The Nuts & Bolts of REITs

Live CLE Webinar Wednesday, April 20, 2016

1:00-2:35 pm Eastern

Speakers Shawna R. Tunnell, Hogan Lovells US LLP, Washington, DC Adam S. Feuerstein, PwC, Washington, DC Monisha Santamaria, EY, Los Angeles, CA David H. Leavitt, PwC, New York, NY

This webinar is being offered in collaboration with Thomson Reuters and content covered in the Thomson Reuters Checkpoint Catalyst tax research solution.

Real Estate Investment Trusts

• Real Estate Investment Trusts (“REITs”) are C Corporations subject to special rules

• The REIT provisions – Require investments in real estate and/or mortgages – Require distributions – Allows a deduction for dividends paid

• 200 + publicly-offered REITs with a combined equity market capitalization approaching $1 trillion

REIT History

• 1960: REIT Act • 1997: REIT Simplification Act • 1999: REIT Modernization Act • 2004: REIT Improvement Act • 2008: REIT Investment Diversification and

Empowerment Act • 2015: Protecting Americans from Tax Hikes Act

REIT Organizational Requirements

• Must be a corporation, trust or association – Sec. 856(a)

• Otherwise taxable as a domestic corporation – Sec. 856(a)(3)

• Not a bank or insurance company – Sec. 856(a)(4)

REIT Organizational Requirements (Cont.)

• Managed by trustees or directors – Sec. 856(a)(1)

• Transferable shares – Sec. 856(a)(2)

REIT Organizational Requirements (Cont.)

• 100 or more shareholders – Secs. 856(a)(5), 856(b))

• Not “closely-held” (the 5/50 Test) – Secs. 856(a)(6), 856(h), 542

REIT Organizational Requirements (Cont.)

• No C Corp E&P – Sec. 1.857-11

• REIT election – Sec. 856(c)(1)

Income Tests - General

• Income tests based on the REIT’s gross income

• Gross income of a partnership is treated as income of the REIT in accordance with the REIT’s capital interest.

• Gross income of a subsidiary corporation is not included in the asset tests. Instead, dividends are included in gross income.

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Income Tests – 75% Income Test At least 75% of total gross income must come from:

– Rents from real property – Interest on mortgages secured by real property – Gains from sale of real property – Dividends from other REITs – Income on “temporary investment” of new capital – Abatements and real property tax refunds – Income and gain from foreclosure property – Non-contingent amounts to enter into mortgages (ie:

loan fees and commitments) – Any other income or gain determined by the Secretary.

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Income Tests – 95% Income Test – At least 95% of total gross income must come from:

• Sources that satisfy the 75% test; • Dividends; • Interest; and • Gains on sale of securities. • Mineral royalty income earned in the first taxable year

from real property owned by a timber REIT.

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Income Tests - Rents from Real Property - Inclusions

– Rents from interests in real property include:

• Charges for services customarily provided in connection with the rental; and

• Rent attributable to personal property if the rent does not exceed 15% of the total rent.

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Income Tests - Rents from Real Property - Exclusions

– Rents determined in whole or part on the profits of any person

• Exception for amounts based on a percentage of gross receipts.

– Rents received from certain related parties.

– Impermissible tenant service income.

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Income Tests - Rents from Real Property - Services

– Income from services may be qualifying income if it is customary to provides the services at similar properties in the same geographic area.

– However, impermissible tenant services income (ITSI) is not qualifying income. A service is an impermissible tenant service if it is:

• provided for the convenience of the occupant; and • it is not customarily provided in connection with the rental

of space only. – This is different than the test above which looks at whether the

service is customarily provided in buildings of a similar class in the same geographic area.

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Impermissible Tenant Service Income Taint

• If the impermissible service income of a property exceeds 1% of the gross income derived from the property, then all of the income derived from the property will fail to qualify as “rents from real property.” – Therefore, a very small amount of services can cause all of

the rents at the property to be non-qualifying income which can raise REIT qualification issues.

– Impermissible service income is the greater of the income received from the service or 150% of the cost of providing the service.

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Avoiding Impermissible Income • A service will not be impermissible tenant

service income if it is performed either by: – an independent contractor (IK) for whom the

REIT receives no income • (i) an IK is generally an entity which does not own

more than 35% of the shares in the REIT, or • (ii) not more than 35% of the IK may be owned by

a person who owns a 35% or greater interest in the REIT.

• Certain procedural requirements must be satisfied: – Cannot be an employee of the REIT. – IK must maintain and operate the facilities through

which the services are rendered. – Other requirements for non-customary services

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Avoiding Impermissible Income (cont.)

• A service will not be impermissible tenant service income if it is performed either by (cont.): – a “taxable REIT subsidiary” (TRS)

• in order make sure that arrangements with the TRS are arm’s length the Code assesses a 100% tax on certain non-arm’s length arrangements.

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Income Tests – Rents from Real Property - Related Party Rents

– Rents from real property do not include any amount received, directly or indirectly, from any entity that is owned 10% or greater interest by the REIT (except for TRS). • 10% ownership applies if tenant sublets to a sublessee in

which the REIT holds a 10% interest • A TRS does not include any corporation

– Which operates or manages a lodging or healthcare facility, and – It cannot provide to any person rights to any brand name under

which hotels or healthcare facilities are operated

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Income Tests – Rents from Real Property - Percentage Rents

– Rents based on the net income or profits of a tenant do not qualify as “rents from real property”, and therefore, constitute non-qualifying income.

– However, rents based on the gross receipts or sales of a tenant will qualify as “rents from real property”.

– When accounts with “percentage rents” are present, always confirm the procedure for which rent is determined and look beyond the terms used in the documents (something labeled as gross income may be defined in a manner so that it is really net income and vice versa).

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Income Test - Interest • Interest income is qualifying income for purposes of

the 95% income test, but is only qualifying for purposes of the 75% income test to the extent derived from a loan secured by a mortgage on real property.

• In some cases, the equivalent of a mortgage on real property, such as the mezzanine loan rules discussed earlier.

• If the real property value exceeds the loan amount then all interest may be qualifying income for the 75% income test. • The real property value is the value at the time

of the loan is made or acquired by the REIT. • The loan value is the maximum principal

amount. • If the loan value exceeds the value of the real property,

the interest income is apportioned between real and other property.

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Income Test: Hedging • Certain properly identified hedging

transactions are excluded from the 95% and the 75% annual testing.

• Must be hedging with respect to: • indebtedness to acquire or carry real estate assets; or • risk of foreign currency fluctuations with respect to

items of income that is qualifying income for purposes of REIT income tests or assets that generate the qualifying income.

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Mitigating a Violation of the Income Tests

– If a REIT fails the 75% or 95% income test and it is:

• Due to reasonable cause and not wilful neglect – Otherwise, disqualified as a REIT and taxable as a C

corporation for the succeeding 5 years.

• A penalty tax is paid

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REIT Asset Tests

• Real Estate Assets

– Real Property – Mortgages on Real Property – Shares in other REITs – Certain property attributable to temporary investment of new capital – Debt securities of publicly offered REITs – Mortgages on Interests in Real Property – Ancillary personal property (no more than 15% of the total fair market

value of the personal and real property) that is leased with real property

– Loans secured by mortgages on property with ancillary personal property

• Cash & cash items (including receivables) • Government securities

At the close of each quarter, at least 75% of value of the REIT’s assets is represented by:

Examples of Real Property

• Manufactured housing / mobile homes permanently installed (Rev. Rul. 71-220)

• Cell towers / transmission towers (Rev. Rul. 75-424)

• Billboards if permanently installed (Rev. Rul. 80-151)

• Rooftop space • Railroad properties (Rev. Rul. 69-94) • Refrigerated warehouses

Proposed “Real Property” Regulations

• Prop. Reg. 1.856-10 published on May 14, 2014

• Clarify definition of “Real Property” • Provide framework for evaluating whether

property is real property • Introduce new “passive” versus “active”

function test • Provide safe harbors • Public Hearing

25%, 25%, 5% & 10% Asset Tests • 25% Asset Test - If 75% test satisfied, 25% test is satisfied • REIT’s investment in securities (e.g., stock and debt

securities) of TRS(s) can not exceed 25% of the gross value of REIT assets – The PATH Act lowered this amount to 20% beginning in 2018

• 5% & 10% Tests - REIT’s investment in securities (excluding securities qualifying for 75% test and securities of TRS) of any issuer: – (i) can not exceed 5% of the value of REITs assets, – (ii) represent more than 10% of the issuer’s voting securities, or – (iii) represent more than 10% of the value of securities of any

one issuer.

Consequences of Failing Asset Test

• General Rule (Section 856(g)(1)) – Loss of REIT status for five years, unless IRS grants

waiver for some portion of years. • Exception for De Minimis Failures of 5% or

10% Tests (Section 856(c)(7)(B)). – Ownership of asset does not exceed greater of 1%

of total value of REIT’s assets and $10,000,000 – Following identification of failure, REIT disposes of

asset within 6 months after last day of quarter of identification of violation.

Consequences of Failing Asset Test

• Exception for Non De Minimis Failures (Section 856(c)(7)(A)). – Following identification of failure, REIT disposes of

asset within 6 months after last day of quarter of identification of violation.

– REIT files schedule with IRS – Failure is due to reasonable cause and not willful

neglect – REIT pays penalty tax of greater of $50,000 or 35%

times net income from the asset.

Distribution Tests

Distribution Requirements

• In order to qualify as a REIT, the deduction for dividends paid (excluding capital gain dividends) for the taxable year must equal or exceed the sum of -- – 90% of Real Estate Investment Trust Taxable

Income (REITTI) excluding net capital gains, and – 90% of the excess of Net Income from Foreclosure

Property over the tax imposed thereon; minus – any excess noncash income (857(a)(1))

Dividends

• Dividends that qualify for DPD (857(b)(2)(B); 561(a); 562(b)): – Regular dividends as defined in section 316 – Consent dividends (565) – Certain liquidating distributions (562(b)) – Deficiency dividends – Stock dividends with a cash-option – Dividends reinvested pursuant to an automatic

dividend reinvestment plan (DRIP)

Computing Dividends Under Section 316

• Dividend means a distribution out of: – Current e&p or – Accumulated e&p

• Computing e&p – Start with the adjustments under that apply to regular C corporations (312)

• Special REIT adjustments apply, which are intended to permit a REIT’s dividends to be treated as paid out of e&p (857(d), 1.857-7(b), Rev Rul 76-299, 316(b)(3))

Dividends

• Dividends will not qualify for DPD unless dividends are pro-rata among all shareholders of the same class, and dividends respect different class rights (562(c))

• Thus, dividends must not be “preferential” • Most common violation – failure to timely pay dividends to

preferred stock shareholders before paying dividends to common stock shareholders

• Following the PATH Act, “publicly offered REITs” are now exempt from the “no preferential dividend” restriction.

• The IRS may now provide a remedy to “private” REITs to cure an inadvertent or due-to-reasonable-cause failure

Dividends - Timing

• Generally, only dividends actually paid during a taxable year are taken into account in applying the distribution requirements

• Two statutory provisions treat dividends actually paid in one year as paid in the prior year – Section 857(b)(9) Distributions – Section 858 Throwback Distributions

Section 857(b)(9) Distributions (“Fourth Quarter”Dividends)

• Any “dividend” (i) declared by a REIT in October, November, or December of any calendar year (ii) made payable to the shareholders of record in such months and (iii) paid during January of the following calendar year shall be deemed: – to have been received by each shareholder on

December 31 of the calendar year – to have been paid by the REIT on December 31 of

the calendar year

Section 858 Throw-Back Distributions

• The REIT must – Declare the dividend before the due date of the

tax return (including extensions) – Distribute the dividend in the 12-month period

following the close of the taxable year and before its first “regular” dividend payment

– Elect in its tax return to have a specified dollar amount of such dividends treated as if paid in the prior year; limited to amount that would constitute a “dividend” in prior year

Excise Taxes - Section 4981

• A 4% Excise Tax is imposed on the excess of the required distribution over the actual distribution

• Limits the REIT shareholders’ deferral of income on the distribution rules under Section 858

• File Form 8612 to figure and pay the excise tax

Excise Taxes - Section 4981 (cont’d)

• The required distribution is the sum of – 85% of the REIT’s ordinary income plus – 95% of the REIT’s capital gain net income, in each

case, for the calendar year plus – 100% of the REIT’s REITTI for all prior tax years.

• The REIT can include over distributions in prior years in the distributed amount calculation for the current year.

Consequences of Violating Distribution Requirements

• General Rule (856(g)(1)) – Loss of REIT status for five years, unless IRS grants

waiver for some portion of years • Exception (856(g)(5))

– Failure to qualify is due to reasonable cause and not due to willful neglect

– $50,000 penalty • Exception (860)

– Self-assessed deficiency dividend

Taxation of REITs, Taxation of Shareholders and Other

Taxes Imposed on REITs

• Corporate tax on REITTI (i.e., the taxable income that is not distributed) and retained net capital gain

• 100% Prohibited Transaction tax (857(b)(6)) • 35% Foreclosure Property tax (857(b)(4)) • 100% excise tax on redetermined rents,

redetermined deductions, redetermined TRS service income and excess interest (857(b)(7))

• Built-in Gain Tax (Regs. 1.337(d)-7) • AMT, Personal Holding Tax

Net Income from Prohibited Transactions

• Taxed at 100% • Tax will not apply if the Safe Harbor

requirements are met • Prohibited Transaction - sale of property “held

primarily for sale to customers in the ordinary course of REIT’s trade or business”

Prohibited Transactions • Safe Harbor for Real Estate Assets

– REIT must have held property at least 2 years for the production of rental income

– Total capitalized expenditures incurred during preceding 2-year period do not exceed 30% of the net sales price

– No more than 7 sales per year, or unlimited sales if adjusted basis (or fair market value) of properties sold does not exceed 10% of total adjusted basis (or fair market value) of assets at beginning of year (but may sell up to 20% of basis in a year so long as 3-year average does not exceed 10%), and substantially all marketing/sales activity through an IK or a TRS

Tax on Built-In Gains

If a REIT receives property from a C corporation in a carryover tax basis transaction (e.g., a nontaxable merger of a C corporation into a REIT), the REIT is subject to section 1374 (unless C corporation elects deemed sale treatment). REIT pays tax on built-in gain only if property is sold within 5-year period. (1.337(d)-6,7)

Capital Gain Considerations (857(b)(3))

• Designation of capital gain dividend w/in 30 days after year end (Forms 1099-Div) or with annual report

• Designation of Undistributed Capital Gain w/n 60 days after year end (Form 2438 – due 30-days; Forms 2439 due 60-days )

U.S. Shareholders • Distributions from operations treated as non-

qualified dividends

• Preferential capital gain rate on dividends from the sale of real property

• No pass-through of foreign tax credits

• Character difference

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Tax Exempt Investors - General

• Dividends of a REIT are generally exempt from UBIT

– Assumes no debt financing to acquire REIT shares

– Debt below the REIT to acquire the property is

generally OK and does not cause tax exempt entity to have debt financed income

– Assumes that REIT is not a pension held REIT

Slide 46

Non-U.S. Shareholders Distributions - Tax

• Dividends from operations generally subject to

tax at 30% • Generally REIT’s are excluded from lower treaty rates

• Dividends attributable to disposition of USRPI

treated as ECI • Not the same as capital gain dividends • Exception for less than 5% shareholders of publicly

traded stock

Slide 47

Non-U.S. Shareholders Distributions - Withholding

• Ordinary dividends are generally subject to

withholding under Sec. 1441.

• Capital gains dividends from the sale of real property are generally subject to withholding Sec. 1445 and reported on the Form 1042-S.

Slide 48

Non-U.S. Shareholders – Sale of REIT Stock

– In general, the sale of REIT stock that is a USRPHC by a non-US person is considered a sale of USRPI unless • The REIT is domestically controlled, or • It is publicly traded under by a less than 10% holder of the class

of stock;

– The sale of REIT stock by a foreign government typically is not considered USRPI provided that it is not a controlled commercial entity

– The sale of REIT stock by a foreign pension plan generally will not be subject to tax

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