corporate tax base and is not justified by the benefits produced. While REIT conversion is gaining in popularity as a tax strategy, it is notable that the current wave of conversions by non-traditional real estate companies is being accomplished with IRS approval, and most converted companies remain headquartered in the U.S. Unlike the recent wave of corporate conversions, they are not relocating to lower tax jurisdictions abroad. The fact that companies not previously considered to be real estate companies are newly classified as REITs gives Wall Street a reason to take a new look at these companies and their management teams, and how those companies are valued in the marketplace. Wall Street tends to like REITS because REITS often have to raise capital. This is because REITs must usually pay out a significant portion of their internally generated cash flow to qualify as a REIT.
If the newly created REIT meets stringent tests such as paying out at least 90% of its taxable income as distributions to shareholders, the corporation will in most cases avoid paying any federal income tax. Even though the laws vary widely by jurisdiction, the new REIT may also avoid most state income taxes. The taxation of the income stream from the new REIT will fall mostly on the shareholders of the REIT, who will pay taxes on the taxable portion of the distributions they receive from the REIT. Such taxable distributions would not be considered “qualified dividends” which are taxed at a rate of 15% or 20%, depending upon the income level of the shareholder, but would be taxed at the shareholder's marginal rate, up to 39.6%.
It is the responsibility of management and particularly the tax team to ensure that the REIT is in compliance with the stringent requirements for REITs under the Internal Revenue Code. The REIT will elect to become a REIT by filing Form 1120-REIT, U.S Income Tax Return for Real Estate Investment Trusts, as its tax return for its initial qualifying year and subsequent years' returns, instead of the regular corporate return Form 1120. The Internal Revenue Service will not acknowledge whether a REIT qualifies as a REIT unless the REIT is audited by the IRS.
The REIT must maintain detailed records to document that it is in regulatory compliance. In addition to the 90% taxable income distribution requirement, the REIT must meet an asset qualification test at the end of every calendar quarter. The REIT must be invested in certain types of assets and in certain percentages of the REIT's total assets. Various income qualification tests must be met on an annual basis. The REIT's gross income must be from certain sources and in certain percentages of the REIT's total income. In addition, there are requirements concerning the REIT's organization, management and its shareholders.
A REIT must carefully plan how it operates its business. A REIT is usually not allowed to render services to tenants and customers in the ordinary course of business, although the former strict rules regarding the rendering of services have been modified over the years, as has the IRS definition of real estate assets. A REIT must meet certain requirements regarding the rendering of services, especially in industries such as hotels and health care. The formation of a taxable REIT subsidiary and the use of independent contractors are the primary ways in which a REIT may render services in its ordinary course of business.
Any company considering a conversion to REIT status should talk to their accounting firm and legal counsel, far in advance of the desired time frame for conversion, as the process of conversion is neither simple nor quick, particularly if taking the company public is part of the vision. However, the long, complex process may be worth the effort if sufficient tax savings will result.