Understanding REITs: An Introduction to Real Estate Investment Trusts

Both real estate investors and real estate private equity fund sponsors must consider the organizational structures they use to hold their investments. Historically, partnerships and limited liability companies (LLCs) have been the top choices due to their flexibility and tax benefits. A REIT is another option, as it offers significant benefits to individual investors and property owners.  

Understanding REITs  

Real Estate Investment Trusts (REITs) generally own and operate real estate assets or provide financing for real estate-related assets.  

A key benefit of REITs is that they can avoid corporate income taxes (mostly) while offering the ability to diversify a portfolio’s investment mix. In the real estate sector, REITs are commonly identified by the type of real estate they hold. 

Various Types of REITs 

• Equity REITs own and operate real estate-related assets (multi-family, office, industrial, hospitality, data storage centers, etc.). 
• Mortgage REITs generally provide financing directly to real estate owners and operators or hold mezzanine debt. 
• Hybrid REITS contain a mix of both equity and mortgage investment strategies. 

Differences between REITS and Traditional Real Estate Ownership 

A REIT is a company that owns, operates, or finances income-producing real estate. This allows investors to enter the real estate market without having to incur substantial purchase prices and debt loads while also implementing management of the underlying properties under the traditional ownership model. From the tax side, this provides investment diversity without exposure to many state filings and automatic 199A QBI reduction, effectively reducing the highest tax rate of 37% to 29.6%. 

Key REIT Requirements 

While REITs offer significant tax benefits, investors must meet four tests and requirements for an entity to be considered a REIT structure.  

Ownership Requirements 

To qualify as a REIT, the following rules apply: 

• A corporation, trust, or association must be in legal formation. Under the tax code, LLCs may elect to be treated as corporations.
• Management must be by one or more trustees or directors.
• Ownership of at least 100 shareholders starts with the second taxable year (100 shareholders must exist for at least 335 days each year after the initial year).
• Five or fewer individuals cannot own more than 50% of an entity’s stock value during the last half of each tax year. 

Within the provisions of the REIT and related structures, it is a common practice to limit the amount of ownership an individual may maintain to less than 10% of the total shares to ensure a REIT maintains the provisions of the “5 or fewer” test. 

Asset Tests 

Under the asset tests in Section 856(c)(4), 75% of the value of the total assets of a REIT at the close of each quarter of a taxable year must consist of qualifying assets. The term “total assets” means gross assets of the REIT determined according to U.S. GAAP. Qualifying assets of the REIT are represented by one or more real estate assets, government securities, cash and cash items, and receivables. 

The term “real estate assets” includes tangible real property, interests in real property, and interests in mortgages. These items include land, land improvements, buildings or structures, interests in real property such as co-ops and timeshares, and mortgage and mezzanine debt. 

Income Tests 

A REIT must have a gross income that meets specific percentage requirements for each taxable year. Under code Section 856(c)(2) and (3), there is a 95% test and a 75% test.  

To fulfill the test requirements, at least 95% of a REIT’s gross income must come from sources described in the 75% test and earnings from specific types of portfolio income, such as interest, dividends, and gains from sales of securities.  
For compliance, REITs may create a TRS to hold property or receive income that does not qualify under various tests. 

Distribution Requirements 

A REIT must distribute at least 90% of its taxable income in a tax year to maintain REIT status. In conjunction with the distribution, REITs are eligible for a deduction for such dividends paid. Therefore, REITs generally distribute at least 100% of their taxable income to avoid entity-level tax. 

Due to depreciation expenses incurred by equity REITs, this requirement is generally not an issue as long as a REIT has sufficient cash flow. There is a mechanism in the tax code where a lack of adequate cash flow will not cause a failure in the REIT’s status. However, the election does require the shareholders to agree to recognize the income reported on the tax returns. 

 How REITs Work 

Before forming a REIT, it is essential to consider an entity’s business structure, the makeup of the investors, and their related preferences. If the business plan calls for short-term income from flipping commercial and residential property, this would not be appropriate for the REIT structure. A 100% tax is imposed on the net income from prohibited transactions, including the sale of property held for sale by an entity in the ordinary course of business (e.g., property held as inventory or short-term real estate flipping). 

The Structure and Operation  

However, if investors are looking for long-term capital appreciation, a REIT structure could be worth considering due to the tax advantages of being entitled to the dividend-paid deduction. Upon making the election, deciding on an Umbrella Partnership REIT (UPREIT) or downREIT structure is essential. 

A UPREIT is a structure in which the REIT owns its required real estate investment through an Operating Partnership (OP). Owners exchange their real estate for units in an OP. In contrast, a downREIT structure typically consists of a joint partnership between property owners and a REIT. In this structure, partners own and operate real estate properties. This structure is more complex than an UPREIT and not as commonly used. The UPREIT structure permits the deferral of a gain upon property contribution while allowing the contributing partner to obtain liquidity and diversification. If an owner were to contribute appreciated real property directly to a REIT, gain or loss would generally be recognized. An UPREIT structure would be ideal for a real estate owner to transfer property to a REIT without recognizing a gain. 

Benefits of Investing in REITS  

REIT investments have several financial benefits, including dividends, tax advantages, and liquidity. REITs are designed to pay at least 90% of taxable income, helping to provide income streams and returns. They also offer tax advantages as they do not pay corporate taxes subject to requirements, which gives investors returns on taxable income distributions. Publicly traded REITs allow investors to sell ownership stakes at any time, unlike owning real estate outright, an illiquid asset. Most REITs distribute 100% of their earnings to avoid corporate income taxes, providing some liquidity as well.  

Aside from financial benefits, investing in REITs enables the investor to diversify their real estate portfolio. By investing in REITs, investors can own multiple asset classes and categories, spreading risks across multiple segments, such as mortgage REITs, hospitality REITs, industrial centers, etc. 

Risks and Challenges Associated With REITS 

Like most investments, there are inevitable risks when following improper legal and tax counsel. Common challenges include: 

• Noncompliance risk: Failure to maintain REIT compliance with quarterly assets and annual income tests can cause significant tax compliance issues, including possibly losing REIT status. 
• Market risk: Like all industries, REITS are subject to market risk, which could lead to poor performance if the market downturns. 
• Interest rate risks: Like most real estate entities, rising interest rates can impact a REITs performance, leading to higher borrowing costs and cash flow restraints. These restraints limit profitability and lower the taxable income required to be distributed to shareholders. 
• Management risks:  If the REITs have unqualified individuals running operations, this could impact the performance of the overall REIT 
• Property-specific risk: The physical real estate's location and the underlying real estate class could impact the REITs’ performance. 

Steps to Begin Investing in REITs

Without significant changes to the tax code, investors will continue to favor REITs in the industry as a form of organizational structure. The REIT structure can be advantageous for a real estate enterprise. As such, speaking with a trusted, experienced business advisor is imperative. Contact EisnerAmper today to learn how we can help diversify your portfolio and save money with REITs.