Real Estate Investment Trust (REIT)

A real estate investment trust is a corporation, trust or association that elects to be taxed under a special part of the Internal Revenue Code and qualifies under section 856. The election removes the usual double layer of tax: a company that meets the requirements deducts the dividends it pays, so income that reaches shareholders is generally taxed once, in their hands, rather than at the company and again on distribution.

The name is misleading in one respect worth clearing up immediately. A REIT does not have to be a trust. "Trust" is a label inherited from the statute that created the status, and nothing in section 856 requires the trust form. What the statute does require is that the entity be managed by trustees or directors, that beneficial ownership be evidenced by transferable shares or certificates, and that it would otherwise be taxable as a domestic corporation.

Five structural tests and two ownership tests. Under section 856(a) the entity must be managed by one or more trustees or directors; have beneficial ownership evidenced by transferable shares; be one that would otherwise be taxable as a domestic corporation; not be a bank or an insurance company; have beneficial ownership held by 100 or more persons for at least 335 days of a 12-month year; and not be closely held. The closely held test borrows the personal holding company rule, which is commonly described as the five-fifty rule: five or fewer individuals may not own more than half the value of the shares during the last half of the year.

Two income tests and an asset test. At least 95 percent of gross income must come from a list that includes dividends, interest, rents from real property and gains on real property. Within that, at least 75 percent must come from the narrower real estate list: rents, interest on mortgages, gains on real property and similar sources. Separately, at the close of every quarter at least 75 percent of the value of total assets must be real estate assets, cash and cash items, or government securities, with further ceilings on how much of any single issuer the REIT may hold. The quarterly timing matters: a REIT that drifts out of compliance has a limited window to fix a discrepancy created by an acquisition.

The distribution requirement is the provision that explains the product. Section 857(a)(1)(A)(i) conditions the whole regime on the REIT's deduction for dividends paid equaling or exceeding 90 percent of its taxable income, computed before that deduction and excluding net capital gain. A company cannot both keep the tax status and retain its earnings, which produces three consequences at once. Yields are structurally high, because the payout is compelled rather than chosen. Growth has to be funded by issuing shares or borrowing rather than by retention, so shareholders are more exposed to the cost and availability of capital than in an ordinary company. And whatever is not distributed is taxed at the REIT at corporate rates under section 857(b)(1), so retention is expensive as well as restricted.

The tax character of the distribution follows directly from that. Because the REIT generally paid no entity-level tax on the income it passed through, the greater part of an ordinary REIT distribution is not a qualified dividend and is taxed at ordinary rates. Part may instead be a capital gain distribution, and part may be a return of capital that is not currently taxed but reduces the shareholder's basis. A partial deduction is available for the ordinary portion. What follows from all of that for the choice of account is a question about asset location rather than about the security, and that is where it is answered.

Three distinctions the label hides. An equity REIT owns buildings and collects rent; a mortgage REIT owns loans and mortgage securities and earns a spread, which makes its risks those of a leveraged bond portfolio rather than those of a landlord. A listed REIT trades on an exchange at a price set continuously by buyers and sellers; a non-listed REIT is registered with the Securities and Exchange Commission but has no exchange listing, so its share value comes from a periodic valuation rather than a market and there is no ready way to sell. And a private REIT is neither listed nor registered and is sold only to investors who meet eligibility rules. All three are entitled to the name.

A company elects REIT status with its tax return, then must satisfy the ownership, income and asset tests continuously, and must distribute at least 90 percent of taxable income each year. Shareholders receive the distributions and report them according to the character the REIT assigns on the annual tax form it issues.

A hypothetical example of the distribution requirement. A REIT reports $100 million of taxable income for the year, computed before the deduction for dividends paid and excluding net capital gain. To keep the status it must pay dividends of at least 90 percent of that, or $90 million. Suppose it distributes exactly $90 million and retains $10 million to fund a renovation. The retained $10 million is taxed at the REIT at corporate rates, so the company has chosen to pay entity-level tax on that slice in order to keep it. Contrast an ordinary operating company, which can retain all $100 million, pay corporate tax on all of it, and reinvest the remainder at its own discretion. The REIT has traded that discretion for the deduction.

The practical reading for an investor is that a REIT's payout ratio carries almost no information about management's confidence, because the floor is set by statute. What does carry information is where the cash to pay it came from: rent, borrowing, or the sale of new shares.

Pros

• Real estate exposure with none of the operating work: no tenants, no repairs, no collections, and no need to concentrate a large sum in one building.
• A listed REIT can be bought and sold in a normal brokerage account on any trading day, which is the opposite of the liquidity profile of a building.
• Diversification across many properties, and usually across geography and tenant type, at a purchase size an individual building could never offer.
• Reporting is comparatively transparent for a listed REIT, because it files with the Securities and Exchange Commission like any other listed company.

Cons

• Most of an ordinary distribution is taxed at ordinary income rates rather than at qualified dividend rates, which makes the account it sits in matter more than it does for a stock fund.
• Because retention is capped by statute, growth generally requires issuing shares or borrowing, so shareholders bear dilution and interest rate risk that a self-funding company would not impose.
• A listed REIT moves with the stock market in the short run, so it delivers property economics with equity market volatility attached.
• A non-listed REIT shares the name and little else: there is no exchange to sell into, the reported share value comes from a periodic valuation rather than a market, and front-end costs can be substantial.
• Mortgage REITs are a different business from equity REITs despite the shared label, and their sensitivity to interest rates is far greater.