Background
REITs are an attractive option for investors due to their special tax treatment. A REIT is an entity that combines the capital of multiple investors to invest in commercial real estate through the purchase of shares, and the entity must pay distributions to its shareholders equal to at least 90% of its income. (IRC sections 856–858). Despite its corporate status, a REIT is not typically subject to federal income taxes (IRC sections 856–858). During the Congressional debate over the law that established REITs, the House Ways and Means Committee indicated that REITs were meant to function as “pooling arrangements whereby small investors can secure advantages normally available only to those with larger resources” by investing in real estate [Cigar Excise Tax Extension Act, Pub. L. 86-779; Real Estate Investment Trusts—Equalization of Investment Opportunity or Unjustified Tax Break to Favored Interests? 1961 Washington U. L. Rev. 436, 441 (1961)]. Many REITs today do not resemble Congress’s original vision, however. As of August 2024, the value of all publicly traded REITs was $1.513 trillion, and there are over 153 REITs on the New York Stock Exchange (“REIT Industry Financial Snapshot,” Nareit, https://tinyurl.com/3zdbnyfj). Currently, REITs possess a wide range of holdings, including hotel and health-care facilities.
REITs in the healthcare and hospitality industry are facing increased scrutiny from congressional leaders and the IRS. In a public letter on July 26, 2024, IRS Chief Counsel Marjorie A. Rollinson stated that the IRS was “aware” that some hospitality REITs were advocating practices that “violate tax rules” and would cause REITs to “lose [their] tax status” (Letter from Marjorie A. Rollinson, Chief Counsel, Internal Revenue Service, to Senator Ron Wyden, Chairman, H. Comm on Finance, Aug. 26, 2024, https://aboutblaw.com/bfud). Roll-inson’s letter was in response to an unreleased July 22, 2024, letter from Senator Ron Wyden, the chairman of the Senate Finance Committee, discussing tax policies for hospitality REITs. Government scrutiny of REITs has extended beyond this exchange, as Senator Elizabeth Warren called on the IRS to investigate tax noncompliance by REITs in the healthcare and hospitality industries in a September 4, 2024, letter (Letter from Senator Elizabeth Warren, to Daniel Werfel, Comm’r., IRS, Sept. 3, 2024, https://tinyurl.com/28vcspsv). These letters from prominent senators and IRS leadership may lead to new government efforts to increase REIT tax compliance, particularly for healthcare and hospitality REITs, which could reshape the REIT industry.
This article provides an overview of REIT tax treatment and regulations, including provisions for healthcare and hospitality REITs, and describes the IRS and congressional efforts for greater enforcement of perceived REIT tax abuses. It concludes with a brief discussion on how tax professionals working with REITs can ensure their clients do not face a loss of tax benefits or costly civil penalties.
REIT Requirements and Tax Treatment
REITs are subject to stringent requirements. For example, at least 75% of REIT gross income must be derived from real estate, and REITs must pay out a minimum of 90% of their taxable income to their shareholders through dividends (IRC section 856). To ensure that REITs are analogous to real estate mutual funds, at least 75% of their assets must be real estate, cash, or short-term government securities; they are prohibited from owning more than 10% of the securities of a single issuer, and no more than 5% of their assets can be from the securities of a single issuer, among other restrictions on their asset holdings (IRC section 856). REITs also have requirements for a minimum number of shareholders, foreign investors, and shareholder tax treatment (IRC section 856).
REITs’ favorable tax treatment stems from their avoidance of the 21% corporate income tax despite holding corporate status and their qualification for the 20% pass-through deduction for qualified business income (QBI), known as the Section 199A QBI Deduction [IRC sections 11(b); 199A (b)(1)]. QBI is defined as “the net amount of qualified items of income, gain, deduction and loss from a qualified trade or business” [section 199A (c)(1)]. Introduced under the 2017 Tax Cuts and Jobs Act, the Section 199A QBI Deduction permits taxpayers (other than corporations) to decrease taxable income by 20% of the net income earned from the business [section 199A (b)(2)]. For REITs, the QBI Deduction is calculated based on 20% of the taxpayer’s QBI plus 20% of the taxpayer’s qualified REIT dividends and qualified (i.e., publicly traded partnership) income [section 199A (b)(2)].
Hospitality and Healthcare REIT Limitations
The Tax Code has special rules related to the management of health-care and hospitality REIT properties through Taxable REIT Subsidiaries (TRS). TRSs are corporations spun off from a parent REIT through a typically tax-free reorganization, and they are directly owned by the REIT parent to hold assets and perform services normally prohibited for REITs [section 856(l)(1)]. TRSs were established by the REIT Modernization Act of 1999, which allowed REITs to create these subsidiary entities under certain conditions. IRC section 856(l)(3) prohibits TRSs from directly or indirectly operating or managing real estate. Typically, REITs structure their ownership arrangement by setting up a TRS to manage the property on behalf of the REIT, thereby removing the REIT from directly, actively managing the property. The TRS, in turn, hires independent contractors or structures management agreements to oversee the underlying real estate business.
Healthcare and hospitality TRSs face unique restrictions. IRC section 856(l)(3) expressly excludes from the definition of a TRS: “(A) any corporation which directly or indirectly operates or manages a lodging facility or a healthcare facility, and (B) any corporation which directly or indirectly provides to any other person (under a franchise, license, or otherwise) rights to any brand name under which any lodging facility or healthcare facility is operated.” IRC section 856(d)(8)(B) does indicate, however, that a TRS is not deemed to be operating or managing a health-care facility or lodging facility “solely because it (i) directly or indirectly possesses a license, permit, or similar instrument enabling it to do so, or (ii) employs individuals working at such facility or property located outside the United States, but only if an eligible independent contractor is responsible for the daily supervision and direction of such individuals on behalf of the taxable REIT subsidiary pursuant to a management agreement or similar service contract.” Accordingly, healthcare and hospitality TRSs must carefully craft their management structures to avoid violating the tax code.
Government Scrutiny of Healthcare and Hospitality REITs
In the health care and lodging industries, some TRS practices have raised concerns that REITs are violating tax law by “indirectly” managing facilities through TRS control over independent contractors. As noted above, these REIT practices have drawn the attention of Senator Warren, who publicly contended in her September 2024 letter to the IRS Commissioner that some health-care and hospitality REITs are not in compliance with tax laws. In her letter, Warren lamented that many large healthcare and hospitality REITs were illegally claiming significant tax breaks through unlawful management practices and urged heightened enforcement of tax laws governing REITs. Based on public statements, the IRS agrees with some of Senator Warren’s sentiments. For example, in her July 2024 letter, IRS Chief Counsel Marjorie A. Roll-inson underscored IRC prohibitions against direct or indirect management by TRSs in the hospitality and healthcare industries. Rollinson noted that there is no objective standard for what constitutes direct or indirect management, although, in the hospitality industry, a TRS is expressly prohibited from managing “day-to-day operation” of lodging such as “recruiting, hiring, daily supervision, and direction of the employees.”
Rollinson’s statements that the IRS was “aware” some in the REIT industry were advocating for practices that would violate these rules and that the IRS “takes seriously the proper enforcement of the tax rules … governing REITs” suggests that the IRS may prioritize addressing hospitality and healthcare REITs’ compliance. The Inflation Reduction Act (IRA) gave the IRS increased resources to strengthen its vigilance and enforcement. The IRA provided the IRS with a significant increase in funding, which the IRS has stated it intends to use, in part, to “restore fairness in tax compliance” by “shifting more [enforcement] attention onto … partnerships [and] large corporations” (IRS press release, Sept. 8, 2023, https://tinyurl.com/ynbk7n9e). Based on Rollinson’s statements, the authors believe that the IRS’s planned enforcement of partnership and corporate tax compliance will extend to REITs.
Penalties for Noncompliance
If a healthcare or hospitality REIT is found to be noncompliant, it could face significant penalties. Noncompliant REITs can lose their preferred tax treatment and be unable to recover their REIT status for a minimum of five years [IRC section 856(g)(3)]. Once REITs lose their status, they are subject to the 21% corporate income tax and lose the QBI deduction. Furthermore, IRC section 856(g)(1) permits the IRS to retroactively tax the REIT as a corporation for all the years it was deemed noncompliant. Healthcare and hospitality REITs found to be misusing TRSs would face further penalties. IRC section 857(b)(7)(A) states that REITs misusing a TRS would face a “tax equal to 100 percent of … redetermined TRS service income,” or, put simply, a 100% tax on the gains related to the noncom-pliant TRS activity. These extensive penalties could be financially ruinous for REITs.
Advising REITs
The recent Congressional and IRS scrutiny of healthcare and hospitality REIT tax compliance may lead to increased enforcement and significant tax consequences for noncompliant REITs. CPAs should keep these realities in mind when advising REIT clients, particularly those involved in the healthcare or hospitality industries. CPAs should review relevant REIT rules with their clients to ensure they are not violating the requirements for REIT status. CPAs should also advise healthcare and hospitality REITs to ensure none of their TRSs are directly managing the day-to-day operations of properties or indirectly managing properties through control over an independent contractor. If healthcare and hospitality REITs follow this guidance, they can avoid costly penalties and protect their tax status.
