Since the introduction of rules governing Real Estate Investment Trusts (REIT) it created a tax efficient means of investing in real estate for investors. Tax exempt status of REIT income means that investors will not pay taxes on trust income if all of the income is distributed.
While there is huge list of REITs listed on the US stock exchange. There is no formal requirement for REITs to be listed. The rules below now only applies to US REITs and each country has their own rules governing REIT taxation. These rules do not apply to ETFs such as International REIT ETF.
How to become a REIT?
REITs must be domiciled in a US state and be governed under US law managed by one or more directors. An entity that would want to be considered as a REIT by the IRS must satisfy specific asset, organization structure, source of income and distribution payout requirements.
For REITs to meet the requirement to be tax exempt it must satisfy the list of requirements listed below.
It must decide to be a REIT and notify the IRS a year before formally construct as a REIT and which it will use the calendar year as the effective tax year.
REIT Ownership Limit
- Minimum of 100 shareholders which directly own shared in the REIT entity
- The above shareholders must hold the shares for at least 335 days of the taxable period
- Limit ownership of no more than 50% by five or few individuals during the second half of the calendar year
Annual REIT activity restrictions and requirements
- 75% of the income of the REIT must be from rents from real property, interest on mortgages on real property, gain on sales of real property. Essentially income must be directly related to the activities of owning and operating real estate.
- At least 95% of the gross income must be from passive sources. Passive sources of income for REITs or REIT passive income means that there is limited requirements on the REIT behalf to maintain the income. For example contracted lease income are ongoing income once the contract is executed while frequently trading real estate securities on active basis can be considered active income.
- For subsidiaries that are considered taxable REIT, it must not be operating or managing lodging or health care facilities. As these are considered operating business.
Quarterly activity restrictions and requirements
- Minimum 75% of asset value in the REIT must be real estate asset, cash or cash like securities like government bonds.
- Upper limit of 25% of asset can be invested in taxable reit subsidiaries
- The REIT must not have more than 5% of its own assets in one security which at the same time must not hold more than 10% of total outstanding units of an issuer
- REITs can only provide standard property management services to the tenants. It is not usually allowed to provide additional services that are not considered for the convenience of the tenant.
- Most state respect federal treatment of REITs
REIT Taxation Requirements – Distribution Income
REIT must pay out at least 90% of the taxable income other than the gain from sale of properties. The amount of earnings not paid out is taxed at the corporate rate of 35%. Therefore by law REITs must payout almost all of its income to maintain its tax status making it an attractive to investors that are income oriented.
Distribution of the capital gains are considered “Capital gain dividends”. If the REIT keep the capital gain in the entity, shareholders can take a proportional share of the income as undistributed income. This can result in a tax credit for the income tax the REIT paid and investors can adjust cost basis of the stock purchase price by the difference.
It must pay out the distribution in the tax year the income is made. It can also with permission of shareholders to make a cashless consent dividend which allows it meeting the REIT income taxation income requirement without actually pay a dividend. They can only do this up to the date of tax filing. Up to 20% of the capital gain distribution may be treated as ordinary income.
- US based shareholders do not have to pay withholding tax on distribution.
- Foreign REIT shareholders will still require to have 30% withholding tax rate on dividends (depending on real estate investment trust investor country of origin)
- Standard 35% withholding tax applies to capital gain distribution to foreign REIT investors.
- Dividends are not eligible for the dividends received deduction
- Investor selling REIT units or shares are subject to normal short term or long term capital gains taxes
Taxes REIT have to pay
- Note that Real Estate Investment Trust is subject to the Alternative minimum tax
- Realised capital gains on sale of properties (capital gains regime follows the same as ordinary capital gains rules)
- non-arm’s length transactions with its own taxable REIT subsidiaries
- State based taxes on transfer of real estate