The Tax Cuts and Jobs Act (TCJA) provides tax reductions to corporations and individuals through various changes to the tax law. One of the key provisions is the new pass-through business deduction for noncorporate taxpayers. The new provision provides a 20 percent deduction for qualified business income (QBI), which includes ordinary dividends from real estate investment trusts (REIT) paid to noncorporate shareholders. The pass-through business income deduction does provide various limitations, but doesn’t limit the benefit afforded noncorporate REIT shareholders. If noncorporate owners of a real estate business or a business holding substantial real estate assets fail to receive the full benefit of the 20 percent pass-through deduction, there could be an opportunity to receive the deduction by forming a REIT.
To qualify for REIT status, a corporation or trust must satisfy several requirements, the first of which is related to ownership. REIT shares must be held by at least 100 persons and can’t be closely held. Either of these requirements can be satisfied through ownership of either common or preferred stock. The use of preferred stock is a good way to help achieve the 100-shareholder requirement, as there are service providers who can assist with providing a sufficient number of preferred shareholders.
A REIT will be considered closely held if, at any time during the last half of the taxable year, more than 50 percent of the value of outstanding stock is owned directly or indirectly by five or fewer individuals. Taxpayers should be careful as attribution rules could cause issues with the closely held requirement. It’s important to note that for purposes of the closely held rule, beneficiaries of certain pensions, stock plans or profit-sharing trusts are counted as shareholders. However, for the 100-shareholder rule, these plans are counted as shareholders and not the beneficiaries. The 100-shareholder requirement, as well as the closely held rule, is waived for the first taxable year for which a REIT election is made.
Income Distribution Requirement
A REIT is required to distribute 90 percent of taxable income annually, net of capital gain income. As a result, a REIT receives a deduction for dividends paid and, therefore, is only taxed on the amounts not distributed to shareholders, which reduces the potential for double taxation. Any remaining income is taxed at corporate rates. The deduction for dividends paid is based on the traditional determination of what constitutes a dividend for a corporation. A dividend is any distribution paid from current or accumulated earnings and profits (E&P). While there are some adjustments specific to REITs, regular corporate E&P rules still apply. The dividend-paid deduction isn’t based on cash distributions, but distributions that are taxed as a dividend or a deemed dividend.
Capital gains may be passed out to shareholders, and the character of these gains is passed out as well such that they will be subject to ordinary or capital gain rates, as may be appropriate.
Asset & Income Tests
REITs are limited to holding certain types of property and are limited to the type of income that can be earned. First and foremost, a REIT must hold assets that are considered “real estate.” Seventy-five percent of total assets must comprise real estate assets, government securities and cash or equivalents. This is measured on a quarterly basis. Also, no more than 25 percent of assets can consist of nonqualifying securities, securities of taxable subsidiaries or other nonqualifying property. For this purpose, real property is defined as land and improvements to land. While this may seem fairly restrictive, the list of what has qualified as real estate is somewhat favorable.
To comply with the income tests, 95 percent of gross income must be from portfolio interest, dividends, interest from mortgages, rents from real property, gains from qualifying assets, income from foreclosure property, tax abatements and gains from sale of real estate that isn’t held for sale in the ordinary course of business. In addition, there’s a secondary 75 percent gross income limitation. Basically, the income that qualifies for the 95 percent test—excluding portfolio interest and dividends—must comprise 75 percent of gross income.
The REIT isn’t required to hold the real property directly, as ownership can occur through partnerships as well.
As previously discussed, a REIT may hold an interest in a taxable REIT subsidiary (TRS) for purposes of conducting business that isn’t properly positioned in a REIT. The TRS is a taxable corporation and can hold most nonqualifying assets or generate most types of nonqualifying income to comply with the general REIT requirements. However, even a TRS is limited in its holdings. A TRS can’t operate or manage a lodging facility or health care facility. Finally, the size of the TRS is limited. As part of the asset tests, the value of all interests in a TRS owned by a REIT is limited to 25 percent of the value of total assets.
The effective tax rate structure for a REIT is certainly more beneficial when compared to a traditional flow-through structure if the shareholders aren’t benefiting from the 20 percent pass-through deduction. A REIT structure provides a way to lock in the benefit provided in the TCJA. But as you can see from the items mentioned above, the creation and operation of a REIT are substantially different from a traditional business structure. Some favorable considerations of a REIT structure include:
- A REIT doesn’t pay federal income tax on the income it distributes. A double layer of taxation is avoided.
- Income paid from a REIT generally doesn’t trigger unrelated business income taxes for tax-exempt investors.
- REIT dividends qualify for the 20 percent pass-through deduction and aren’t subject to other limitations that income from a noncorporate entity is subject to.
- For purposes of the new 30 percent interest limitation of Internal Revenue Code (IRC) Section 163(j), portfolio interest income is included in the “net business interest” calculation.
- Many REITs elect the Alternative Depreciation System due to the E&P effect on the dividend-paid deduction. For purposes of the new 30 percent interest limitations, making the real property trade or business election to avoid the interest limitations of IRC §163(j) wouldn’t have any additional adverse consequences.
- Dividends from a REIT are taxed to the state of an individual’s residence and could eliminate multistate tax filings at the shareholder level.
Those are just a few of the benefits of transitioning to a REIT. As with many things, there also are a few adverse considerations, which include:
- A REIT must be a corporation or trust. A partnership isn’t eligible to make a REIT election.
- The rules related to the REIT structure are more complex and restrictive than a traditional business entity.
- Shareholders don’t benefit from losses, whether they result from operations, asset disposals or bonus depreciation rules.
- There’s no opportunity for asset basis adjustments that would result from a qualifying event, as would be the case with a partnership or proprietorship.
The rules governing REITs focus on protecting and limiting the operations inside the REIT to the real property trade or business. While the rules may seem restrictive, the benefits to be gained may outweigh the costs. A decision to move to a REIT structure is a complicated one, and any consideration should include a comprehensive analysis. The information detailed above provides a preliminary look at the basic rules and should be analyzed further, considering any specific business that may be considering a transition.
Contact Michael or your trusted BKD advisor for help assessing the effect and for planning opportunities specific to your situation.