By Anthony Diosdi
In the United States, a Real Estate Investment Trust or “REIT” is a common vehicle for earning income from rental property. A REIT can be thought of as a modified passthrough entity similar to a partnership that avoids corporate level taxes by utilizing a dividend paid deduction. However, unlike partnerships, REIT distributions are treated as a dividend, which may be favorable to foreign investors. Although dividends are subject to a 30 percent withholding tax under the so-called “FDAP” rules, tax treaties generally provide for the reduction or elimination of the 30 percent withholding tax. In addition, a properly structured REIT may avoid FIRPTA withholdings. Another advantage of a REIT is from a compliance perspective. A foreign investor may invest in U.S. real estate without having to apply for and obtain an individual taxpayer identification number or “ITIN.” The purpose of this article is to provide an overview of the mechanics of a REIT to the foreign investor considering investing in U.S. real estate.
Overview of the Operating Requirements of a REIT
In order for an entity to qualify for REIT status under the Internal Revenue Code, it must have a minimum of 100 direct shareholders no later than January 30th of its second year of operation. Unlike corporate structures, a REIT cannot be “closely held.” The Internal Revenue Code specifically prohibits five or fewer individuals to own more than 50 percent of the equity of a REIT during the last half of any taxable year. The Internal Revenue Code Section 318 treats certain family members and related parties as a single owner. For example, an individual is considered as owning shares owned by his spouse, child, grandchildren and parents. Siblings and inlaws are not part of the “family” for this purpose, and there is no attribution from a grandparent to a grandchild. See IRC Sections 318(a)(1) and 318(a)(5)(B). In addition to the ownership restrictions discussed above, the Internal Revenue Code requires that a REIT be “managed by one or more trustees or directors” and a REITs shares must have fully transferable interests.
A REIT Must be Taxed as a C Corporate Structure
Although a REIT can be established as a trust, limited liability company or “LLC,” or state law corporation, it must make a timely election with the Internal Revenue Service (“IRS”) to be taxed as a C corporation. A REIT must file a Form 1120-REIT annually with the IRS.
A REIT must satisfy the gross income and diversification of investment requirements of Internal Revenue Code Section 856(c). This requires REITs to satisfy a 95 percent and a 75 percent gross income test. To satisfy the first test, at least 95 percent of its gross income of a REIT must be derived from:
(c) Rents from real property;
(d) Gain from the sale or other disposition of stock, securities, and real property (including interests in real property and interests in mortgages on real property);
(e) Abatements and refunds of taxes on real estate;
(f) Income and gain derived from foreclosure property;
(g) loans secured by mortgages on real property or leases from the rental of real property;
(h) Gain from the sale or other disposition of a real estate asset;
(i) Mineral royalty income earned from real property by a timber real estate investment trust.
To satisfy the 75 percent test, at least 75 percent of the REIT’s gross income must be derived from:
(a) Rents from real estate;
b) Interest on obligations secured by mortgages on real property or on interests in real property;
(c) Gain from the sale or other disposition of real property (including interests in real property and interests in mortgages on real property);
(d) Dividends or other distributions on, and gain from the sale or other disposition of, transferable shares in other real estate investment trusts;
(e) Abatements and refunds of taxes on real property;
(f) Income and gain derived from foreclosed property;
(g) Amounts received or accrued as consideration for entering into agreements i) to make loans secured by mortgages on real property or on interests in real property or ii) to purchase or lease real property.
(h) Gain from the sale or other disposition of a real estate asset.
(i) Qualified temporary investment income.
A REIT must make sure that at the close of each taxable year:
(a) At least 75 percent of the value of its total assets is represented by real estate assets, cash, and cash items (including receivables), and government securities; and
(b) Not more than 25 percent of the value of its total assets is represented by securities;
(c) Not more than 20 percent of the value of its total assets is represented by securities of one or more taxable REIT subsidiaries;
(d) Not more than 25 percent of the value of its total assets is represented by nionqualified publicly offered REIT debt instruments;
(e) Not more than 5 percent of the value of its total assets is represented by securities of any one issuer;
(f) The REIT does not hold securities possessing more than 10 percent of the total voting power of the outstanding securities of any one issuer; and
(g) The trust does not hold securities having a value of more than 10 percent of the total value of the outstanding securities of any one issuer.
The Internal Revenue Code provides that REITs must distribute 90 percent of their taxable income. However, as a practical matter, REITs generally distribute 100 percent of their taxable income annually to avoid incurring a second layer corporate level tax.
Taxable REIT Subsidiaries
A REIT may own up to 100 percent of the stock in one or more taxable REIT subsidiaries or “TRS.” A TRS must be a corporation (other than a REIT or qualified REIT subsidiary) and may provide services to the REIT’s tenants without disqualifying the rent received by the REIT. Any transactions between a TRS and its associated REIT must be at arm’s length.
Restrictions on Tax-Free Spinoffs from REITs
An REIT is generally ineligible to participate in a tax-free spinoff as either a distributing or controlled corporation under Section 355 of the Internal Revenue Code. This general rule does not apply if both the distributing corporation and the controlled corporation are REITs immediately after the distribution. A REIT may spin off a TRS if the following apply:
1) The distributing corporation has been a REIT at all times during the three year period ending on the date of distribution;
2) The controlled corporation has been a TRS of the REIT at all times during such period; and
3) The REIT has had control (as defined in Section 368(c) of the Internal Revenue Code applied by taking into account stock owned directly and indirectly, including partnership, by the REIT of the TRS at all times during such period.
A controlled corporation is treated as meeting the control requirements if the stock of the corporation was distributed by a TRS in a transaction to which Section 355 applies and the assets of the corporation held by one or more TRSs of the distributing corporation meeting the control requirements discussed above.
An Example as to How Foreign Investors are Taxed on a REIT Distribution
As indicated above, the downside of utilizing a REIT is that the set up and operation of the entity can be quite complex. Consequently, any foreign investor considering utilizing a REIT to invest in U.S. real estate should consult with a qualified tax attorney. The complexities of an REIT goes beyond the set up and operation of a REIT. Determining the U.S. income tax of a REIT also requires a careful consideration regarding both U.S. tax law and the investor’s home country. For example, let’s assume a group of Canadian investors decided to form a REIT as a vehicle for earning income from U.S. rental property. Let’s also assume that the REIT had fully transferable interests, had a minimum of 100 investors, and made current distributions out of income derived from U.S. real estate investment. Consequently, any distributions from the REIT would be taxed in the United States as corporate distributions but there would be no U.S. corporate-level tax.
Currently, there is a bilateral income tax treaty between the United States and Canada. Under Article X, paragraph 7(c) of the treaty, the REIT should withhold U.S. tax at 10 percent on dividends paid by the REIT: 1) to a Canadian resident individual owning 10 percent or less of the REIT; 2) if the dividends are paid regarding a class of stock that is publicly traded and the beneficial owner is a person owning not more than 5 percent of any class of stock; or 3) if the REIT is diversified, the owner owns 10 percent or less of the interest in the REIT.
In any other case, the withholding U.S. tax rate would be 30 percent on dividends paid by the REIT. For U.S. tax purposes, any distributions in excess of the REIT’s earnings and profits would be treated as a nontaxable return of capital of capital or, if the distributions exceed basis, as taxable gains; in either case, the distribution may be subject to a 10 percent U.S. withholding tax unless an exception applies. For Canadian tax purposes, a REIT is considered a commercial trust, and a distribution of the trust’s interest’s adjusted cost basis may be taxed as a capital gain.
REIT offers significant tax planning opportunities to foreign investors. However, this area is full of minefields. If you are considering investing in U.S. real estate through a REIT, you should consult with an international tax attorney as soon as possible.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in cross-border tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.