Real Estate Investment Funds: To REIT or Not to REIT?
A real estate investment trust, or REIT, can be a riddle for real estate fund sponsors seeking to scale beyond the “friends and family” investment stage. Some sponsors see the REIT as the “next stage” of the fund’s growth style – almost like a rite of passage to becoming a large-cap fund. Sometimes the sponsor is right, and a REIT really is the best fit for the sponsor’s needs. Many times, however, what the sponsor actually wants is not a REIT, but rather a better vehicle for accepting institutional capital. This determination often has nothing to do with tax. For example, a sponsor may be seeking an “open-ended” or “evergreen” fund to grow and maintain an existing portfolio of stabilized assets or a closed-end fund to raise capital more efficiently for development activities. A REIT may be helpful in attracting investment funds to achieve those goals, but a REIT is not necessary for achieving those goals. In many situations, a REIT may serve as little more than a cost burden and compliance headache. For this reason, a sponsor needs to know when to consider a REIT and when to avoid it. This article considers this matter at a basic level.
A REIT is merely a tax classification that allows an entity that would otherwise be taxed as a corporation to avoid “double taxation” and achieve tax treatment similar to – but in some important ways, different than – a tax partnership. Instead of passing through all items of gain, loss, deduction, and credit to its partners to avoid double taxation, a REIT avoids double taxation via a “dividend paid deduction.” The dividend paid deduction reduces the REIT’s taxable income dollar-for-dollar based on the amount of dividends paid — or deemed paid — to its shareholders in a given taxable year. Thus, a REIT may avoid corporate income taxation entirely — and most REITs do — by distributing an amount equal to 100% of the REIT’s taxable income each year to its shareholders as dividends. Shareholders, in turn, pay tax on REIT dividends received at tax rates that correspond to the underlying nature of the income generating the cash for the dividend. For example, dividends funded by cash from operations, such as rental income – and other sources that would be taxable at ordinary rates if earned directly by an individual – are taxed at ordinary income rates, and dividends funded by cash from the sale of business or investment assets held by the REIT for more than one year generally are taxed at capital gains rates. By encouraging the passing through of all cash received as dividends, Congress envisioned the REIT as serving as a sort of “mutual fund for real estate,” whereby non-institutional and institutional investors could invest in a pool of real estate assets held by a passive investment vehicle. Over the years, the once strict REIT rules have been relaxed, and certain tax benefits have arisen that have expanded the usefulness of REITs beyond that initial vision.
Despite the similarity between REITs and tax partnerships summarized above, REITs differ from tax partnerships in key ways that dictate when one should – or should not – deploy a REIT in one’s fund structure. Many of these differentiators derive from Congress’s original intent that REITs serve as a “mutual fund for real estate.” For example, REITs can offer their securities on public markets, but a REIT must maintain at least 100 investors and comply with a myriad of special requirements intended to ensure REITs are sufficiently passive in nature. These requirements require conducting detailed testing of the REIT’s assets, income, and dividends, amongst other requirements. Consequently, REITs require a costly internal and external compliance framework to operate. REITs also differ from partnerships in that REITs are grounded in principles of corporate taxation rather than partnership taxation. This hybrid structure allows for material tax savings for a limited but influential class of investors.
So when does it make sense to implement a REIT structure? Historically, the answer was dictated in large part by the fund’s proposed investment strategy. The strict REIT rules effectively limited REITs to a “buy-and-hold” investment strategy and a limited set of “traditional” real estate assets, but the advent of the “taxable REIT subsidiary” and relaxation of REIT rules generally has opened the door to a wide variety of REITs. Today, the calculus is usually whether the additional tax cost and administrative burdens of running a REIT – regardless of asset class or level of involvement in operations – are worth the benefits to the fund sponsor. Of course, if the operations will principally be acting as a developer of real property, then a REIT is not an appropriate vehicle for the business, as the REIT will be subject to tax at a rate of 100% on any sale of portfolio assets in the ordinary course of business – amongst other issues.
And what are these “benefits”? For a U.S. sponsor, the two main benefits are the ability to: (1) gain liquidity and raise capital by going public, and (2) facilitate a capital raise from the aforementioned limited but influential class of investors who prefer private REITs, such as:
- Non-U.S. for-profit investors.
- Sovereign wealth funds.
- Foreign pension funds.
- U.S. tax-exempt entities — excluding certain arms of state governments.
These investors prefer REITs to avoid U.S. income tax return filing obligations, to avoid the Foreign Investment in Real Property Tax Act (FIRPTA) withholding on exit – when structured properly – to avoid Effectively Connected Income (ECI) or Unrelated Business Taxable Income (UBTI), as the case may be, or to avail themselves of favorable tax treaty benefits for dividends.
While few cut-and-dry answers exist as to when the formation of a REIT makes sense for any particular fund, below are a few simple guideposts for fund sponsors to consider.
Consider a REIT when:
- The sponsor seeks liquidity for its existing private investment fund via public markets – usually via an Umbrella Partnership REIT (UPREIT) structure, in which historic investors receive partnership interests in exchange for REIT shares.
- The sponsor seeks to raise capital from public markets.
- The sponsor has investors who prefer a REIT structure and whose capital or stature are considered material to the fund’s success.
Avoid a REIT when:
- The key capital commitments are coming from U.S. for-profit investors or other “REIT agnostic” investors (e.g., state pension funds who are tax-exempt and do not face UBTI issues).
- The fund’s investment strategy relies on disposing of portfolio assets in the ordinary course of business, (e.g., operating as a developer).
- The fund’s investment strategy includes reinvestment of a material portion of the cash flow generated by the business.
In nearly every case, sponsors considering REITs must balance the value of the additional capital raised via the implementation of a REIT structure against the substantial costs of forming and maintaining a REIT.
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