Real Estate Investment Trusts are corporations, trusts or associations that act as agencies in real estate and associated mortgages. This is a specialized tax segment and it requires recognition by the Internal Revenue Service to operate as a Real Estate Investment Trust (REIT). In general, the REIT pays little to no income taxes and acts very similar to a pass-through entity for tax purposes. All REITs must comply with Code Section 856 which addresses compliance for this privileged tax advantage. Typically, REITs file Form 1120-REIT for tax purposes.
A secondary advantage for REIT status is the ability to raise capital via syndication. Section 856(a) and (b) require a minimum of 100 shareholders or owners of interest in the business entity. This allows for a more advantageous management situation by having a more formal elected board of trustees or directors. In addition, it allows for greater ease of transfer of ownership with the respective investors.
To fully appreciate the Real Estate Investment Trust, you should become acquainted with the history behind REITs. From there, there are unique advantages associated with REITs and an investment in one. As with all business situations, there are some disadvantages and you should be aware of them. The following sections cover these three topics and I’ll finish off with my own conclusion.
Code Section 856 was signed into law in 1960 by President Eisenhower. It was designed to bring about the benefits of owning stock and orienting capital towards the passive investment in real estate. Three of the original REITs trade on the New York Stock Exchange today. They are Winthrop Realty Trust (FUR), Pennsylvania REIT (PEI) and Washington REIT (WRE). 54 years later, there are over 160 REITs traded on the NYSE. In addition there are over 14 REITs in the S&P 500.
There are two types of REITs, Equity Based and Mortgage Based. Equity based REITs own, operate and often sell properties. Property types include apartment complexes, office complexes, light commercial facilities such as shopping centers and medical complexes. In addition, properties can include nursing homes, hotels/motels and student housing. Unlike Equity based REITs, Mortgage based REITs hold mortgages on the same types of properties. It is estimated that all REITs in the United States own over $400 Billion in assets. Worldwide, the estimated asset value is in excess of $1 Trillion.
REITs – Advantages
The primary advantage of a Real Estate Investment Trust is the tax savings. The goal of Section 856 is to foster investment in real estate throughout the United States. To incentivize investment, Congress reduced the tax implications of those involved in real estate. Similar in nature to rental properties at the individual level, income is taxed at ordinary rates and not as earned income. Losses are allowed up to the basis of the investment.
To qualify REITs must pass the following tests:
- At least 95% of the entity’s gross income must be from real property rents or gains on disposition of real property.
- For Mortgage based REITs, 75% of gross income must be from sources related to real property.
- At least 75% of all assets must be real estate related including any restricted cash and receivables from tenants.
- The REIT must distribute at least 90% of the ordinary earnings to the respective investors.
The tax savings is in the form of eliminating double taxation commonly found in the normal corporate structure. That is, the corporation pays an income tax and then any corresponding dividends are taxed at the individual level. In a REIT, the corporation does not pay an income tax contingent upon distributing the net earnings to the shareholders. Do you notice a problem here? The problem with this is that in normal corporate structure, cash is retained to expand business operations i.e. expand the fixed assets section, open new lines of business and reduce long term debt. In order for a REIT to expand operations, the cash needed must come from the expansion of the existing shareholder pool. It must sell more shares to raise cash to invest in more real estate.
In a typical real estate situation, earnings are normally used to reduce the principle portion of debt. The REIT financial income statement’s net income and the depreciation deduction is the cash used to pay down debt and distribute to shareholders as required by law. This cash management requires experienced and trained individuals to accomplish. Good management in a REIT is essential for success.
This form of operation tends towards better management and level operations from period to period. Therefore REITs are generally considered a safer investment than your typical common stock investment. Although this is true, there are still several disadvantages.
From the tax perspective, the one distinct disadvantage is the inability to take any losses in excess of basis for the shareholder. At the individual level for real estate investment reported on a Schedule E, an individual is allowed to take losses on real estate that is rented out contingent on any existing mortgage that is considered qualified (money borrowed from an accredited lender) debt. For the K-1 information at the shareholder level related to REITs, the shareholder is not allowed to take losses in excess of their basis even if there is qualified debt (whether recourse or nonrecourse debt).
For investment purposes, a REIT’s stock value will mirror more closely the book value for market purposes. The reason is simple, the corporation has limited cash resources to expand operations or provide future opportunity without issuing additional stock to acquire these opportunities. This is related to the restrictions imposed by Section 856 of the Internal Revenue Code.
Conclusion – Real Estate Investment Trusts (REITs)
Because of the tax restrictions and required management imposed via Section 856, REITs are a relatively safe investment. However, the drawback is a limited upside potential for an increase in value for the stock due to the requirement to distribute the earnings to the shareholders. Remember the history for this type of investment; Congress’s goal is to allow smaller investors (individuals) the ability to invest in passive based real estate especially for larger more secure properties. In exchange for the reduced tax implications, the investor’s upside potential is limited. Act on Knowledge.