A real estate investment trust, or REIT, can be a riddle for real estate fund sponsors seeking to scale beyond the “friends and family” investment stage. Some sponsors see the REIT as the “next stage” of the fund’s growth style – almost like a rite of passage to becoming a large-cap fund. Sometimes the sponsor is right, and a REIT really is the best fit for the sponsor’s needs. Many times, however, what the sponsor actually wants is not a REIT, but rather a better vehicle for accepting institutional capital. This determination often has nothing to do with tax. For example, a sponsor may be seeking an “open-ended” or “evergreen” fund to grow and maintain an existing portfolio of stabilized assets or a closed-end fund to raise capital more efficiently for development activities. A REIT may be helpful in attracting investment funds to achieve those goals, but a REIT is not necessary for achieving those goals. In many situations, a REIT may serve as little more than a cost burden and compliance headache. For this reason, a sponsor needs to know when to consider a REIT and when to avoid it. This article considers this matter at a basic level.
A REIT is merely a tax classification that allows an entity that would otherwise be taxed as a corporation to avoid “double taxation” and achieve tax treatment similar to – but in some important ways, different than – a tax partnership. Instead of passing through all items of gain, loss, deduction, and credit to its partners to avoid double taxation, a REIT avoids double taxation via a “dividend paid deduction.” The dividend paid deduction reduces the REIT’s taxable income dollar-for-dollar based on the amount of dividends paid — or deemed paid — to its shareholders in a given taxable year. Thus, a REIT may avoid corporate income taxation entirely — and most REITs do — by distributing an amount equal to 100% of the REIT’s taxable income each year to its shareholders as dividends. Shareholders, in turn, pay tax on REIT dividends received at tax rates that correspond to the underlying nature of the income generating the cash for the dividend. For example, dividends funded by cash from operations, such as rental income – and other sources that would be taxable at ordinary rates if earned directly by an individual – are taxed at ordinary income rates, and dividends funded by cash from the sale of business or investment assets held by the REIT for more than one year generally are taxed at capital gains rates. By encouraging the passing through of all cash received as dividends, Congress envisioned the REIT as serving as a sort of “mutual fund for real estate,” whereby non-institutional and institutional investors could invest in a pool of real estate assets held by a passive investment vehicle. Over the years, the once strict REIT rules have been relaxed, and certain tax benefits have arisen that have expanded the usefulness of REITs beyond that initial vision.