PORTFOLIO

Real Estate Investment Trusts (Portfolio 742)

Tax Management Portfolio, Real Estate Investment Trusts, No. 742-3rd, discusses the requirements for qualification as a real estate investment trust (REIT) and the tax treatment of its operation. The Portfolio is a revision of 742 T.M., Real Estate Investment Trusts, by Steven F. Mount, Esq., of Squire Sanders (US) LLP, Columbus, Ohio.

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DESCRIPTION

Tax Management Portfolio, Real Estate Investment Trusts, No. 742-3rd, discusses the requirements for qualification as a real estate investment trust (REIT) and the tax treatment of its operation. The Portfolio is a revision of 742 T.M., Real Estate Investment Trusts, by Steven F. Mount, Esq., of Squire Sanders (US) LLP, Columbus, Ohio.


There are eight basic organizational requirements an entity must satisfy to qualify as a REIT. It must be organized as a corporation, trust, or association; it must have centralized management by trustees or directors; ownership must be evidenced by transferable shares or certificates; it must be taxable as a domestic corporation but for the REIT provisions; it must not be a financial institution or an insurance company; the entity must be owned by at least 100 persons; five or fewer individuals may not own more than 50% in value of the entity's outstanding shares; and it must properly elect to be taxed as a REIT.


A REIT is strictly limited in the assets it may own and the sources from which it may earn its income. Thus, at the close of each quarter of the taxable year it must satisfy six interacting asset tests. In addition, a REIT must satisfy two source of income tests annually. A REIT must also comply with certain distribution and record-keeping rules.
If all the requirements of §§856 through 860 of the Internal Revenue Code are satisfied, the REIT functions as a conduit; its earnings are passed through to its investors and taxed only at the investor level.


Because many provisions of §§851 through 855, concerning regulated investment companies, are similar to the comparable real estate investment company provisions, authorities concerning regulated investment companies are cited throughout this Portfolio.


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AUTHORS

MICHAEL K. CARNEVALE
Michael K. Carnevale, Esq., University of Michigan (1982); University of Detroit (1990). Certified Public Accountant (New York, New Jersey, Michigan); Partner, Deloitte Tax LLP; member, American Institute of Certified Public Accountants, Michigan Society of Certified Public Accountants, American Bar Association, Michigan Bar Association, and National Association of Real Estate Investment Trusts.

JAMES P. DE BREE, JR.
James P. de Bree, Jr., B.S., California State University Northridge (1975). Certified Public Accountant (California); Partner, Deloitte Tax LLP; member, American Institute of Certified Public Accountants, California Society of Certified Public Accountants, National Association of Real Estate Investment Trusts; author of numerous articles on REITs and REIT taxation; frequent speaker on REIT-related matters.

MARK N. SCHNEIDER
Mark N. Schneider, B.S., Lehigh University, magna cum laude (1971); M.B.A., Columbia University (1973). Certified Public Accountant (California, DC, New York and Texas); Partner, Deloitte Tax LLP; member, American Institute of Certified Public Accountants, National Association of Real Estate Investment Trusts, American Society of Pension Professionals & Actuaries; AICPA Tax Practice Responsibilities Committee; and former member of the AICPA Employee Benefits Tax Committee.

CHARLES B. TEMKIN, ESQ.
Charles B. Temkin, Esq., B.A., Columbia University, summa cum laude (1969); J.D., Harvard University, magna cum laude (1972). Attorney advisor, U.S. Dept. of the Treasury, Office of Tax Legislative Counsel (1974-1976). Director, Deloitte Tax LLP; member, American Bar Association Section of Taxation, National Association of Real Estate Investment Trusts; D.C. Bar Taxation Section, member, Steering Committee (1989-1994), Vice-Chair and then Chair, Pass-Through Entities and Real Estate Committee (1996-2001).

FRED T. WITT, ESQ.
Fred T. Witt, Esq., B.S., Nebraska Wesleyan University (1976); J.D., University of Nebraska College of Law (1979); LL.M. (Taxation), New York University (1980). Attorney Advisor, Hon. Irene F. Scott, United States Tax Court (1980-1982); co-author, Collier on Bankruptcy Taxation (Matthew Bender 2001), part of the nationally recognized Collier on Bankruptcy 15th Ed.; Principal, Deloitte Tax LLP and National Director (retired), Real Estate Tax Services, Deloitte Tax LLP, Phoenix, Arizona; member, American Bar Association Section of Taxation (Chair, Real Estate Committee, 1996-98), State Bar of Arizona.

TABLE OF CONTENTS

Detailed Analysis

I. Introduction

II. Organizational Requirements

A. Corporation, Trust, or Association

1. In General

2. Paired Stock Arrangements

3. Paper-Clipped REITs

B. Management by Trustees or Directors

1. In General

2. Shareholder Powers

C. Share Transferability

1. In General

2. Good Faith Acquisition or Transfer Restrictions

3. Multiple Classes of Shares

D. “But for” Corporate Taxability

E. No Financial Institution or Insurance Company

F. One Hundred Shareholders

1. In General

2. Definition of “Person”

G. Closely Held Prohibition

H. Election to Be Taxed as a REIT

I. Accounting Period

J. C Corporation Earnings and Profits

III. REIT Qualification

A. Overview

B. Asset Tests

1. Summary

2. 75% Test

a. Cash Items

b. Government Securities

c. Real Estate Assets

(1) In General

(2) Real Property

(a) Inherently Permanent Structures

(b) Structural Components

(c) Specific Examples of Real Property

(3) Mortgage Assets

(a) Mortgages

(b) Mortgage Participation Interests

(c) Mortgage-Backed Securities

(d) REMIC Tiered Provisions

(e) Credit Enhancements

(f) Mortgage Loan Defaults

(g) Hypothecation Loans

d. Apportionment

e. Value

f. Total Assets

3. The 25% and Related Asset Tests

a. In General

b. Straight Debt Securities

c. Other Securities

d. Corporate and Partnership Issuers

e. Look-Through Rule for Partnership Securities

f. Other Partnership Debt

g. IRS Guidance

h. Other Matters

(1) Determination of Value

(2) Voting Securities

(a) Substantive Rights of Holder

(b) Timing of Voting Rights

(c) Percentage Ownership

i. 20% Test

(j) 25% Test

4. Quarterly Application of the Asset Tests

5. Consequences of Failure to Meet Asset Tests

a. In General

b. De Minimis Asset Failures of 5% or 10% Tests

C. Income Tests

1. Summary

2. 75% Income Test

3. 95% Income Test

4. Gross Income

a. In General

b. Gross Income Not Considered

c. Litigation Award Settlements

d. Reimbursements

e. Real Estate Taxes Paid by Lessee

f. Wraparound Mortgages

5. Failure of the Income Tests

6. Categories of Income

a. Dividends

b. Interest

(1) In General

(2) Contingent Interest

(3) Interest for Purposes of the 95% Income Test

(4) Interest for Purposes of the 75% Income Test

(5) Hedging Transactions

(6) Points and Original Issue Discount

(7) Market Discount

(8) Prepayment Penalties, Loan Assumption Fees, and Late Payment Charges

c. Foreign Currency Transactions

d. Equity Participation

e. Rents from Real Property

(1) Summary

(2) Items Specifically Included in Rents

(a) Rents from Interests in Real Property

(b) Charges for Customary Services

(c) Leases of Incidental Personal Property

(d) Impermissible Tenant Service Income

(3) Items Specifically Excluded from Rents

(a) Rent Based on Income or Profits

(b) Fixed Percentage Leases

(i) Adjustments

(ii) Escalator Provisions

(iii) Overage Provisions

(iv) Normal Business Practices

(4) Rent Derived from an Owned Tenant

(a) In General

(b) Sublease

(c) Attribution Rules

(5) Rent Derived from REIT-Managed Properties

(a) In General

(b) Permissible Services

(c) Definition of Independent Contractor

(i) Independent Contractor Relationship to the REIT Adviser

(ii) REIT May Not Receive Income from the Independent Contractor

(iii) Compensation of the Independent Contractor

f. Other Qualifying Income

7. Certain Wholly Owned Corporations and Partnership Interests

8. 30% Income Limitation for Pre-August 6, 1997 Taxable Years

9. Evolution of the Preferred Stock Subsidiary

10. Taxable REIT Subsidiaries

a. In General

b. Limited Rental Exception

c. Time For Testing Rent Comparability

d. Earnings Stripping Limitations

e. Mechanics of Election

IV. Operation of a REIT

A. Distribution Requirement

1. In General

2. Distributions and Cash Flow

a. Distributions Less Than Cash Flow

b. Distributions in Excess of Cash Flow

3. Issuance of Stock to Satisfy Distribution Requirement

4. Year-End and Subsequent Year Dividends

5. Deduction for Deficiency Dividends

a. In General

b. Definitions

c. Interest Charges

6. Excise Tax on Certain Undistributed Income

7. Automatic Dividend Reinvestment Plans

B. Taxation of the REIT and Its Shareholders

1. Summary

2. Taxation of Real Estate Investment Trust Taxable Income

a. Real Estate Investment Trust Taxable Income

(1) In General

(2) Amounts Eligible for Designation as a Capital Gain Dividend

(3) Net Operating Losses

(4) Net Capital Losses

(5) Accounting Method Changes

b. Computation of Tax

(1) In General

(2) Alternative Capital Gains Tax

(3) Tax on Net Built-in Gains

(a) In General

(b) Conversion Transactions

(c) Section 1374 Treatment

(d) Election of Deemed Sale Treatment

(e) Exceptions

(4) Personal Holding Company

(5) Residual Interests in REMICs

c. Deduction for Dividends Paid

(1) Significance

(2) Definition of Deduction for Dividends Paid

d. Liquidating Distributions

e. Earnings and Profits

f. Timing and Amount of Dividend

(1) Timing

(2) Amount

g. Nontaxable Stock Dividends

h. Taxable Stock Dividends

i. Stock Options

j. Dividend Reinvestment Plan

3. Capital Gain Dividends

a. REIT Capital Gain Tax

b. Minimum Distribution Requirement

c. Designation Requirements and Adjustments

d. Net Operating and Capital Loss Carryforwards

e. Allocation of Capital Gain Dividend Among Classes of Stock

f. Retained Capital Gains

g. Preferential Dividends

4. Taxation of Net Income from Foreclosure Property

a. In General

b. Definition and Acquisition Rules of Foreclosure Property

(1) Real Property

(2) Personal Property

(3) Ineligible Property

c. Election to Treat as Foreclosure Property

(1) In General

(2) Election Period

(3) Revocation of Election

d. Computation of Tax

(1) In General

(2) Net Income from Foreclosure Property

(a) Deductions Directly Connected

(b) Allocations of Deductions

(c) Allocation and Apportionment of Interest

e. Termination of the Election

(1) Summary

(2) Subsequent Leases

(3) Completion of Construction

(a) Determination of Percentage of Completion

(b) Modification of Plans

(c) Repairs and Maintenance

(4) Use in a Trade or Business

f. Qualified Healthcare Property

5. Taxation of Income from Prohibited Transactions

a. In General

b. Definition of Prohibited Transaction

c. Prohibited Transaction Safe Harbor Provisions

(1) Real Estate Property Sales

(2) Timber Sales

(3) Sales Not Meeting Requirements

d. Computation of Tax

e. Effect on Distribution Requirement

6. Alternative Minimum Tax

7. Taxable Year and Method of Accounting

8. Taxation of the REIT Shareholder

a. Capital Gain Distributions

(1) Rates Applicable to Distributed Capital Gain Dividends

(2) Treatment of Retained Capital Gain

b. Earnings and Profits

(1) In General

(2) Ordering Rules

c. Qualified Dividend Income

d. Wash Sale Provisions

e. Tax-Exempt Shareholders

f. The Partial Conduit

g. Foreign Shareholders and Partners of Operating Partnerships

(1) In General

(2) Special Look-through Rules Regarding REIT Distributions

(3) Sale of REIT Stock

(4) Mutual Fund Shareholders of REITs

(5) Wash Sales

(6) Withholding on Operating Income

(7) Capital Gain Distributions

(8) UPREIT/DownREIT Partnership

h. Estimated Tax Payments

9. Disqualification

a. In General

b. Election after Termination

10. Application of Other IRC Provisions to REITs

a. In General

b. Section 351 Tax-Free Organization

c. Reorganizations

d. Conduit Financing Transactions-Fast-Pay Stock Arrangements

C. Records and Reporting

1. Actual Ownership

2. Asset Tests

3. 10% Tenant Ownership Rule

4. Independent Contractor Requirement

5. Annual and Other Information Returns

6. Capital Gain Dividend

V. Umbrella Partnership Real Estate Investment Trusts

A. Introduction

B. Look-Through Rule

C. Partnership Issues

1. In General

2. Allocation of Nonrecourse Debt

3. Section 465(e) “At-Risk” Recapture

4. Marketable Securities under 731(c)

5. Application of 704(c)

6. Section 754 Elections

7. Disguised Sale Rules

8. Publicly Traded Partnerships (PTPs)

9. Constructive Sale Rules on Risk Reduction

VI. DownREITs

VII. Tax Protection Agreements


WORKING PAPERS

Working Papers

Table of Worksheets

Worksheet 1 H.R. Rep. No. 2020, 86th Cong., 2d Sess. (1960)

Worksheet 2 Conference Report (H.R. Rep. No. 2214), 86th Cong., 2d Sess. (1960)

Worksheet 3 Treasury Comments Dated April 15, 1974, on H.R. 11083 Real Estate Investment Trust Act of 1973

Worksheet 4 S. Rep. No. 1357, 93d Cong., 2d Sess. (1974) [To accompany H.R. 421] REIT Provisions as Amended by P.L. 93-625

Worksheet 5 S. Rep. No. 938, 94th Cong., 2d Sess. (1976) [To accompany H.R. 10612] REIT Provisions as Amended by P.L. 94-455 (The Tax Reform Act of 1976)

Worksheet 6 S. Rep. No. 1263, 95th Cong., 2d Sess. (1978) [To accompany H.R. 13511] REIT Provisions as Amended by P.L. 95-600 (The Revenue Act of 1978)

Worksheet 7 Conference Report H.R. Rep. No. 841, 99th Cong., 2d Sess. (1986) REIT Provisions as Amended by P.L. 99-514 (The Tax Reform Act of 1986)

Worksheet 8 S. Rep. No. 445, 100th Cong., 2d Sess. (1988) Senate Committee on Finance REIT Provisions as Amended by P.L. 100-647 (The Technical and Miscellaneous Revenue Act of 1988)

Worksheet 9 Conference Report H.R. Rep. No. 478, 106th Cong., 1st Sess. (1999) [To accompany H.R. 1180] REIT Provisions as Amended by P.L. 106-170 (The Tax Relief Extension Act of 1999)

Worksheet 10 H.R. Rep. 108-94, 108th Cong., 1st Sess. (2003), Conference Report, H.R. Rep. No. 126, 108th Cong., 1st Sess. (2003) (Jobs & Growth Tax Relief Reconciliation Act)

Worksheet 11 Conference Report, H.R. Rep. No. 699, 108th Cong., 2d Sess. (2004) (Working Families Tax Relief Act)

Worksheet 12 H.R. Rep. No. 548, 108th Cong., 2d Sess. (2004); Conference Report, H.R. No. 755, 108th Cong., 2d Sess. (2004) (American Jobs Creation Act)

Worksheet 13 Abstract of Private Letter Rulings Concerning Permissible Services1

Worksheet 14 Elections Available to Real Estate Investment Trusts

Bibliography

OFFICIAL

Statutes

Legislative History

Other Authorities

Treasury Rulings

Cases

UNOFFICIAL

Periodicals

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