Real estate is an evergreen investment vehicle, but few investors are willing to confront the high risk of trading in real property. Real estate investment trusts (REIT) and real estate mortgage investment conduits (REMIC) provide a safer alternative for risk-averse investors interested in this market. In this article, the author delves into these entities, comparing their structure, examining their tax implications, and covering recent developments in the field.
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Individuals with discretionary income may wish to invest in real estate but lack the knowledge necessary to make prudent decisions. Particularly daunting are the fluctuations in real property values during the past several years, especially during and after 2008. Individuals who wish to invest in real estate without using real property as their investment medium have indirect investment alternatives in the form of real estate investment trusts (REIT) and real estate mortgage investment conduits (REMIC), and properly informed CPAs can educate potential investors on the nuances of these entities. This article describes the essential aspects of REITs and REMICs, explains the relevant tax provisions, and covers recent developments.
Although REITs and REMICs are both vehicles for making passive investments in real estate, they differ significantly in their structure and their federal income taxation. The Exhibit compares REITS and REMICs in terms of federal income tax entity classification, types of ownership instruments offered, and federal tax returns filed.
General Comparison of REIT and REMIC Characteristics
Real Estate Investment Trusts
The original federal REIT legislation was enacted in 1960 to give average investors a tax-advantageous vehicle for investment in a professionally managed, large-scale portfolio of real estate assets through the purchase of equity (i.e., stock). REIT opportunities are numerous. The National Association of Real Estate Investment Trusts (NAREIT; http://www.reit.com), states that as of August 31, 2015, there were 300 REITs registered with the SEC and trading on major stock exchanges, with a combined equity market capitalization of $900 billion. In addition, IRS data shows that approximately 1,100 U.S. REITs have filed tax returns, and 30 countries have enacted REIT provisions (“Understanding the Basics of REITs,” http://bit.ly/2ajGWZW).
With regard to federal income tax, the advantageous tax treatment accorded to REITs is a deduction for dividends paid to shareholders, which eliminates the double taxation generally associated with corporate income. To qualify for REIT status, however, an entity must distribute at least 90% of its taxable income (other than net capital gain) for the taxable year [IRC section 857(a)(1)]. This distribution requirement provides an investment advantage to REIT shareholders because it assures a steady stream of income. A REIT may also retain and pay corporate income tax on net capital gain. Under this scenario, REIT shareholders include the net capital gain in income, apply a credit for the tax paid by the REIT, and step up the basis of their REIT stock by the amount included in income [IRC section 857(b)(3)].
NAREIT cautions that not all states allow a dividends-paid deduction to REITs (Carisa Chappell, “PwC Exec Says State, Local Taxes Can Cause Concern for REITS, ” Apr. 2, 2013, http://bit.ly/2awoWvf). For example, states like Washington and Ohio tax corporate gross receipts and disallow deductions, which would include disallowance of the REIT dividends-paid deduction.
An entity that would otherwise be a taxable domestic corporation becomes a REIT by making a REIT election in accordance with IRC section 856(c)(1); such an entity must be a calendar-year taxpayer (IRC section 859). The REIT election is valid until terminated and may be revoked by the REIT after the first taxable year for which it is effective. Additional restrictive criteria identified in IRC section 856(a) include:
- The entity must be owned by at least 100 persons;
- No more than 50% of the REIT interests may be owned by five or fewer individual shareholders;
- The entity cannot be a financial institution or an insurance company;
- The entity is managed by one or more trustees or directors; and
- The entity issues transferable ownership instruments in the form of shares or certificates of beneficial interests.
REITs are also subject to substantial limitations as to the composition of their income and assets.
Generally, REIT income must be real-estate-related income. More specifically, IRC section 856(c) describes a 95% income test and a 75% income test. The two tests contain common elements, but they are not identical. The 95% income test requires that at least 95% of REIT gross income for the taxable year be derived from these sources:
- Rents from real property
- Gain from the sale or other disposition of stock, securities, and real property [including interests in real property and interests in mortgages on real property not described in IRC section 1221(a)(1), i.e., inventory-type property]
- Abatements and refunds of taxes on real property
- Income and gain derived from fore-closure property
- Amounts received or accrued as consideration for entering into agreements 1) to make loans secured by mortgages on real property or on interests in real property or 2) to purchase or lease real property
- Gain from the sale or other disposition of a real estate asset that is not a prohibited transaction [as defined in IRC section 857(b)(6)]
- Certain mineral royalty income.
The 75% income test requires that at least 75% of a REIT’s gross income be derived from these sources:
- Rents from real property
- Interest on obligations secured by mortgages on real property or on interests in real property
- Gain from the sale or other disposition of real property [including interests in real property and interests in mortgages on real property not described in IRC section 1221(a)(1), i.e., inventory-type property]
- Dividends or other distributions on and gain from the sale or other disposition of transferable shares in other tax-qualified REITs
- Abatements and refunds of taxes on real property
- Income and gain derived from fore-closure property
- Amounts received or accrued for entering into agreements 1) to make loans secured by mortgages on real property or on interests in real property or 2) to purchase or lease real property
- Gain from the sale or other disposition of a real estate asset that is not a prohibited transaction [as defined in IRC section 857(b)(6)].
- Qualified temporary investment income [as defined in IRC section 856(c)(5)(D)].
Note that the income sources for each test are not completely identical. In its technical explanation of the Protecting Americans from Tax Hikes (PATH) Act of 2015, the Joint Committee on Taxation (JCT) summarizes the tests as follows:
95 percent of the gross income of a REIT for each taxable year must be from the 75-percent income sources and a second permitted category of other, generally passive sources such as dividends and interest. (Dec. 17, 2015, http://bit.ly/2a5dXdN)
IRC section 856(c)(4)(A) requires that at least 75% of the value of a REIT’s total assets consist of three categories of property at the close of each quarter of a REIT’s taxable year:
- Real estate assets, which are real property (including interests in real property and interests in mortgages on real property) and shares in other REITs
- Cash and cash items (including receivables)
- Government securities, defined in IRC section 856(c)(5)(F).
Not all REIT distributions are ordinary income. Long-term capital gains can be passed through separately to REIT owners.
IRC section 856(c)(4)(B) provides further restrictions as to asset composition. For example, under prior law, not more than 25% of the value of total REIT assets could be represented by securities of one or more taxable REIT subsidiaries (TRS). The PATH Act, however, reduced the TRS ownership limit to 20%.
Because REIT ownership is evidenced by shares, distributions are reported to REIT investors on Form 1099-DIV. Although the items that constitute REIT income are not separately stated (as they are for S corporations and partnerships), not all REIT distributions are ordinary income. Long-term capital gains can be passed through separately to REIT owners.
IRC section 857(b)(3)(C) describes a REIT capital gain dividend as any dividend, or part thereof, designated by the REIT as such in a written notice mailed to its shareholders within 30 days after the close of its taxable year. REIT shareholders treat capital gain dividends as a gain from the sale or exchange of a capital asset held for more than one year [IRC section 857(b)(3)(B)]; in other words, as long-term capital gains regardless of shareholder holding period. As mentioned above, a REIT may retain its net capital gain and pay a corporate income tax on the amount retained. In addition, a corporate REIT shareholder that receives an ordinary REIT distribution (i.e., dividend) is not eligible for a dividends-received deduction. This is because a REIT distribution is generally paid from income not subject to tax to the distributing REIT.
Recent Federal Tax Developments
The PATH Act contains several substantive provisions pertaining to the federal income taxation of REITs. For example, a recent Wall Street Journal article described the recent popularity of REIT spin-offs among retailers, restaurant chains, casinos, and telecommunication companies (Richard Rubin and Liz Hoffman, “Tax Bill Targets REIT Spinoffs,” Dec. 8, 2015, http://on.wsj.com/2aAlEZb). In such a transaction, frequently initiated by activist investors, a company (typically a C corporation) seeks to non-taxably “spin off” company real estate into a REIT to liberate the value of its real estate holdings. Prior law permitted such nontaxable spin-offs if the “active business test” associated with non-taxable reorganizations was satisfied, which was usually done through rental activities.
Section 314 of the PATH Act repeals the preferential dividend provision for publicly traded REITs.
Section 311 of the PATH Act thwarts such a strategy by providing that a REIT is generally ineligible to participate in a nontaxable spin-off as either a distributing or controlled corporation under IRC section 355. Two exceptions exist, the most prominent of which is that the general rule prohibition does not apply if, immediately after the spin-off, both the distributing and the controlled corporations are REITs. This new law affects distributions made on or after December 7, 2015.
In addition, IRC section 856 previously permitted REITs to own securities of one or more TRSs; however, not more than 25% of the value of total REIT assets could consist of securities of one or more TRSs. Section 312 of the PATH Act reduces this percentage to 20%. This is effective for taxable years beginning after December 31, 2017.
REITs are also subject to a 100% tax on the net income from prohibited transactions, defined as sales or other dispositions of REIT property that is 1) stock-in-trade of the taxpayer, 2) other property that would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or 3) property held for sale to customers by the taxpayer in the ordinary course of trade or business. (Sale or distribution of foreclosure property is allowed.) IRC sections 857(b)(6)(C) and (D) contain safe harbors from the prohibited transactions tax (PTT), but only if an asset has a holding period of at least two years. Among the safe harbors under prior law was a provision that permitted a REIT to either 1) make no more than seven sales during the taxable year or 2) sell not more than 10% of the aggregate basis, or not more than 10% of the aggregate fair market value, of its assets (computed at the beginning of the taxable year) without imposition of the PTT. Section 313 of the PATH Act increases the 10% of aggregate–basis or aggregate–fair market value limitation to 20%. It is effective for taxable years beginning after enactment.
Prior to the PATH Act, a REIT could deduct dividends paid to shareholders only if the dividend was distributed pro rata to shareholders and had no preferences with regard to different classes of stock. Dividends not meeting these criteria are called “preferential dividends.” Section 314 of the PATH Act repeals the preferential dividend provision for publicly traded REITs, defined as those that are publicly offered and are required to file annual and periodic reports with the SEC. It applies to distributions in taxable years beginning after December 31, 2014.
As noted above, 75% of the value of a REIT’s assets must consist of real estate assets, cash and cash items (including receivables), and government securities. Under section 317 of the PATH Act, debt instruments issued by publicly traded REITs and interests in mortgages pertaining to real property are treated as real estate assets for purposes of the 75% test. The effective date for this provision is December 31, 2015.
Real Estate Mortgage Investment Conduit (REMIC)
REMICs were created as part of the Tax Reform Act of 1986 (TRA). The TRA Conference Report states that the REMIC was created as the exclusive means of issuing multiple-class, real estate mortgage–backed securities without the imposition of two levels of tax. The IRS describes a REMIC as an entity formed for the purpose of holding a fixed pool of mortgages secured by interests in real property (IRS Publication 550, Investment Income and Expenses, 2015). A REMIC is generally treated as a partnership, the income or loss from which is not treated as income or loss from a passive activity. REMICs issue regular interests (treated as debt instruments) and residual interests (treated as partnership interests). A REMIC may issue several classes (tranches) of regular interests, but may issue only one class of residual interests.
IRC section 860D defines a REMIC as any entity—
- that has elected REMIC status for the taxable year and all prior taxable years;
- with ownership interests that are represented by regular interests or residual interests;
- that has only one class of residual interests, to which pro rata distributions are made;
- substantially all of whose assets, as of the close of the third month beginning after the startup date and at all times thereafter, consist of qualified mortgages [defined in IRC section 860G(a)(3)] and permitted investments [defined in IRC section 860G(a)(5)];
- that has a taxable year that is a calendar year; and
- that has made arrangements to ensure that 1) residual interests are not held by disqualified organizations [defined in IRC section 860E(e)(5)], and 2) information necessary for the application of IRC section 860E(e)(5) is made available by the entity.
Because REMICs are not publicly traded, information about particular REMICs is not publicly disseminated by a neutral third party such as the SEC. IRS Publication 938, Real Estate Mortgage Investment Conduits (REMICs) Reporting Information, does, however, contain directories pertaining to REMICs. Each directory contains information submitted to the IRS by the REMIC for that particular quarter and identifies representatives from whom REMIC-specific information can be obtained.
The most significant aspect of investing in a REMIC is distinguishing the characteristics of regular and residual interests and the tax consequences of each. IRC section 860G(a)(1) defines a regular REMIC interest as any interest that is issued on the entity startup date with fixed terms and which is designated as a regular interest if—
- such interest unconditionally entitles the holder to receive a specified principal (or similar) amount, and
- interest or other similar amounts are 1) payable based on a fixed rate or 2) consist of a specified portion of the interest payments on qualified mortgages and such portion does not vary during the period such interest is outstanding.
In other words, an investor who acquires a regular REMIC interest is purchasing a debt instrument. Such debt classification is confirmed by IRC section 860B(a). Therefore, holders of regular REMIC interests must use the accrual method to report interest income and the original issue discount (OID), if any. REMICs consequently provide regular interest holders with IRS Form 1099-INT (and Form 1099-OID, if applicable).
The most significant aspect of investing in a REMIC is distinguishing the characteristics of regular and residual interests and the tax consequences of each.
IRC section 860G(a)(2) defines a residual REMIC interest as any interest issued on the startup date that is not a regular interest and that is designated as a residual interest. There can be no more than one class of residual interest, and all distributions on those interests must be pro rata. In other words, a residual interest is an interest in the REMIC itself and resembles an interest in a partnership. REMICs do not, however, allocate entity income or loss to residual interest owners by means of Schedule K-1 but rather by Schedule Q. Residual interest owners do not attach Schedule Q to their Form 1040; instead, they report their REMIC income or loss from Schedule Q in Schedule E (Supplemental Income or Loss) to Form 1040. Allocated REMIC income or loss is not classified as income or loss from a passive activity, which enables residual interest owners to offset allocated REMIC losses against income from salaries and other active sources of income—a significant income tax advantage.
Safer, but Complex, Alternatives
Although REITs and REMICs are a less risky alternative to direct investment in real property, they can still be quite complex, and their tax consequences are just as serious. CPA financial advisors whose clients elect to use these investments would be well served to study them thoroughly in order to properly guide individuals though the complexities.