Bachelor Thesis, 2008
99 Pages, Grade: 1.3
TABLE OF ILLUSTRATIONS
1.1 Problem Definition
1.2 Approach of Investigation
2 GENERAL INFORMATION ABOUT REITS
2.1 Definition of Real Estate Investment Trusts
2.2 REIT History/ Legal Developments
2.3 Types of REITs
2.4 Special REIT Structures
2.4.1 Umbrella Partnership REITs
2.5 Economic Performance and Industry Growth
3 PREREQUISITES TO BE TAXED AS A REIT IN THE U.S
3.1.1 General Structure
188.8.131.52 Paired Stocks
184.108.40.206 Trustees and Directors
220.127.116.11 Shareholder Rights
3.1.3 REIT Ownership
18.104.22.168 Ownership of Shares and its Restrictions
22.214.171.124 Domestic Corporation
126.96.36.199 Banks and Insurances
188.8.131.52 Number of Shareholders
184.108.40.206 Closely Held Prohibition
3.1.4 Election to be taxed as REIT
3.1.5 Conversion of “C Corporation”
3.2 Asset Tests
3.2.1 75% Test
3.2.2 25% Test
3.2.3 Failure of the Asset Tests
3.3 Income Tests
3.3.1 Gross Income
3.3.2 75% Test
3.3.3 95% Test
3.3.4 Failure of the Income Tests
3.4 Taxable REIT Subsidiaries (TRS)
3.4.1 General Information
3.4.2 Effects on Asset and Income Tests of a REIT
3.5 Distribution Requirements
3.5.1 General Information
3.5.2 Distribution of Stock
3.5.3 Capital Gain Distributions
3.5.4 Distributions at a later date
4 taxation OFAREIT
4.1 General Information
4.1.1 Filing the Return
4.1.2 Tax Payments
4.1.3 Failure to Comply
4.1.4 Accounting Method and Period
4.2 Income Types
4.2.1 REIT Taxable Income
4.2.2 Deductions for Dividends Paid
4.2.3 Earnings and Profits
4.2.4 Excess Non-Cash Income
4.2.5 Capital Gains
4.2.6 Net Operating Losses
4.2.7 Net Capital Losses
4.2.8 Income from Foreclosure Property
4.2.9 Income from Prohibited Transactions
4.2.10 Income through Changes of Accounting Method
4.3 Calculation of Federal Tax Liability
4.3.1 Taxes on REITTI including Capital Gains
4.3.2 Tax on Net Income from Foreclosure Property
4.3.3 Tax on Income from Prohibited Transactions
4.3.4 Tax on Gains through C Corporation Conversions
4.3.5 Excise Tax on Undistributed Income
4.3.6 Penalty Taxes for Failure of Asset or Income Tests
4.3.7 Penalties for Failure of Ownership
4.3.8 Penalty Taxes for Certain Dealings with TRS
4.3.9 Alternative Minimum Tax
4.4 Taxationthrough States
4.4.1 Importance of Federal Laws for States
4.4.2 Connection between REIT and State
4.4.3 Business In More Than One State
4.4.4 Division of Income for Tax Purposes
5 TAXATION OF SHAREHOLDERS
5.1 US Shareholders
5.1.1 Distributions from Earnings and Profits
5.1.2 Capital Gains Dividends
5.1.3 Retained Capital Gains
5.1.4 Capital Gains Tax Rates
5.1.5 Qualified Dividends
5.1.6 Tax-Exempt Shareholders
5.2 German Shareholders
5.2.1 General Regulations for Foreign Shareholders
220.127.116.11 United States Real Property interest
18.104.22.168 Capital Gains Distributions
22.214.171.124 Ordinary Dividends
5.2.2 Double Taxation Treaty USA-Germany
126.96.36.199 General information
188.8.131.52 Ordinary Dividends
184.108.40.206 Gains through Disposition of Shares
5.2.3 German Income Taxation
220.127.116.11 Provisions of the German REIT Act and income Taxation
18.104.22.168 Corporate investors
22.214.171.124 individual investors
126.96.36.199 Contrast of the Tax Regimes
6 FUTURE FORECAST AND CONCLUSION
Figure 1: Overview over number of public REITs 1971-2007
Figure 2: Share of the different types of REITs
Figure 3: Structure of an Umbrella Partnership REIT
Figure 4: Structure of a DownREIT
Figure 5: Property types REITs invest in as of Dec. 2003
Figure 6: Annual Returns of REITs & S&P 500 between 1990-2007
Figure 7: „Asset Test“ provisions
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This Bachelor Thesis about the taxation of Real Estate Investment Trusts (REIT) in the United States and of German investors gives an overview over the provisions of the Internal Revenue Code and some special rules and regulations for REITs issued by the United States Treasury and the Internal Revenue Service. Furthermore, it regards withholding tax issues for foreign investors constituted by U.S. tax law, in addition to the provisions of the Double Taxation Treaty between the U.S. and Germany.
The object of this thesis is to provide potential German investors with an insight into the tax situation of REITs in the United States of America and to present the possibility of relatively save investments with a tax reduction aspect. Furthermore this document can be used for the U.S. perspective in an evaluation of similarities and differences between the long established U.S. REITs and the new German REITs (G- REITs) that have been introduced in Germany in 2007 through an act (Gesetz zur Schaffung deutscher Immobilien-Aktiengesellschaften mit börsen-notierten Anteilen) of May 28, 2007, which was dated back to January 1, 2007.1
Real Estate Investment Trusts have a special position in U.S. federal and state tax law, which is only recognized if all the prerequisites described in the thesis are being met. Additionally, the REIT status has to be actively elected before the taxation according to those principles is possible.
Real Estate Investment Trusts have their origin in the United States, from where they spread out into the whole world. Today, this way for rather small investors to invest in real estate is possible and established in over 20 countries around the globe.
Depending on the country, entities have to meet different standards, usually concerning organization and income and asset types as well as the distribution of that income, to qualify for the REIT status and enjoy certain tax benefits.
This paper is divided into six chapters. At the beginning the reader will obtain some general information about REITs, their history and legal developments as well as an overview over two special REIT structures that developed over time. This is followed by a brief description of the economic progress and situation over the last four decades.
Chapter three describes the important requirements concerning organization, management and ownership, as well as income the REIT can receive and assets it can hold. Furthermore, the distribution requirements are explained. All of those standards are in accordance with §856 of the Internal Revenue Code (IRC), which especially treats REITs.
The fourth chapter covers the taxation of REITs. It is shown, which kinds of income are taxed in special ways and how the REIT can avoid taxation almost completely.
Another important point is the state and city taxation. Every federal state in the U.S. and some cities, like New York City have the right to impose their own taxes and there are some differences between the states, which will be shown.
The fifth chapter treats the tax treatment of the REIT’s shareholders. It depends on the fact whether the investors are U.S. citizens or foreigners, because for foreign shareholders U.S. law, the tax treaties and the specific laws of the home country are different. For German investors, especially the double taxation treaty with the United States as well as the German Income taxation are important for calculating the taxes.
Finally, to conclude the thesis, the last chapter will give a short future forecast about the expected economic situation and pending tax law, which will have an influence on REITs in the next years.
“They [Real Estate Investment Trusts] are real operating companies that lease, renovate, manage, tear down, rebuild, and develop from scratch.”2
REITs are mutual real estate funds. In §856(a) of the IRC they are defined as
corporation, trust or association3 that specializes in investing in real estate and real estate mortgages.4 To qualify as a REIT, those companies have to meet six defined formal requirements and have to elect to be taxed as REITs in order to receive tax benefits. Besides the six initial requirements, they also have to comply with several tests regarding assets and income during the tax periods to retain their special status.5
REITs receive federal tax credits equal to the dividends distributed to their shareholders, if they distribute at least 90% of their net income.6
REITs have their origin in the United States, where they were first defined in the Real Estate Investment Trust Act of I960.7 The legislation intended to offer an opportunity for individual investors to invest in real estate portfolios which are diversified and professionally managed as well as to provide tax and other benefits, that could only be used by large investors before.8 After the passing of the act by the U.S. Congress it took three years until the first REIT developed in 1963.9
The original law provided many restrictions to REIT activities, which were significantly eased by the Tax Reform Act of 1986. Whereas the REIT management was initially obliged to engage external companies to perform certain services, like property leasing and management services, after the reform they could execute those services inside the organization. This change was extremely important, because especially efficient leasing has always been essential for being profitable and successful.10
With the REITs becoming more important, innovative forms of trusts developed. In the early 1990s the “Umbrella Partnership REITs“ (UPREITs) and DownREITs were implemented.11 Real estate owners were looking for other ways of financing, which they found with the new constructions that allowed them access to capital markets and it also gave already established real estate companies the opportunity to bring their properties into a REIT structure without the obligation to sell them to the REIT.12
A milestone in the REIT history is the Real Estate Modernization Act (RMA) signed in 1999 by President Clinton. This legislation allowed REITs to own taxable REIT subsidiaries (TRS). Those subsidiaries, allow REITs to perform specialized services, like concierge services for their tenants which would have threatened their legal position before. Even though the TRS created new ways for REITs to elevate their revenue, it is still to determine whether TRS will be really beneficial for shareholders in the years to come, because many TRS attempts, especially in internet investments, have failed.13
Another important point in the history was the Jobs and Growth Tax Relief Reconciliation Act of 2003. With the new law, some of the REIT dividends will only be taxed at a maximum rate of 15%. This is the case, when the individual taxpayer would be taxable at a lower personal rate as well as when the REIT distributes certain capital gains or dividends from a TRS. The 15% rate also counts when a REIT retains earnings and pays corporate taxes, which is not always permitted. Experts estimate that about one third of all dividends qualified for the 15% rate in 2003, even though more than 50% were represented by capital gains distributions.14
Today REITs are important investment instruments, which are becoming more and more popular all over the world. In the U.S., most REITs are fully integrated companies nowadays and handle all their operations internally. Many federal and state laws have been issued concerning the special treatment of REITs and some are still pending, which among others concern the treatments of foreign income and investments.
Today, there are many different types of REITs. Some of them are publicly traded at one of the major stock exchanges and registered with the Securities and Exchange Commission and some are held privately.15 Within the last 20 years the number of publicly traded REITs has ranged from 110 to 226 per year with its climax in 1994. At the end of 2007, there existed 152 public Real Estate Investment Trusts in the United States, which can be divided into three broad categories.16
Equity REITs are the biggest group. They primarily engage in acquisition, management and sale of property. Their revenue consists mainly of rent.17 The second group is Mortgage REITs, which concentrate on investing in property mortgages.
Sometimes they also take loans from a bank and re-lend them at higher rates to real estate investors. Their revenues come mainly from the earned interest.18 Hybrid REITs are the third and smallest group of real estate investment trusts, which combine both investment forms. They invest in real estate as well as in real estate mortgages and thus generate revenues from interest, rent and capital gains.
As shown in Fig. 1 until the beginning of the 1990s the share of the different types of REITs was relatively even between those three groups.
Afterwards Equity REITs became much more popular than the other two, because they offered the greatest reward potential. Today Equity REITs are by far the most popular group with a share of 78%, compared Mortgage REITs and Hybrid REITs (cp. Fig. 2).19
The umbrella partnership real estate investment trust (UPREIT) is a REIT that holds most/all of the property through an operating partnership (OP), in which the REIT holds an interest. In a typical structure, as shown in Fig.3, the property owners contribute their property to the umbrella partnership (the OP unit) and obtain a limited partnership (L.P.) interest in return.20 The newly formed REIT will transfer the cash raised in the initial public offering (IPO) to the OP and receives general partnership interest in exchange. Afterwards, the limited partners are also allowed to “put” their L.P. interest to the REIT or the OP and will obtain REIT shares or cash as a one to one exchange. However, the conversion of L.P. interest into REIT shares will be fully taxable after §707(a)(2)(B) and §741 of the Internal Revenue Code.21 Furthermore, if property that was transferred to the umbrella partnership has built-in gains, it is taxed under §704(c) of the IRC.22
illustration not visible in this excerpt
Figure 3: Structure of an Umbrella Partnership REIT
(Source: Chilcote, L. (1998), http://library.findlaw.eom/1998/Aug/1/126264.html)
It was primarily created to avoid the taxation of gains, which would have been taxable if property owners had transferred their property to a REIT directly.23 The recognition of gain is excluded under §351(a) of the Code, if the property owners transferred their property for stock in return and have a controlling interest in the partnership afterwards. However, investment companies are excluded from that rule, which is the reason for using the umbrella partnership in between.24 Furthermore, through trading the property interest for stocks, which are usually listed on a national exchange, an interest in an illiquid individual property becomes more easily saleable.25
After the development of UPREITs, traditional REITs formed multiple new structures. One of the best known is the DownREIT, which is formed by existing REITs that plan on acquiring property the same way UPREITs do.26 Thus, a REIT or an UPREIT forms an OP and for a limited interest (operating units) in it, the property owners contribute their assets.27 The structure can be divided into two categories. The first ones are DownREITs, where the REIT contributes the capital to the partnership and will be the sole general partner and receive a distribution, which corresponds to the return of capital. In the second category, the REIT contributes little or no money to the OP and then the limited partners will obtain a preferred return on the operating cash in an amount equal to the distributions the REIT shareholders receive.28 As shown in Fig. 4, like in an UPREIT structure, the property owners are also given put rights, to convert the L.P. interest into REIT shares, but other than in an UPREIT, the conversion ratios are negotiated according to the value of the contributed property.29
illustration not visible in this excerpt
Figure 4: Structure of a DownREIT
(Source: Chilcote, L. (1998), http://library.findlaw.com/1998/Aug/1/126264.html)
The goals of a DownREIT structure are to provide a tax deferral method for property owners through an exchange of the assets for stocks. Furthermore, they offer greater flexibility and liquidity to the sellers of the property. However, to really be able to offer tax deferral, the DownREIT has to hold the property contributed by the limited partners over a certain time, the “lock-up” period.30 Typically, the OP obligates itself to keep the property over a period of typically five to ten years. If the OP disposes of the property earlier, it breaks the contract and has to reimburse the former property owner for the excess of taxes he has to pay over the amount the partner would have had to pay after the lock-up period.
During the 1960s only a few REITs developed and most of them had a fairly small portfolio.31 The range was between $11 million (Washington REIT) and $44 million for the REIT of America. The total of all investments industry-wide was fairly small with about $200 million, compared to the sum of approximately $535 billion in 2004.32 Despite their small size and the little stock ownership of usually less than one percent, those REITs showed a good performance which was supported by the healthy real estate market in the 1960s. They grew about 5.8% per year and their average annual total return was at approximately 11.5% compared to the S&P 500’s of annually only 6.7% during the same period.
The 1970s were a difficult time for the whole REIT industry. At the beginning of this decade Mortgage REITs were very popular and within two years about fifty new ones were founded. Those REITs used some of their shareholders equity and lots of borrowed funds to provide loans to construction companies, which built many new office buildings all over the U.S. Many big banks also started to sponsor their own REIT. This industry boomed during the first five years of that decade and the total assets went from $1 billion in 1968 up to $20 billion in the mid seventies.33 By 1973 the office market started to weaken, mainly driven by high interest rates. The new mortgage REITs were hurt by new underwriting standards and by the end of 1974 the share prices collapsed after their non-performing assets rose to 73% of invested assets.
Contrary to mortgage REITs, equity REITs did pretty well during this period, since real estate markets remained stable. They still had an average growth rate of 4.2% annually and their cash flow increased by about 6.2% per year.34 By the end of the decade, the REIT industry was still suffering under the big problems of mortgage REITs. The acceptance of the investors declined too much and therefore in 1979 the REIT industry was smaller than in 1972.35
After this difficult decade, the hope was great that the real estate market and REITs would recover during the 1980s. At the beginning of the 80s the funds from operations (FFO) averaged about 8.7% which was very respectable after those big problems during the prior years, and the annual rate of returns distributed to the shareholders was at a surprising level of about 28.6%. Through the Economy Recovery Act of 1981 a very attractive tax shelter was created, with many possibilities of saving money and this encouraged many people to buy and invest. Major brokerage firms formed real estate limited partnerships and promised big capital gains and many tax benefits. This situation inflated property prices and could not be supported by rental prices anymore.36
Over time the problems for REITs increased again. First, they had to compete with private investors and limited partnerships that did not have to have a positive cash flow while creating tax shelters. Second, real estate prices skyrocketed due to the buying frenzy investors got in. The third and biggest problem was the new constructions. Because real estate price were above replacement costs, many investors began to build, without regarding demand. Through overbuilding and oversupply the prices weakened significantly and in 1986 through the Tax Reform Act Congress took away the tax shelter advantages and therefore at the end of the 1980s the real estate market was in big trouble again.37 Surprisingly the stocks of REITs did not do badly through this whole time, but in that decade the total annual compounded returns underperformed the S&P 500 after outperforming them the decades before.
In the 1990s REITs had many ups and downs. With the growing and faster moving markets, REITs started a real rollercoaster ride through the whole decade. After a bad year in 1990 where the industry still suffered under the problems in the 1980s, the market started to stabilize and grow again between 1991 and 1993. The main reason for this development were the cheap property prices, due to overbuilding during the 1980s, the internalization of certain services, like leasing, maintenance and redevelopment. During this period, the annual return went up to an average of 23.3% from 1991 to 1993, mainly because the property prices went back to normal and the interest rates were at a low level and so investors showed interest in REITs again. In 1993 and 1994 the industry boomed, especially because of the REIT IPOs, where 50 new REITs raised about $9.3bn in 1993 and another 45 new REITs in 1994 raised an extra $7.2bn. After those two boom years, the REITs market capitalization was at about $38.8bn, compared to $5.6bn in 1990. Another important factor for a little more stabilization was the investment in more property sectors, like regional malls, industrial properties and hotels as indicated in Fig. 5, where the diversification in the year 2003 can be seen.
illustration not visible in this excerpt
Figure 5: Property types REITs invest in as of Dec. 2003
(Source: NAREIT (ed.) (2003), www.investinreits.com)
The run for new superlatives ended very quickly. At the end of 1995 the REITs traded at prices again that were way below their 1993 level, whereas their FFOs were still growing. For the next two years REITs did pretty well, because the access to capital was better for many REITs after going public and there were many development opportunities. Another positive factor for REITs was the high stock prices and the low interest rates on government bonds.
Unfortunately, in 1998 the good trend stopped again and many inexperienced investors sold their shares quite quickly, when the times were not as good anymore. During the successful years, the offerings grew more and more, but they reached a level, where they were much higher than the demand and therefore the prices started to drop again. At the end of the 90s high-tech stocks were a lot more attractive than REITs. Investors tried to save themselves and raise new capital with equity-forward contracts. That helped them to raise equity immediately and issue stocks later, but during the next years the share prices fell an even more and the REITs had to issue significantly more stocks.
The total annual return of REITs in comparison with the S&P performance during the same time (illustrated in Fig. 6), demonstrates the turbulent journey through the last decade of the 20th century.
illustration not visible in this excerpt
Figure 6: Annual Returns of REITs & S&P 500 between 1990-2007
(Source: own elaboration; NAREIT (ed.) (2008b), www.nareit.com, and Standard & Poor’s (2007), www.standardandpoors.com)
After the latest period, during which REITs had a rough time again, the bull market returned in 2000. Because of the bad performance, REIT prices were extremely low, up to 25% under their estimated net asset values. At the same time the rental rates rose and value investing became more popular again. Therefore REIT shares began to rise once more and that continued until 2004. Even though commercial real estate markets struggled during that time and apartment vacancy rates rose up to 6.8%, investors still had trust in REITs. Those trusts started their great time, right at the point when the high-tech stocks did not perform well anymore. As shown in Figure 6, the S&P 500 recorded their biggest losses during those years. REIT managers did a good job of managing these trusts even through some problems in real estate markets and therefore REITs were stable and also not overprized.
In the early 2000s the number of REITs was declining. Starting at the end of the 1990s many REITs started to merge with others to grow stronger. Other REITs were bought by private investors and so the number declined from 178 REITs in 1995 to only 118 in 2007.38 With the REITs becoming bigger and stronger and the IRS ruling that REITs are active businesses, it was decided in October 2001 to include them with the S&P 500 index, which enhanced the credibility of the whole industry and attracted even more investors.
After seven years of outperforming the S&P 500, 2007 was the first year again, where REITs performance was weaker, with a downturn of almost 18%.39 The problematic real estate market in the United States scared many investors away, because, since the beginning of 2007 it has been very hard to sell property and sales prices as well as rents were declining all over the U.S.. Many property owners started face big problems paying their loans and had to deal with high losses, when trying to sell the property. This resulted in the withdrawal of investors from real estate and REITs, especially when the illiquidity problem in the credit markets concerning U.S. real estate and problems with asset-backed securities (ABS) or commercial papers started to show how big the crisis really was.40 This was particularly hard for mortgage REITs, which had and still have been extremely affected by this crisis, because “the ability of these companies to access adequate sources of liquidity at an attractive cost of funds has been severely hindered with the problems in ABS and commercial paper markets,”41.
As already mentioned REITs have to be organized as trusts, associations or corporations42 and must be taxable as a domestic corporation.43 However, since the laws prohibit REITs from earning revenues through some kinds of active business, many different constructions developed over time. The IRS started to implement new laws to disable some of them, but the industry developed new structures to enjoy the benefits.
For tax purposes paired stock arrangements were developed in the 1970s, since federal tax law limited the income types a REIT could receive and the assets it was allowed to hold. This time restricted REITs mainly to passive investments and prevented them from operating as active businesses.44 Therefore a business, for example a hotel (C Corporation), was “stapled” to a REIT and their stocks were only traded together. Thus, the accrued profits were distributed to the same shareholders, who owned the REIT and gave them more control over the REITs active assets.45 The major reason for REITs to take that step and for the government to prohibit paired- stock arrangements was the possibility to distribute the operating company’s profits to REIT shareholders without paying corporate taxes.46 Today, almost all REIT entities that are “stapled” to another entity and whose stocks are traded together must be treated as one single entity for all tax years ending after March 26, 1998 for purposes of the gross income tests.47 With all the different incomes of the operating company, it would have been impossible for most REITs to pass the in chapter 3.3 described income tests for tax purposes and so they would have lost their REIT position and tax benefits. This provision was added in 1984 by the Deficit Reduction Act (DEFRA), but it included the exception that all REITs which were stapled entities before June 30,1983 already, were permanently exempt from that ruling.48 Though in 1998, the “1998 legislation” froze those grandfather rules.49
Since the paired stock arrangements no longer worked, investors began to develop a new form; the paper-clipped REITs. This structure is similar to the paired-share structure, but here the stocks are traded separately. The REIT purchases the facilities of the C corporation and forms a subsidiary into which business operations are contributed.50 The shares of that subsidiary are spun-off to the REIT shareholders according to their ownership of the REIT. The two entities could have common board members and officers, but a majority of them was supposed to be different, to not appear as stapled entities.51 Through that structure the shareholder value could be improved, because they could use the advantages of the relationship between the two companies but they were also able to trade their stocks separately in accordance with their own investment strategy. One big disadvantage might be disagreements regarding intercompany transactions.52
However, paper-clip REITs still have to consider limitations of federal law provisions and tax regulations concerning debt vs. equity characterization and arms-length principles.53 Furthermore, REITs may have up to 50% ownership interest in the other company, but not more than 10% of its votes.54
Depending on the chosen legal form, the management has to consist of one or more directors or trustees.55 Trustees, if the REIT is a trust, have to have similar powers to those of directors of corporations.56 In regulation (regs.) §1.856-1 it is defined that trustees are responsible for and have the exclusive authority over the management of the trust, its business and the property, even if the shareholders can elect and remove trustees or have the right to terminate the trust.57 Nevertheless, for property management and disposition there are some exclusions and limitations after §856(d)(2)(C) and regs. §1.856-4 concerning “rents from real property”, whereas clause (b) of the regulation specifies all the excluded and included amounts.58 59
Even though trustees need sufficient rights to satisfy the “centralization of management”59 and their “exclusive authority”, they are allowed to delegate some of their work to a third party, without violating aforementioned requirements. In its Revenue Ruling 72-254 and Rev. Rui. 74-471 the 1RS approved the delegation of some investment and loan decisions to outside advisors within specified limits.60 Regs. §1.856-4(b)(5) says “Furnishing of services or management of property must be through an independent contractor.“ The reason for it is that Congress decided that the income of REITs has to be mainly passive and should not be earned through active business operations, which will be explained in more detail later.61
One kind of service that is not excluded by those regulations is according to regs.
§1.856(b)(5)(ii) the management of the trust. It is said that “The trustees or directors of the real estate investment trust are not required to delegate or contract out their fiduciary duty to manage the trust itself...“.62 Therefore trustees or directors are allowed to choose their tenants, renew leases, deal with insurances and taxes and establish rental terms. They are also allowed to make decisions about repairs and capital expenditures in connection with the trust’s property, the costs of which will be paid by the trust.63
Although trustees have the “exclusive authority” when it comes to managing the trust, the shareholders also have their powers, mainly by approving certain actions. The shareholders are granted the rights to elect and remove trustees or terminate a trust and ratify amendments to the trust proposed by a trustee.64 Furthermore, shareholders have the right to approve or refuse an increase in the compensation of advisers and the merger of the REIT with another organization or the sale of the REIT’s property.65
The next provision a REIT has to satisfy is the beneficial ownership. According to IRC §856(a)(2) this is “evidenced by transferable shares, or by transferable certificates of beneficial interest”.66 This rule is not disobeyed by the Securities Act of 1933, which limits the transferability. Additionally, restrictions on interests in a partnership through which the REIT’s business is conducted, would also not violate that regulation.67 For acquiring or transferring shares, some restrictions are essential, especially when the REIT is in danger of losing its status, because, e.g. shareholders transfer the shares among each other and the required number of shareholders would not be met anymore. At that point the trustee has the right to prevent the transfer of the shares or buy them back, if he believes “in good faith” that it avoids the disqualification of the REIT.68 Another critical point is the provision that the trust has to be “domestically controlled”. This term is explained in §897(h)(4)(B) and means that during a testing period69 less than 50% of the stock value “was held directly or indirectly by foreign persons”.70 If the domestic control and hence the REIT status is in danger, the transfer or acquisition of shares can also be prohibited without violating rule §856(a)(2).
Besides, a REIT is also allowed to issue different classes of shares without infringing upon the transferability rule. It is possible to hand out preferred shares or capital as well as income shares, whereas only capital gains can be distributed on capital shares.71
To qualify as a REIT, the entity furthermore has to be taxable as domestic corporation as described in §856(a)(3) of the Code. To satisfy this, the corporation has to be domestically held, because the IRS ruled in its Rev. Rul. 89-13072, that a foreign corporation cannot qualify as a REIT, even if the corporation satisfies all requirements in §856(a), except for provision §856(a)(3), the domestic taxability. The reasoning of the IRS is that a “corporation’73 that is not incorporated under U.S. law will not be able to comply with §7701(a)(4) of the code, which defines the term “domestic” as “created or organized in the United States or under the law of the United States”74. This is particularly important, because the calculation of the tax liability is very different for domestic and foreign corporations.
A corporation will also not qualify as a RE\T, if it is a financial institution or an insurance company.75 This is regulated in §856(a)(4) of the Code, which explicitly excludes the financial institutions defined in §582(c)(2) \RC that are (i) “any bank’76 or foreign corporation that would under U.S. law be a bank, (ii) “any financial institution”, like mutual savings banks or domestic building and loan associations77, (iii) “any small business investment company” or “(iv) any business development corporation’78.79
Insurance companies will not qualify as Real Estate Investment Trusts, because the Code also determines that a REIT cannot be a company that is treated under subchapter L of the Internal Revenue Code, which deals with all kinds of insurance companies.80
All those above described provisions of §856(a)(1)-(4) have to be met during the entire taxable year of the entity which chose to be taxed as a REIT according to §856(b) of the Code.
As mentioned earlier, a REIT has to have a minimum number of shareholders. This number is set to at least 100 “persons” in §856(a)(5). To determine the number of owners, only the number of actual stock owners is taken into account.81 The actual owner is defined in Reg. §1.857-8(b) as to be the person who has to include the received dividend into the gross income on his personal income tax return.82 Contrary to the previous requirements, this one does not have to be satisfied during the whole tax year, but for at least 335 days of a taxable year of 12 months or a proportionate part of a shorter tax period.83 According to an 1RS regulation these days do not have to be consecutive84 and in §856(h)(2) it is constituted, that the requirement of having 100 shareholders is waived in the first year the corporations elects to be taxed as a REIT.85
The word “persons” is not defined in a section of the Internal Revenue Code that treats Real Estate Investment Trusts, but in §856(c)(5)(F) it is established that all terms which are not defined, have the meaning they were given in the /nvesŕmenŕ Company Act of 1940. There it is stated that the term “person means a natural person or a company”86 and a company is mainly defined as "... a corporation, a partnership, an association, a joint-stock company, a trust, a fund, or any organized group of persons whether incorporated or not... ”87.
For the natural persons or companies to be considered a “beneficial owner” and to belong to the (minimum) 100 shareholders, they have to hold stock for at least $10 according to an 1RS ruling, but in practice most advisers insist on a larger amount.88
If a trust has many shareholders with small shares of stocks, it qualifies as REIT, but it may not be closely held.89 “C/ose/y Ле/ď' means that 50% or more of the outstanding stock is held directly or indirectly by or for five or fewer individuals at anytime during the last half of the taxable year.90 If the stock is owned by an individual, it will be treated as being possessed by the individual and his whole family (spouse, siblings, ancestors and lineal descendants)91, and if the stock is held by a company, it shall be considered as owned by its shareholders, partners or beneficiaries.92 In the case a person owns a stock option, it shall be treated as if the option has been exercised.93
An entity satisfies that provision in §856(a)(6) of not being closely held, if it meets the requirements of §857(f)(1) of the Code and if it does not know or could not have known whether the entity met the requirements of §856(a)(6) for the taxable year or not.94 However, the closely held prohibition of that paragraph is waived for the first taxable year.95
If an entity met all the described requirements of §856(a)(1)-(6), it has to elect to be taxed as a real estate investment trust by filing the election with the tax return or to have made such a election for a previous year already, without it having been revoked or terminated.96 The REIT has to choose the calendar year as its accounting period, a different taxable year is not acceptable.97
A corporation is taxed as a REIT as long as the decision has not been revoked by the trust or until there has been a failure to qualify for being treated as one.98 In any year that the trust does not comply with all the rules described above or with the asset or income tests described below, the status will be terminated and the termination shall be effective for that particular tax year and all the following.99 If the trust still meets the requirements, but does not want to be treated as a REIT anymore, it can revoke the decision. But this has to be “made on or before ŕbe 90№ day /f ŕbe f/rsŕ ŕaxab/e year”, for which the revocation is supposed to be effective100 and has to be accomplished by filing a statement acc. to the regs. §1.856-8(a).
After the revocation or the termination of the REIT status, the entity has to wait five years before being able to apply for that position again, unless it qualifies for the exceptions made in §856(g)(4) of the Code and regs. §1.856-8(d).101 The entity has to show that the failure to comply by the rules was due to reasonable cause and that the former REIT was not able to prevent it from happening.102
A C Corporation is an entity that is subject to a two-tier tax system. This means that the income is taxed on the corporate as well as on the shareholder level.103 On the other hand, REIT income, if distributed entirely, is only taxed as shareholder income on their personal income or corporate tax returns. Therefore some C Corporations strive for a conversion into a REIT or a Regulated Investment Company (RIC), which is treated similarly to a REIT.
1 see Zucker, О. (2007), p.1, www.kpmg.de
2 Block, Ralph L. (2006), p.8
Stan Ross is a former managing partner of Ernst & Young’s Real Estate Group
3 see Internal Revenue Code §856(a)
4 see CCH, Inc. (ed.) (2006): 2007 U.S. Master Tax Guide, p. 681
5 see Carnevale, de Bree, Schneider & Witt (2002), p. A-1
6 see Block (2006), p.351
7 see Block (2006), p.42
8 see Carnevale, de Bree, Schneider & Witt (2002), p. A-1
9 see Block (2006), p.42
10 see Block (2006), p.42
11 see Block (2006), p.43
12 see Carnevale, de Bree, Schneider & Witt (2002), p. A-73
13 see Block (2006), p.45/46
14 see National Association of Real Estate Investment Trusts (ed.), www.nareit.com
15 see Baker, Donelson, Bearman, Caldwell & Berkowitz (2008), www.martindale.com
16 see NAREIT (ed.) (2008), www.nareit.org
17 see REITNet (ed.) (2001), www.reitnet.com/reits101/types.phtml
18 see REITs Anleger (ed.), www.reits-anleger.de/reit-arten.php
19 see REITNet (ed.) (2001), www.reitnet.com/reits101/types.phtml
20 see Chilcote, L.(1998), http://library.findlaw.com/1998/Aug/1/126264.html
21 see Carnevale, de Bree, Schneider & Witt (2002), p. A-73
22 see Carnevale, de Bree, Schneider & Witt (2002), p. A-74
23 see Carnevale, de Bree, Schneider & Witt (2002), p. A-73
24 see IRC §351(e)
25 see Chilcote, L.(1999), http://library.findlaw.com/1999/Jun/1/126071
26 see Chilcote, L. (1998), http://library.findlaw.com/1998/Aug/1/126264.html
27 see Souza, L.(1998), p.2, www.the-commercial-group.com
28 see Carnevale, de Bree, Schneider & Witt (2002), p. A-79
29 see Carnevale, de Bree, Schneider & Witt (2002), p. A-79
30 see Carnevale, de Bree, Schneider & Witt (2002), p. A-79
31 the following chapter is based on Ralph L. Block, (2006), p. 110ff. if not indicted otherwise.
32 see Block (2006), p.110
33 see Block (2006), p.111
34 see Block (2006), p.112
35 see Block (2006), p.113
36 see Block (2006), p.114
37 see Block (2006), p.115
38 see NAREIT (ed.) (2008), www.nareit.org
39 see Invesco (ed.) (2007), www.institutional.invesco.com
40 see AllBusiness (ed.)(20ü8),
41 AllBusiness (ed.)(2007), comment by Steven Marks, Managing Director & REIT group head of Fitch
42 see IRC §856 (a), IRC §7701(a)(3)
43 see CCH, Inc. (2006), p.681
44 see Friedman, S., Hoppe, S. (1998), www.ciremagazine.com/article.php?article_id=550
45 see Carnevale, de Bree, Schneider & Witt (2002), p. A-3, footnote 7
46 see Waldenberg & Burk (1998), www.srz.com
47 see IRC §269B (a)(3)
48 Private Letter Ruling 9822013; Carnevale, de Bree, Schneider & Witt (2002), p. A-3
49 see Chilcote, L. (1998), http://library.findlaw.com/1998/Aug/1/126264.html
50 see Id.
51 see Waldenberg & Burk (1998), www.srz.com
52 see Carnevale, de Bree, Schneider & Witt (2002)s, p. A-3
53 see Friedman, S. & Hoppe, S. (1998), www.ciremagazine.com/article.php?article_id=550
54 see Chilcote, L. (1998), http://library.findlaw.com/1998/Aug/1/126264.html
55 see IRC §856(a)(1); Regulation §1.856-1(b)(1); Directors had not been defined, because at the time of those provisions REITs had to be unincorporated entities
56 see Carnevale, de Bree, Schneider & Witt (2002), p. A-3
57 see Regs. §1.856-1(d)(1)
58 see Regs. §1.856-4, IRC §856(d)(2)(C)
59 Regs. §1.856-1(d)(1)
60 see Revenue Ruling 72-254,1972-1 C.B. 207 and Rev. Rul. 74-471,1974-2 C.B. 198; see Carnevale, de Bree, Schneider & Witt (2002), p. A-4
61 Regs. §1.856-4(b)(5)(i); see Carnevale, de Bree, Schneider & Witt (2002), p. A-4;
62 Regs. §1.856-1(b)(5)(ii)
63 see Regs. §1.856-1(b)(5)(ii)
64 see Regs. §1.856-1(d)(1)
65 see Carnevale, de Bree, Schneider & Witt (2002), p. A-4; see Rev. Rul. 70-596,1970-2 C.B. 147
66 IRC §856(a)(2); Reg. §1.856-1(d)(2); CCH, Inc. (ed.) (2006)
67 see Carnevale, de Bree, Schneider & Witt (2002), p. A-4;
68 see Regs. §1.856-1(d)(2)
69 see IRC §897(h)(4)(D)
70 IRC §897(h)(4)(C)
71 see Carnevale, de Bree, Schneider & Witt (2002), p. A-4
72 see Rev. Rul. 89-130,1989-2 C.B. 117
73 IRC §7701 (a)(3)
74 IRC §7701 (a)(4)
75 see IRC §856(a)(4)
76 IRC §581
77 IRC §591
78 IRC §582(c)(2)(B)
79 IRC §582(c)(2)
80 see IRC §856(a)(4); Subchapter L, §§801-848
81 see Carnevale, de Bree, Schneider & Witt (2002), p. A-5
82 see Regs. §1.857-8(b)
83 see IRC §856(b)
84 see Regs. §1.85б-1 (c)
85 see IRC §856(h)(2) in connection with §856(c)(1)
86 Investment Company Act of 1940 as amended, §80(a)-2(a)(28)
87 Investment Company Act of 1940 as amended, §80(a)-2(a)(8)
88 see Carnevale, de Bree, Schneider & Witt (2002), p. A-5
89 see IRC §856(a)(6) and §856(h)
90 see IRC §542(a)(2)
91 see IRC §844(a)(2)
92 see IRC §844(a)(1)
93 see IRC §844(a)(3)
94 see IRC §856(k)
95 see IRC §856(h)(2)
96 see IRC §856(c)(1) in connection with Regs. §1.856-2(b)
97 see IRC §859(a)(1) and (2)
98 see Warren, Gorham & Lamont Treatises: Bittker, Emory & Streng, 1.03
99 see IRC §856(g)(1); Regs. §1.856-8(b)
100 IRC §856(g)(2); Regs. §1.856-8(a)
101 see IRC §856(g)(3); Regs. §1.856-8(c)
102 see IRC §856(g)(4); Regs. §1.856-8(d)
103 see National Association of Real Estate Investment Trusts (ed.)(1999), www.nareit.com
104 see IRC §857(a)(2)
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