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Private Investment Forum - Spring 2012


Rebounding of the Real Estate Investment Trust (REIT) – Tax Considerations and Potential Legislation



The real estate “bubble” that was created by overzealous investing through 2008 and its ultimate “bursting” has created significant opportunities in the real estate market for the astute investor including professionally managed REITs. Considering the history of profits made from purchasing and selling real estate and real estate type assets, REITs are in the spotlight of many investment and tax periodicals. What makes REITs attractive to investors and why are they rebounding when it appears the economy is just barely moving forward?

REITs have established themselves as a means for the average investor to directly participate in the higher returns generated by real estate properties and related assets. REITs invest in diversified pools of properties, mortgages and other qualified interests in real property that are offered publicly (listed on a stock exchange) or privately (offered through private placement memorandums). REITs are akin to Regulated Investment Companies (otherwise known as mutual funds (MF)) in the fact that they are subject to similar taxation rules. REITs can avoid corporate taxation as long as the REIT passes certain asset and income tests (as described in the following article) and distributes at least 90% or more of the REIT’s taxable income.

REITs possess three tax preferences for taxable investors, primarily those in the distribution phase of the investment life cycle, which are as follows:

  1. A portion of the annual income stream (reflecting non-cash flow expenses such as depreciation) is considered areturn of capital(ROC) by the Internal Revenue Service (IRS) and is not taxed upon distribution. The investor reduces the basis of the investment by the amount of the return of capital and is taxed on the distribution only upon a sale of shares. The taxation of the return of capital is thus deferred, and when realized, is taxed at preferential capital gains tax rates, or never paid if inherited under the step up/down valuation provisions of the tax code.
  2. Capital Gain Distributions (CGD)– if the REIT distributes its capital gains to its investors, the CGD will be taxed at the favorable long term capital gain tax rate (up to a maximum of 25% for the portion of capital gain distribution that is deemed to be Section 1250 gain (depreciation recapture portion of the gain))
  3. The shares of a REIT (REITs must be taxed like C Corporations but get a dividend deduction against REIT income as noted above and have fully transferable shares) will qualify for long term capital gain treatment if held for more than one year under the current tax provisions.

Dividend income is taxed at ordinary tax rates for individuals (REIT dividends do not qualify as qualified dividends).

Mortgage REITs were very popular investments due to the high rate of return prior to the 2008 real estate market collapse. What investors never paid attention to in the fine print when purchasing such investments was the potential negative aspect of investing in a mortgage REIT- market risk. As noted earlier, REITs must pass income tests. Mortgage REITs had not been significantly affected by such tests because real estate values continued to increase… until the real estate market collapse. Mortgage modifications and defaults created phantom income at the REIT level with real estate values lower than the value of the mortgages. Mortgage REITs’ cash flows were not able to keep pace with the income and were subject to tax at the corporate level making these investments less favorable. In addition, many investors saw investments drastically decrease and caused a “run on the market” by selling their interests in REITs. It has taken several years for the market to rebound for REITs.

At the request of the National Association of Real Estate Trusts (NAREIT), the IRS has partially assisted the REIT industry with Revenue Procedure 2011-16 (Rev. Proc.) that gave guidance including defining the term “significant modification” of a debt instrument and provided a “safe harbor” by utilizing the value of the property at the time a mortgage was issued when determining if that mortgage is a “qualified asset” and its income eligible for the corporate dividend deduction when distributed. Without this guidance, the assets could be non-qualifying REIT assets as well as the income derived from such assets – this would cause the REIT to be subject to corporate tax on such assets’ income as well as on the phantom income. Unfortunately, the Rev. Proc. only assists the REITs in one area and does not deal with asset values that are distressed and currently purchased or purchased after 2008 when the decrease in real estate values occurred. NAREIT is lobbying to get additional favorable guidance in this area.

In addition to the above, President Obama has proposed a new tax on “large” partnerships and similar companies with more than $50 million of gross receipts that are currently exempt from the corporate income tax (REITS and MF would fall under this proposal). Most REITs have gross receipts (rent, interest income, etc.) that are in excess of that amount and would be subject to the tax. In general, it is imperative to spark the real estate industry for our economy to grow. REITs generally provide such stimulus because investors have a means to consolidate such investments with less risk. Such legislation, as previously noted, could cause a negative impact to the industry just as the rebound is gaining traction. If this or similar legislation were to be enacted, an updated Flash from Marcum will advise on the details of such enactment.




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