FUNDAMENTALS OF REAL ESTATE INVESTMENT TRUSTS

Transcription

1 UPDATED SEPTEMBER 21, 2008 FUNDAMENTALS OF REAL ESTATE INVESTMENT TRUSTS Donald A. Hammett, Jr. Locke Lord Bissell & Liddell LLP 2200 Ross Avenue, Suite 2200 Dallas, Texas (214) Michael A. DePompei Locke Lord Bissell & Liddell LLP 2200 Ross Avenue, Suite 2200 Dallas, Texas (214)

2 I. QUALIFICATION AS A REIT A. Organizational Requirements 1. Organized as a corporation, association or trust. 2. Management by one or more trustees or directors. 3. Beneficial ownership evidenced by transferable shares or transferable certificates of beneficial interest. 4. Taxable as a domestic corporation but for the REIT rules.

3 I. QUALIFICATION AS A REIT A. Organizational Requirements (Continued) 5. Not a financial institution or insurance company. 6. Owned by 100 or more persons. a. Must be met for at least 335 days of a tax year, or a proportionate part of a tax year less than 12 months. b. Does not apply to first taxable year of REIT. c. No look through or rules of attribution.

4 I. QUALIFICATION AS A REIT A. Organizational Requirements (Continued) 7. Not closely held. a. Not more than 50% of the value of outstanding shares may be held, directly or indirectly, applying applicable constructive ownership rules, by five or fewer individuals at any time during the last half of each taxable year. b. Subject to the look through or rules of attribution, i.e., shares owned, directly or indirectly, by a corporation, partnership, estate, or trust are treated as owned proportionally by the shareholders, partners or beneficiaries. c. shares owned by a pension trust are generally treated as held directly by its beneficiaries in proportion to their actuarial interests in such trust. d. does not apply to first taxable year of REIT. failed the e. Even if failed, this requirement is considered satisfied for a taxable year if (i) the REIT complies with certain record-keeping requirements and (ii) the REIT does not know, or exercising reasonable diligence would not have known, whether it closely held test.

5 I. QUALIFICATION AS A REIT A. Organizational Requirements (Continued) 8. Elects to be taxed as a REIT on the tax return for the year in which election is to be effective. 9. Adopts calendar year accounting period.

6 I. QUALIFICATION AS A REIT B. Income Test Requirements 1. 75% Income Test At least 75% of gross income, but excluding gross income from prohibited transactions, must be derived from: a. Rents from real property. Special exclusions from rents will be discussed later. b. Interest on obligations secured by mortgages or on interests in real property, provided such interest is not contingent on the income or profits of any person. However, interest can be based on a fixed percentage or percentages of receipts or sales. c. Gains from the sale of real property, interests in real property and interests in mortgages. The term "interests in real property" includes fee ownership, leaseholds, and options but excludes mineral, oil, or gas royalties.

7 I. QUALIFICATION AS A REIT B. Income Test Requirements 1. 75% Income Test (Continued) d. Dividends, distributions and gains from shares or interests in other qualified REITs. e. Abatements and refunds of taxes on real property. f. Income and gains from foreclosure property. g. Amounts (other than amounts the determination of which depends in whole or in part on the income or profits of any person) derived as consideration for entering into agreements to (i) make loans secured by mortgages or (ii) purchase or lease real property. h. Gain from the sale of certain real estate assets. i. Qualified temporary investment income, which is generally income from the temporary investment of new capital in shares or debt instruments for a period not longer than one year.

8 I. QUALIFICATION AS A REIT B. Income Test Requirements 1. 75% Income Test (Continued) Rents from real property do not include: (1) payments based on the income or profits derived by any person from the rented property; (2) with limited exceptions, payments received from a person in which the REIT owns (a) 10% or more of the vote or value the shares (if the payor is a corporation other than a taxable REIT subsidiary) or (b) an interest in 10% or more in the assets or net profits of the payor (if the payor is not a corporation);* and (3) payments for services to tenants or for the management or operation of property, except for services that are (i) provided through an independent contractor from whom the REIT does not derive or receive any income, (ii) provided through a taxable REIT subsidiary or (iii) usual and customary in connection with the rental of space. If such amounts are greater than 1% of all amounts received or accrued during such taxable year by the REIT with respect to a property then all such amounts are excluded from rents. * There is an exception for taxable REIT subsidiaries that will be discussed below.

9 Pitfall: Nonqualifying Services It is a factual question whether services are usually and customarily rendered in connection with the rental of space. Factors that can influence this inquiry are whether such services are rendered in the same geographic area at similar rental properties. Furthermore, there are certain services that the IRS considers so inherently personal that they are never regarded as qualifying services, such as maid service.

10 Pitfall: Lease of Space to Independent Contractor A REIT hires a management service and a parking operator to perform services as independent contractors. Both the management service and parking operator lease space at the property and pay rent to the REIT. Because the REIT derives income in the form of lease payments, the services provided by the independent contractors arguably cannot be included in rents from real property. However, the IRS has ruled that services rendered by an independent contractor tenant can be included in rent from real property if the independent contractor's presence on the property is conducive to the better performance of the independent contractor s duties.

11 I. QUALIFICATION AS A REIT B. Income Test Requirements 2. 95% Income Test At least 95% of gross income, but excluding gross income from prohibited transactions, must be derived from: a. Sources qualifying under the 75% Income Test. b. Dividends. c. Interest that is not contingent on the income or profits of any person. However, interest can be based on a fixed percentage or percentages of receipts or sales. d. Gains from the sale of shares or securities.

12 Pitfall: Interest Based on Income or Profits A REIT makes a loan secured by a mortgage on real property. Annual interest on the loan is calculated as 5% of the principal amount plus 5% of the borrower s net profit with respect to the property. Such interest generally does not qualify for purposes of the 75% income test or the 95% income test because it is based in part on the income or profits of another party. However, if annual interest is calculated as 5% of the principal amount plus 5% of the borrower s receipts or sales, such interest will generally qualify for purposes of the 75% income test and the 95% income test.

13 I. QUALIFICATION AS A REIT C. Asset Test Requirements 1. 75% Asset Test At the close of each quarter, at least 75% of the value of a REIT's assets must consist of real estate assets, cash items, receivables and government securities. Real estate assets include real property and interests in mortgages on real property as well as shares in other REITs % Asset Test for Ownership of Securities Not more than 25% of the value of a REIT's assets is represented by securities, except those qualifying under the 75% test.

14 I. QUALIFICATION AS A REIT C. Asset Test Requirements (Continued) 3. 25% Asset Test for Ownership of Taxable REIT Subsidiaries Not more than 25% of the value of a REIT's total assets is represented by securities of one or more taxable REIT subsidiaries. 4. 5% and 10% Asset Tests for Ownership of Securities Except for taxable REIT subsidiaries and securities qualifying under the 75% test: a. Not more than 5% of the value of a REIT's total assets is represented by securities of any one issuer. b. The REIT does not hold securities possessing more than 10% of the total voting power of any one issuer. c. The REIT does not hold securities having a value of more than 10% of the total value of any one issuer.

15 Pitfall: Amount of Note Exceeds Value of Property Property owner holds real property worth $10,000. A third party lender makes a loan to property owner in the amount of $6,000 secured by the property. REIT is asked to make an additional loan of $5,000 to property owner. The property does not have sufficient value to secure the entire loan made by the REIT, so the REIT bifurcates the $5,000 loan into a $4,000 loan secured by the remaining value of the real property and an unsecured $1,000 loan. The $4,000 loan is a good real estate asset and produces income that qualifies for both the 95% income test and 75% income test. The $1,000 loan is not a good real estate asset and produces income that qualifies for the 95% income test, but not the 75% income test.

16 I. QUALIFICATION AS A REIT D. Distribution Requirement Must make distributions to shareholders sufficient to generate a dividends paid deduction at least equal to: 1. 90% of REIT taxable income for the tax year (explained below); plus 2. 90% of net income from foreclosure property, less tax imposed on such property (explained below); minus 3. Certain items of non-cash income. Typically, dividends from a REIT are treated as corporate dividends to the recipient shareholders. However, such dividends are not generally eligible for the preferred 15% rate applicable to many corporate dividends, except to the extent they reflect dividends received by the REIT and income on which the REIT has already paid tax. The dividends paid deduction is determined without regard to capital gains dividends.

17 II. TREATMENT OF SUBSIDIARY ENTITIES A. Partnership A REIT that is a partner in a partnership is considered to own its proportionate share of each asset of the partnership and is considered to be entitled to the income of the partnership attributable to that share. Example: UPREIT REIT invests in real estate through a partnership. REIT Other Partners Partnership Real Property

18 Pitfall: Impermissible Asset Held in Partnerships A REIT owns a 50% interest in a partnership ( Upper-Tier Partnership ), that owns a 50% interest in another partnership ( Lower-Tier Partnership ), that owns 80% of the vote and value of the stock of a corporation ( Corporation ). REIT and Corporation have not elected to treat Corporation as a taxable REIT subsidiary of REIT. REIT is deemed to own 20% of the vote and value of the stock of the Corporation (i.e., the Lower-Tier Partnership s 80% interest in the Corporation multiplied by the Upper-Tier Partnership s 50% interest in the Lower-Tier Partnership multiplied by the REIT s 50% interest in the Upper-Tier Partnership). Accordingly, the REIT fails the asset test because it holds more than 10% of the vote or value of the stock of the Corporation. REIT Upper-Tier Partnership Lower-Tier Partnership Corporation 50% 50% 80%

19 II. TREATMENT OF SUBSIDIARY ENTITIES B. Qualified REIT Subsidiary A qualified REIT subsidiary is a corporation in which the REIT holds 100% of the stock. A qualified REIT subsidiary is not treated as a separate corporation for federal income tax purposes. All assets, liabilities, and items of income, deduction and credit of a qualified REIT subsidiary are treated as those of the REIT.

20 II. TREATMENT OF SUBSIDIARY ENTITIES C. Taxable REIT Subsidiary A taxable REIT subsidiary is a corporation in which the REIT directly or indirectly owns stock and the REIT and corporation jointly elect to treat the corporation as a taxable REIT subsidiary of the REIT. A taxable REIT subsidiary is taxable as a corporation. A REIT is not treated as owning the assets of a taxable REIT subsidiary or receiving the income of a taxable REIT subsidiary. This allows an entity affiliated with the REIT to hold assets and receive income that the REIT could not hold or receive directly. A taxable REIT subsidiary can engage in activities that the REIT cannot, such as providing certain services. However, a taxable REIT subsidiary cannot directly or indirectly operate or manage a lodging facility or a health care facility.

21 Special Rule for Rents from Taxable REIT Subsidiaries: Notwithstanding the related party rules described above, a REIT can lease a lodging facility (except a lodging facility where wagering activities are conducted) or a health care property (subject to certain limitations) to a taxable REIT subsidiary as long as the lodging facility or health care property is operated by an eligible independent contractor. An eligible independent contractor is an independent contractor that is actively engaged (or related to a person that is actively engaged) in operating lodging facilities or health care properties, as appropriate, for any party that is not related to the REIT or the taxable REIT subsidiary. Pitfall: No Eligible Independent Contractor REIT leases a lodging facility to a wholly owned taxable REIT subsidiary. The taxable REIT subsidiary enters into a management agreement with an independent contractor to operate the property. As of the date of the management agreement, the independent contractor is not actively engaged in operating lodging facilities for any other party. The independent contractor does not qualify as an eligible independent contractor. Accordingly, rent from the taxable REIT subsidiary does not qualify as rents from real property. Additionally, the IRS may take the position that the taxable REIT subsidiary is operating the lodging facility, which could result in the termination of its status as taxable REIT subsidiary.

22 III. TAXATION OF A REIT A. REIT Taxable Income REIT taxable income is computed and taxed like the taxable income of a corporation, with certain adjustments, including: 1. Exclusion of net income from foreclosure property; 2. Exclusion of net income from prohibited transactions; and 3. Exclusion of certain penalty taxes. The amount of tax that a REIT will pay is reduced due to the required dividends paid deduction discussed in Part I.D. above.

23 III. TAXATION OF A REIT B. Capital Gains Dividends A REIT can pass through its capital gains to its shareholders by declaring capital gains dividends. A capital gain dividend is any dividend which is designated by a REIT as a capital gain dividend in a written notice mailed to its shareholders within 30 days after the close of the applicable tax year, or mailed to its shareholders with its annual report for the tax year. If the total amount designated as capital gain dividends for the tax year is greater than net capital gain (excess of the net long-term capital gain over the net short-term capital loss), then only a proportionate amount of each distribution is considered to be a capital gain dividend.

24 III. TAXATION OF A REIT C. Net Income from Foreclosure Property Net income from foreclosure property is subject to tax at the highest corporate rate. Foreclosure property is generally real property and incident personal property that the REIT acquired through foreclosure (or by otherwise reducing the property to ownership or possession by agreement or process of law) after a default (or imminent default) of debt secured by the property. Property is not foreclosure property when the loan was entered into with an intent to foreclose or if the REIT knew, or had reason to know, that default would occur. Foreclosure property does not include property after the close of the 3rd taxable year after the taxable year in which it was acquired. Net income from foreclosure property is (i) gain from the sale or disposition of foreclosure property, plus (ii) gross income derived from foreclosure property (except to the extent such gross income would qualify for the 75% income test), minus (iii) deductions directly connected with the amounts described in clauses (i) and (ii).

25 III. TAXATION OF A REIT D. Prohibited Transactions 1. General A 100% tax applies to the net income derived from prohibited transactions. Prohibited transactions are sales or dispositions of property (except foreclosure property) primarily held for sale to customers in the ordinary course of a trade or business.

26 III. TAXATION OF A REIT D. Prohibited Transactions (Continued) 2. Safe Harbor The 100% tax does not apply to a sale of property that is a real estate asset if: a. The property has been held for at least two years; b. Aggregate expenditures by the REIT or by any partner of it, during the two-year period before the sale date that are includible in the property's basis do not exceed 30% of the property's net sales price; c. Any one of the following is true: i. During the tax year the REIT does not make more than seven sales of property (except foreclosure property or certain property that is involuntarily converted); or ii. The aggregate adjusted bases of property (except foreclosure property or certain property that is involuntarily converted) sold during the tax year does not exceed 10% of the aggregate bases of all of the assets of the REIT as of the beginning of the tax year; or iii. The aggregate fair market values of property (except foreclosure property or certain property that is involuntarily converted) sold during the tax year does not exceed 10% of the aggregate fair market values of all of the assets of the REIT as of the beginning of the tax year.

27 III. TAXATION OF A REIT D. Prohibited Transactions (Continued) 2. Safe Harbor (Continued) d. In the case of property that is land or improvements not acquired through foreclosure or lease termination, the REIT must have held the property for production of rental income for at least two years; and e. In the event that there have been more than seven sales of property, all marketing and development expenditures were made through an independent contractor from whom the trust does not derive any income. For purposes of determining whether there have been more than seven sales of property, a sale of more than one property to a single buyer as part of a single transaction is considered to be one sale.

28 III. TAXATION OF A REIT E. Improperly Allocated Amounts Between REIT and Taxable REIT Subsidiary A 100% tax is imposed on certain amounts not determined at arm's length in transactions between a REIT and a taxable REIT subsidiary: 1. Redetermined rents 2. Redetermined deductions; and 3. Excess interest

29 III. TAXATION OF A REIT E. Improperly Allocated Amounts Between REIT and Taxable REIT Subsidiary 1. Redetermined Rents Redetermined rents are the rents from real property that a REIT receives from its tenants to the extent that such rents have been increased (as determined under transfer pricing principles) by services provided to such tenants by a taxable REIT subsidiary. There are several exceptions to redetermined rents: A. De minimis amounts; B. When the taxable REIT subsidiary renders substantial amount of similar services to unrelated persons, but only to the extent the charge is substantially similar; C. When the charge for the service is separately stated and the rents paid by tenants that are not receiving the service are substantially comparable; and D. When the gross income of the taxable REIT subsidiary from the service is not less than 150% of the direct cost.

30 III. TAXATION OF A REIT E. Improperly Allocated Amounts Between REIT and Taxable REIT Subsidiary 2. Redetermined Deductions Redetermined deductions are the deductions of a taxable REIT subsidiary, other than redetermined rents, to the extent the amount of the deductions would be decreased, as determined under transfer pricing principles, to properly reflect income. It is often advisable to obtain a third party evaluation of rent charged by a REIT to a taxable REIT subsidiary as support that the rent deductions of the taxable REIT subsidiary properly reflect income.

31 III. TAXATION OF A REIT E. Improperly Allocated Amounts Between REIT and Taxable REIT Subsidiary 3. Excess Interest Excess interest is the interest deductions of a taxable REIT subsidiary for interest payments to the REIT to the extent that the interest payments exceed a commercially reasonable rate v2