practical tax considerations for working with...

Practical Tax ConsiderationsFor Working With REITs

by Cara Griffith

Real estate investment trusts have historicallybeen an attractive investment because they provideregular cash distributions. REITs, like most otherinvestment vehicles, struggled as the economy de-clined. In the past year, however, REITs have begunto renew their place as an attractive investmentvehicle. In comparison with U.S. treasuries andbonds, the performance of REITs has been solid.According to Barron’s, in 2010 the MSCI GlobalEquity Indices, the U.S. REIT Index, was up 23.5percent, while the S&P 500 was up only 12.8 per-cent.1 Moody’s Investor Service likewise reportedthat REIT dividends have begun to rebound, al-though dividends won’t return to what they werebefore the economic crisis, at least not this year.2

REIT dividends sharply declined during theheight of the financial crisis, but many firms havenow taken positive steps to deleverage their balancesheets and better manage their liquidity. The resultis that many REITs are in a better financial positiontoday than they were in 2009. On the tax front, a2009 IRS ruling has helped to improve REITs’liquidity. That ruling provided that REITs could payup to 90 percent of their dividends through 2011 incommon stock.3 Many REITs took advantage of theruling, though some have now returned to all-cashdividends.

But from a tax perspective and more narrowly,from a state tax perspective, what does all this

mean? First, it means that the news for REITs isgenerally positive, though the road ahead will likelyhave some bumps. It also means that investors willremain interested in REITs as an investment ve-hicle. So state tax practitioners must stay on top ofdevelopments and issues that might affect the taxa-tion of REITs and their shareholders. This articlewill start with the basics of REIT taxation and thenwill turn to other state tax considerations and recentstate developments affecting REITs.

REIT BasicsA REIT is a company that uses the pooled capital

of many investors to purchase and generally tooperate income-producing property or finance realestate. REITs can either be private or offered as apublicly traded security. Individual investors pur-chase a unit of the investment trust. Each unitrepresents a proportionate fraction of ownership ineach of the underlying properties in the REIT.REITs are popular for small investors because aREIT allows them the opportunity to invest in realestate without needing to have the necessarycapital for direct ownership of those same proper-ties.4

REITs must adhere to a variety of requirementsto maintain their status.5 REITs may be formed aspartnerships, trusts, or corporations, though theyare taxed for federal income tax purposes as corpo-rations regardless of how they are organized. REITsare passive entities that must derive at least 95percent of their income from passive activities, notedJoseph Gulant, partner and Business Tax PracticeGroup leader at Blank Rome LLP. REITs must, ingeneral, have at least 100 shareholders.6 To ensurediversification of ownership, 50 percent of any REIT

1See Hillard Lyons, ‘‘Which REITs Have the Right Stuff?’’Barron’s, Oct. 18, 2011, available at http://online.barrons.com/article/SB50001424052748703664104576639201151449080.html?mod=BOL_twm_da.

2See Nathalie Tadena, ‘‘REIT Dividends Rebound, But Notat Pre-Recession Levels,’’ The Wall Street Journal, Oct. 17,2011, available at http://online.wsj.com/article/BT-CO-20111017-710851.html.

3IRS Rev. Proc. 2008-68.

4This article is generally addressing REITs as a legitimateinvestment vehicle and does not specifically address thecaptive REIT structure that has been used for tax avoidancepurposes.

5IRC section 856(a) provides numerous organizationalrequirements.

6IRC section 865(h).

Cara Griffith is a legal editor of State Tax Notes.

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cannot be owned by fewer than five persons.7 Thereare also income requirements for REITs, underwhich 75 percent of a REIT’s gross income mustcome from rents from real property, interest fromloans secured by real property, gain from the sale ofreal property, REIT dividends, income from fore-closed property, qualified temporary investmentproperty, or other specified sources.8

There are three categories of REITs, which arebased on their source of income: equity REITs,mortgage REITs, and hybrid REITs. As the nameimplies, equity REITs own and rent properties.These REITs can make solid long-term investmentsbecause they earn dividends from rental income aswell as capital gains from the sale of properties.Mortgage REITs actually make loans. These REITsare more speculative because their income is tied tointerest rates. When interest rates rise, the value ofa mortgage REIT will drop. Conversely, if interestrates are expected to drop, a mortgage REIT couldbe an attractive investment. Hybrid REITs do acombination of owning and renting properties andmaking loans.

REITs may be created for a single developmentproject or they may be set up for a specific number ofyears. In either case, when the project is over or thenumber of years has expired, the REIT is liquidatedand proceeds are distributed to shareholders. If aREIT is publicly traded, it may be either closed-ended, meaning it can issue shares to the public justonce unless approval is obtained from current share-holders, or open-ended, meaning it may issue sharesand redeem shares at fair market value at any time.

Federal Taxation of REITsFor federal tax purposes, REITs are taxed as

corporations, said Jennifer Weiss, a partner withAlston & Bird LLP. That technically means thatREITs are taxed first at the entity level and then atthe shareholder level. However, said Weiss, REITsfunction as hybrid entities in that they are taxed aspassthrough entities as long as they comply withthe requirements to maintain their REIT status. Toenable them to avoid corporate-level taxation,REITs are permitted to deduct dividends paid toshareholders from their corporate taxable income.And because REITs are required by law to distrib-ute at least 90 percent of their taxable income totheir shareholders each year, with most REITsdistributing 100 percent of their taxable income,this means that REITs effectively avoid federalincome tax.9 REITs will, however, be subject tocorporate-level tax on what is left after their annual

distributions, Weiss noted. That is, if a REITchooses to distribute 90 percent of its taxableincome, it will become subject to corporate-level taxonly on the remaining 10 percent.

A determination of a REIT’s tax liability at theentity level begins with the REIT’s taxable income,which will include capital gain and loss distributionsto shareholders with adjustments for net incomefrom foreclosure property. Net income from foreclo-sure property is generally computed at the highestcorporate level. REITs must also factor in a tax onprohibited transactions and on any income attribut-able to gross income that caused the REIT to fail oneof the income tests, both of which are imposed at a100 percent penalty rate.10 REITs also may besubject to the alternative minimum tax based on taxpreference items.

REIT dividend payments are taxable to the share-holder as ordinary income. Under IRC section243(d)(3), dividends issued by a REIT to share-holders are not considered a dividend for federalincome tax purposes. That means shareholders arenot permitted to take a dividends-received deductionfor dividends received from a REIT. If, however, thedividends qualify as capital gains, they are taxed atthe capital gains rate. If a dividend qualifies as acapital gain dividend, it is long-term capital gain tothe shareholder regardless of whether the sale ofthat shareholder’s unit shares would result in long-term capital gain or loss.

A portion of the dividends paid to a shareholderalso may constitute a nontaxable return of capital,which is not considered income. What portion of adistribution is taxable as a dividend and whatportion is nontaxable as a return of invested capitalis determined based on the REIT’s earnings andprofits, not on its taxable income. A nontaxablereturn of capital occurs when some or all of themoney a shareholder has in an investment isreturned to that shareholder. That generally hap-pens when the REIT’s distribution to the share-holder exceeds the REIT’s earnings and profits. Areturn of capital does reduce the shareholder’sadjusted basis in the REIT, and while that return isgenerally nontaxable, it is taxable as a capital gainif the return exceeds the shareholder’s adjustedbasis.

Taxation at the State LevelBecause many states conform to the federal tax

code, REITs are generally afforded similar treat-ment at the state level. However, state conformity tothe Internal Revenue Code is anything but simple,particularly regarding the tax treatment of REITs.

7IRC section 856(h)(3).8IRC section 856(c)(3).9IRC section 857(a)(1)(A).

10The two income tests a REIT must satisfy every year arethe 95 percent income test and the 75 percent income test.

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For those states that impose an income tax, mostbegin the calculation of state taxable income withfederal taxable income, or they incorporate federaltaxable income in some manner in the state taxcode. Also, most states follow the federal treatmentof REITs by allowing for a dividends-paid deduction(DPD). In some cases that is because the definitionof state taxable income is federal taxable incomeafter the DPD or, if the definition of state taxableincome is federal taxable income before the DPD,the state will provide for a state-level DPD.

However, some states deviate from the federalrules. Jeff Glickman, a partner with Alston & BirdLLP, explained that some states have chosen to limitor modify the DPD. For example, New Hampshireimposes an entity-level tax on REITs, without sub-tracting the dividends paid. It is also important tonote that even if the DPD is allowed, some statesrequire that the REIT and any qualified REITsubsidiaries (QRS) file income tax returns. Therealso are states, such as Mississippi, where the DPDis allowed only if the REIT is publicly traded.

Even though REITs may not payfederal or state income tax at theentity level because of the DPD,states may impose franchise,gross receipts, or net worth taxeson the REIT and the QRS.

Another concern for REITs is the variety of alter-native taxes being imposed by states. Even thoughREITs may not pay federal or state income tax at theentity level because of the DPD, states may imposefranchise, gross receipts, or net worth taxes on theREIT and the QRS. Glickman explained that moreand more states are using alternative taxes, such asgross receipts taxes. In these states, REITs will be apart of the taxpaying structure like any other corpo-ration. For example, Glickman said, the commercialactivity tax in Ohio does not provide a DPD forREITs.

REITs and their shareholders also may be liablefor sales and use taxes depending on the types oftransactions in which the REIT engages. States mayor may not have special rules or exceptions forREITS. If there are no exceptions, states can holdshareholders personally liable for any unpaid tax.

Other State Tax Considerations for REITs

Choice of EntityAnother tax consideration for REITs is choice of

entity. As noted above, a REIT can be formed as acorporation, trust, or partnership. States generallydo not limit the type of entity that can qualify as aREIT, though most are formed as a corporation or

trust. That said, there may be specific state taxplanning reasons to form a REIT as a partnershiprather than a corporation. Typically, for federal andstate income tax purposes, REITs are taxed ascorporations regardless of how they were organized.For purposes of state alternative or non-incometaxes, however, how a REIT is organized mattersgreatly. For example, said Steven Wlodychak, aprincipal in the Transaction Advisory Services/Stateand Local Tax Practice with Ernst & Young LLP, aREIT in Illinois would be subject to the franchise taxif it was formed as a corporation, but not if it wasformed as a business trust, limited liability com-pany, or partnership, because the franchise tax isassessed only against corporations. ‘‘Business struc-ture is critical when considering alternative taxes,’’Wlodychak said.

NexusOne problem state officials frequently face is that

a state may conform to the federal code regardingthe income tax treatment of REITs at the entitylevel, but federal and state laws limit the state’sability to collect income tax from nonresident share-holders. Wlodychak used the following example:Assume a REIT operates entirely in California, butall of its shareholders are located in Florida. If theREIT earned $100 in any given year and distributedthe $100 to its shareholders, the REIT will paynothing in federal and state income tax because ofthe DPD. However, the Florida residents will notpay tax on the REIT dividends either becauseFlorida does not impose an income tax. Dividendsare treated for individual income tax purposes asincome received from a corporation. Case law haslong held that only an individual’s state of residencecan tax dividend income received from a corporation.In this scenario, the REIT’s income that was earnedin one state may escape tax in another state at boththe entity and the shareholder levels.

Net Operating LossesGiven the continued strain on state budgets,

several states are still suspending the use of netoperating losses. For example, Illinois implementeda three-year suspension of the NOL carryover de-duction for C corporations for tax years ending afterDecember 31, 2010, and before December 31, 2014.11

In Massachusetts, losses sustained in tax yearsbefore January 1, 2010, may be carried forward fiveyears but may not be carried back. Losses sustainedin any tax year beginning on or after January 1,2010, may be carried forward for 20 years but maynot be carried back.

State conformity to federal rules, NOL suspen-sions, and their relationship to the cancellation of

11SB 2505.

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indebtedness income (CODI) rules of IRC section108(i) present another issue for REITs. Section108(i) was enacted as part of the American Recoveryand Reinvestment Act of 2009 and permits operatingbusinesses (including REITs) to elect to defer federalincome tax on CODI recognized from some types ofreacquisitions of applicable debt instruments during2009 and 2010. If an election is made, the CODI maybe recognized ratably over a five-year period begin-ning in 2014.

Many REITs had CODI events in 2009 and 2010and took advantage of the one-time deferral provi-sion. For federal income tax purposes, CODI de-ferred under section 108(i) is not taken into accountin computing a REIT’s taxable income until theincome is includible (presumably beginning in2014). However, explained Wlodychak, if a statedecouples from section 108(i), the CODI deferred forfederal income tax purposes is immediately recog-nized for state income tax purposes. Because theDPD that the REIT would have received at thefederal level would not have included the CODI, theREIT is left with taxable income at the state level.However, when CODI is recognized at the federallevel, if the state provides for a tax base modificationin that year, the REIT will be left with a state-levelNOL. Although having an NOL may not be a badthing for regular corporations, REITs are not regu-lar corporations. They distribute all their taxableincome each year. Because most states do not allowNOL carrybacks, the REIT would be unable torecognize the loss associated with the section 108(i)event at a later date.

The end result, Wlodychak said, is that the REITwould have a stranded loss it is unable to use. Inessence, the impact of these complex rules is thatwhat should have been a temporary differenceturned into a permanent tax item on the REIT’sbooks. Unfortunately, there is no quick solution tothat problem. Wlodychak noted that those statesthat decoupled from section 108(i) could choose toconform only for REITs, but that solution seemsunlikely and could further complicate compliancewith section 108(i).

Transfer TaxesIn California, REITs should be on the lookout for

separate city and county controlling interest trans-fer taxes not only when they transfer properties bydeed but when they sell the equity of their subsid-iaries that own real property regardless of the legalform of the subsidiaries that are sold. Transfer taxesare, in essence, a transaction fee imposed on thetransfer of title to property. California delegates bystate law the authority to impose documentarytransfer taxes to counties and local governments,

provided these jurisdictions impose their taxes inconformity with the state provisions.12

In most jurisdicitions, California’s documentarytransfer tax is imposed at a relatively low rate of$1.10 per $1,000 of value. However, several ‘‘char-ter’’ jurisfictions that assert they are not limited bystate law also impose their transfer taxes at higherrates and as if they operated as a controllinginterest tax. These jurisdictions include the city ofOakland, the city and county of San Francisco, andSanta Clara County. Wlodychak questioned thelegal authority for local jurisdictions to deviate fromthe state statute’s prescribed method of imposingdocumentary transfer tax, but the amount of taxcollected from a REIT by a local jurisdiction is lowenough that owners or real property, includingREITs, appear reluctant to challenge the tax.

In California, REITs should be onthe lookout for separate city andcounty controlling interest transfertaxes.

Also, Los Angeles County has adopted a verybroad reading of the state’s documentary transfertax. The county’s website states:

The Los Angeles County Registrar-Recorder/County Clerk (‘‘RRCC’’) began enforcing collec-tion of Documentary Transfer Tax (‘‘DTT’’) onlegal entity transfers where no document isrecorded, but which resulted in a greater than50 percent interest in control of the legal entitybeing transferred. The collection is made pur-suant to Chapter 4.60 of the Los AngelesCounty Code, and California Revenue andTaxation Code (‘‘RTC’’) sections 11911 and11925, and is consistent with case law whichdefines ‘‘realty sold’’ as having the same mean-ing as changes in ownership for property taxpurposes in RTC section 64(c)(1). In addition,effective January 1, 2010, RTC section 408 wasamended to allow recorders to obtain informa-tion pertaining to these transfers from theAssessor. As a result, in an effort to collect thetax, the RRCC will continue to identify, andsend notices for, properties where a change ofownership occurred which transferred agreater than 50 percent controlling interest inthe legal entity thereby creating a liability forthe DTT.

Property TaxIn terms of fixed costs for REITs (and in particu-

lar, equity REITs), property taxes rank close to the

12Calif. Revenue and Taxation Code section 11911.

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top. But REITs may be paying excessive propertytax bills. Michael Allen, a partner with Ryan LLC,explained that the nature of a REIT’s business isthat it raises money on Wall Street, not Main Street,to purchase commercial property. Accordingly, inves-tor yield expectations are different. Wall Street’sexpectations are typically aligned with stock returnsand are generally much lower than what typical realestate investors require. When the REIT raisesmoney, it cannot hold that money in cash. The REITis expected by its investors — and required by theIRS in order to maintain its preferential tax treat-ment — to invest that money by purchasing realestate. However, the expected return on an invest-ment in a REIT is typically only 2 to 3 percent, basedon Wall Street equity returns. That is relatively lowwhen compared with the 6 to 9 percent return atraditional commercial real estate investor will ex-pect from a real estate investment. Because of theirlower investor expectations, REITs are able to pur-chase property at a higher cost while still achievingtheir expected returns. Therefore they can overpaythe market for a property and still meet investorrequirements regarding the return on that invest-ment.

To maintain their tax status, allREITs are required to have nomore than 15 percent of theirrevenues in non-realty assets. Thatposes a problem for hotel REITs.

This is where the problem begins. If the REITpurchases a property at an inflated sales price,‘‘local taxing authorities will chase the sales pricewhen assessing property tax,’’ Allen said. Althoughcomparable properties are often used to determineassessed value, taxing authorities will argue thatthe best indication of fair market value on any givenproperty is a recent arm’s-length sale, Allen said.The result is twofold. First, REITs are assessedproperty taxes on the sales price and not on the fairmarket value of the property. Second, property val-ues as a whole may increase if REITs’ purchases arefactored in as comparable or recent sales whendetermining the assessed values of other propertiesin the area. Practitioners have a difficult challengeto convince local taxing authorities that the propervaluation of any given property is what a futurebuyer would pay, not what the REIT paid, Allen said.Although some states do equalization of this kind,most do not.

Allen mentioned an important point regardingREITs that purchase hotels. To maintain their taxstatus, all REITs are required to have no more than15 percent of their revenue in non-realty assets.13

That poses a problem for hotel REITs because asignificant portion of the assets purchased with ahotel may include both tangible and intangible per-sonal property. For example, a hotel sale includesnot only the real property itself, but the beds,furniture, linens, and other items in the hotel. Anoperating hotel will also typically include significantintangible assets, such as the hotel’s flag name, thestaff in place, and the reservation system. Because ahotel is so much more than just the real propertyhousing it, and because the REIT cannot have morethan 15 percent of its revenue in non-realty assets,REITs are allocating a disproportionate amount ofthe purchase price to the real property itself, Allenexplained. That causes the assessed value to be setartificially high, which results in inflated propertytax assessments not only for the purchased hotel butalso for all others in that market.

Other Recent State DevelopmentsAffecting REITs

Numerous states have moved to combined report-ing, and that now that includes the District ofColumbia. Although that may not affect all REITs, itdoes affect those structured as captive REITs. Be-cause REITs generally do not pay corporate incometax, they have been used by a parent corporation asa means of tax avoidance. The parent corporationcould shift profits to a REIT subsidiary or stashincome-earning assets with a REIT subsidiary. Com-bined reporting eliminates the ability of corpora-tions to benefit from that structure. The change iseffective for tax years beginning on or after Decem-ber 31, 2010.14

Many states are now requiringpassthrough entities to withholdan amount equal to a partner’sshare of income multiplied by thestate’s highest individual tax rate.

In a recent trend, many states are now requiringpassthrough entities to withhold an amount equal toa partner’s share of income multiplied by the state’shighest individual tax rate. For example, Kentuckyenacted legislation that required, for tax years be-ginning on or after December 31, 2011, anypassthrough entity doing business in the state, withthe exception of a publicly traded partnership, towithhold income tax on nonresident individuals and

13IRC section 856(c)(4)(A).14Fiscal Year 2012 Budget Support Act of 2011.

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corporate partners if the estimated tax liability isreasonably expected to exceed a specific threshold.15

Last year, when the New York State Legislaturefinished its 2010-2011 budget law year, the billextended indefinitely the combined reporting rulesadopted in 2008 for captive REITs and regulatedinvestment companies. The 2008 budget legislationrequired that for tax years beginning in 2008, 2009,and 2010, all captive REITs and RICs that weremore than 50 percent owned by a New York bank orother corporation were required to file a combinedreturn with the closest corporation that directly orindirectly owned or controlled them. The 2010 leg-islation also amends the definition of a captive REITto mean a REIT that is not traded on an establishedsecurities market and of which more than 50 percentof the REIT’s voting stock is owned or controlled bya single entity traded as an association but taxableas a corporation under the IRC that is not exemptfrom federal income tax and is not a REIT.

Finally, in March 2011 the Multistate Tax Com-mission issued a draft model statute ‘‘regarding

partnership or pass-through entity income that isultimately realized by an entity that is not subject toincome tax.’’ The model statute was designed toaddress a perceived tax inequity in which insurancecompanies, which pay a premium tax as opposed toan income tax, could receive income from apassthrough entity that would avoid income taxa-tion. The model statute would impose an entity-levelstate income tax on a passthrough entity that ismore than 50 percent owned by an insurance com-pany or other entity that is not ‘‘subject to incometax.’’ The definition of passthrough entity wouldinclude a REIT.

Conclusion

REITs, like most other investment vehicles, arein a transitioning state. The outlook is generallypositive; however, the feasibility of forming andoperating a REIT may be influenced by a variety offactors, including state taxes. Understanding thestate tax issues facing REITs, including how choiceof entity or a section 108(i) election could affect aREIT’s tax liability, could be vital to the success ofthe entity. ✰15KRS 141.206.

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