Changes in the tax law have made REITs more appealing for investors interested in real estate. Here's how REITs are taxed and what to look for when investing in REITs.

Before TRA 86, investments in real estate provided a tax shelter for high income taxpayers by generating losses to offset income from other sources. TRA 86 amended IRC Sec. 469 limiting the amount of loss deductible from such activities to the income derived from passive activities. As a result, real estate limited partnerships were virtually eliminated as tax shelters. Real estate losses could only be used to offset ordinary or portfolio income upon the disposition of the entire interest in the passive activity. These changes shifted the focus of investors to another form of real estate investment--real estate investment trusts (REITs).

REITs have been around since the early 1960s, but volatile interest rates and risky investments by some of the trusts kept the focus of most investors on limited partnerships. Several newer REITs offer solid capital structures, better management, and greater geographic diversity, lowering their risk and making them more appealing to investors.

1992 was a banner year for REITs, as evidenced by increased stock prices. In addition to TRA 86, TAMRA 88 eased many of the restrictions for qualifying and maintaining REIT status, thus enabling REITs to attract investors seeking replacements for lost tax shelters.

Characteristics of a REIT

REITs are an excellent way for small investors to pool their resources and invest in real estate properties without the major commitment of time and capital required for direct ownership of real estate. REIT investments offer greater liquidity (especially if publicly traded) and diversification can be easily achieved through allocation of investments in mixed portfolios of properties and geographic areas. Long-term growth in share values is possible through increases in property values, and REIT income, sheltered through depreciation deductions, can be reinvested in additional property. As the bulk of their investments is in real estate, the price of REIT shares is affected by swings in the real estate market. As a result they tend to be less volatile than other equity stocks. There is also a greater liquidity to the shares than a direct investment in real estate.

Types of REITs

REITs are divided into three categories based on their source of income: 1) equity REITs simply own and rent properties; 2) mortgage REITs make loans; and 3) hybrid REITs do both. Equity REITs are considered superior for the long run because they earn dividends from rental income as well as capital gains from the sale of properties. Mortgage REITs are a good speculative investment if interest rates are expected drop. They react more sharply to interest rate movements than equity REITs because their dividends are from interest payments. Some REITs may be organized for a single development project. Others, called finite-life REITs, are set up for a specified number of years, after which they are liquidated and the proceeds are distributed to the shareholders. Another type of classification for REITs involves the ability to issue additional shares. Closed-end REITs can issue shares to the public only once and cannot issue additional shares (causing dilution) unless approval is given by current shareholders. Open-ended REITs may issue new shares and redeem shares at their fair market value at any time.

Taxation of REITs

With some exception, REITs are not taxed on the income they distribute to shareholders. This avoids the double-taxation problem of regular corporations. One of the requirements for REITs is that they distribute nearly all of their income to shareholders annually to avoid a penalty tax.

Investors are assured that annual dividends will be forthcoming if the REIT is profitable. Except in the case of capital gain distributions, the dividends are normally considered portfolio income, and they cannot be used to offset passive losses from limited partnerships.

Qualifying To Be A REIT

To apply for REIT status, an organization must be a corporation, trust, or association whose main investments are in real estate and mortgages and which otherwise would be taxable as a domestic corporation. It must be managed by one or more directors or trustees who hold legal title to the property of the trust and who have the rights and authority to control the trust as would a centralized corporate management. The trustee may be an officer, employee, or shareholder of an independent contractor that provides services to the REIT, such as handling real estate mortgages owned by the trust. A wholly-owned subsidiary of a corporate investment advisor to the REIT can also serve as an independent contractor to manage the trust's property. The shareholders may review and re-elect the trustees annually, so their performance is not above scrutiny and criticism.

Ownership Requirements. The beneficial ownership of the trust must be evidenced by transferable shares or certificates and held by at least 100 persons. For purposes of the 100-person test, shares held by related parties of an individual are not attributed to that individual.

Additional Tests. Other requirements for REIT status include an extensive three-fold income test, designed to ensure that the income of the REIT is primarily derived from real estate investments, and a strict asset test, which must be met at the end of each quarter of the REIT's tax year. Prohibited transactions trigger a 100% penalty tax on the net income from the transaction, unless the criteria are met for a "safe harbor" exclusion. Gross income, for purposes of the tests, includes only recognized income which is determined in accordance with the trust's method of accounting. It includes only the gross profit, and not gross receipts, on the sale or other disposition of assets.

The Three-fold Income Test. Seventy-five percent of the REIT's gross income (excluding gross income from prohibited transactions) must come from the following sources:

* Rents from real property;

* Tenants' reimbursements for property tax abatements and refunds;

* Interest on real estate mortgages;

* Distributions from other REITs;

* Gains on the sale of real estate and real estate mortgages not held primarily for sale to customers;

* Income from shared appreciation mortgages;

* Commitment fees; and

* Qualified temporary investment income.

In addition to the 75% test, the REIT must also derive 95% of its gross income (excluding gross income from prohibited transactions) from the sources which meet the 75 percent test, plus dividends, interest, and gains from the sale or other disposition of stocks and securities. These two tests are to ensure that income is from investments and principally real estate investments.

The last part of the income test restricts the REIT's gross income to less than 30% from the sale of stocks and securities held short-term, prohibited transactions, real property held less than four years (other than foreclosure property and property involuntarily converted), and interests in mortgages on real property held less than four years.

Investment Diversification Requirements. In addition to the income tests, the electing trust must also satisfy a two-fold asset test. For purposes of this test, total or gross assets of the trust are TABULAR DATA OMITTED determined in accordance with GAAP.

For the first part of the test, at least 75% of the value of the REIT's total assets must be in cash and cash items, real estate, and government securities at the end of each quarter of the REIT's tax year. Cash includes cash on hand and time or demand deposits with financial institutions. Cash items include receivables which arise in the ordinary course of the REIT's operation.

Long-term installment obligations from the sale of REIT property are considered as a real estate asset if secured by a mortgage on real property, and are not included in receivables for purposes of this test. Government securities may include securities issued by the FHA, FHLB, Federal Land Bank, Federal Intermediate Credit Bank, Public Housing Administration, U.S. Postal Service, and the Small Business Administration.

Real estate assets for this test are defined as real property, including interests in real property and interests in mortgages of real property and shares in other qualified REITs. For shares held in other REITs to qualify, the issuing REIT must have been a qualified REIT for the entire taxable year of the shareholder REIT. A regular or residual interest in a real estate mortgage investment conduit (REMIC) is also treated as a real estate asset, but if less than 95% of the REMIC's assets are real estate assets, the REIT is treated as holding directly its proportionate share of the assets and income of the REMIC.

The second part of the asset test provides that not more than 25% of the value of the REIT's total assets be invested in securities (other than the securities included in the 75% test). Of the 25%, no more than 5% of total assets may be from one issuer, and that 5% cannot exceed 10% of the issuer's outstanding voting securities. The 25% test is redundant, since it is automatically met if the 75% test is fulfilled. However, the five and ten percent limitations provide significant limitations on investments. Congress' intent was to ensure adequate diversification of the REIT's assets, thereby reducing the overall risk of the portfolio through regulation.

Prohibited Transactions

REITs are subject to a 100% tax on net income from "prohibited transactions," unless certain safe harbor rules apply. A prohibited transaction is the sale or other disposition of property held primarily for sale to customers in the ordinary course of a trade or business, with the exclusion of foreclosure property. Since it may be unclear whether property is being held by a REIT primarily for sale, safe harbor rules are available for determining when a particular sale does not constitute a prohibited transaction. These requirements include that:

* The property sold must be a real estate asset;

* The REIT must have held the property at least four years;

* The total expenditures made by the REIT toward the property during the prior four-year period must not exceed 30% of net sales;

* The REIT must have no more than seven sales of property during the taxable year, excluding foreclosure property; and

* If the property consists of land or improvements, it must have been held by the REIT for the production of rental income for at least four years, with the exception of foreclosure or leased property.

If a particular sale falls under the prohibited transaction category, the net income from that sale is excluded from REIT taxable income and does not affect the REIT's distribution requirement.

Foreclosure Property

Several IRC Secs. related to REITs make reference to foreclosure property, usually as an exception or exclusion to a requirement or test. The distinction made for foreclosure property was in recognition of many involuntarily acquired holdings of REITs in the mid-seventies. In general, foreclosure provisions apply during a two-year period (at the election of the REIT) following acquisition of the property. Foreclosure property includes real property and personal property such as attached fixtures that are acquired by the REIT as a result of a bid at foreclosure proceedings, or as a result of an agreement by process of law after a default on leased property or indebtedness secured by the property. Election to treat property as foreclosure property is voluntary and irrevocable and applies to all such property acquired in a taxable year. Subsequent leases and completion of construction cause additional rules to apply to foreclosure property. All income from foreclosure property is qualified income for the 75% and 95% income tests. If the REIT sells the property, the net income from the sale is multiplied by the highest corporate tax rate to compute the tax.

Tax Computations

A qualified, electing REIT may deduct dividends paid to its shareholders in computing its taxable income. The determination of a REIT's tax liability involves six separate computations, including the following:

* REIT taxable income, including capital gains and loss distributions to shareholders, with adjustments for net income from foreclosure property, to which the usual corporate tax rate is applied;

* The effect of a net capital gain is taxable dependent upon the amount of the gain distribution to shareholders as compared to the taxable income;

* The alternative minimum tax based on tax preference items;

* The tax on the net income from foreclosure property computed at the highest corporate rate;

* The tax on prohibited transactions at the 100% penalty rate; and

* A 100% penalty tax on any income attributable to the gross income which caused the REIT to fail the income tests. Any income resulting from a change in accounting methods (from cash to accrual basis) is included in REIT taxable income, usually prorated over a ten-year period.

Dividends Paid Deduction

A REIT's main purpose is to provide a conduit through which shareholders can receive the income from passive investments in real estate without being taxed at the corporate level. For this reason, the REIT is allowed a deduction for dividends paid, both for ordinary income and capital gains, to reduce the amount of taxable income to the trust. Dividends may be paid in cash or property valued at the adjusted basis to the REIT at the time of distribution. If a determination is made that the REIT incorrectly calculated its taxable income and did not meet the distribution requirements for qualification as a REIT, a deficiency dividend may be appropriate.

Prior to 1974, the IRS automatically disqualified the trust and imposed the corporate tax on all of its income, regardless of the amount previously distributed. The deficiency dividend now allows the REIT to make the additional distribution within 90 days of the determination and retain qualifying status without the additional tax penalty, although interest charges do apply. The REIT must also file a claim for a deficiency dividend deduction within 120 days of the determination.

An excise tax equal to four percent of the excess of the required distribution over the distributed amount for the year is imposed on REITs that fail to distribute 85% of ordinary income and 95% of capital- gain net income by year end. This is to penalize REITs that manipulate the timing of dividends to defer recognition of income by certain shareholders, and to restrict income timing advantages of non-calendar year REITs.

Taxation of the REIT Shareholder

The shareholder treats a REIT distribution as ordinary income, unless it has been designated as a capital gain dividend. A capital gain dividend is a long-term capital gain to the shareholder, even if the sale of his REIT shares would not result in a long-term capital gain or loss. The determination of what portion of a distribution is taxable as a dividend and what portion is a return of invested capital is based on the REIT's earnings and profits, rather than its taxable income. If the REIT's distribution to its shareholders exceeds the trust's earnings and profits, the distribution is treated as a return of capital. Such distributions are tax free to the shareholder and reduce the adjusted basis. They are taxable as a capital gain if they exceed the shareholder's adjusted basis. Dividends received from a qualified REIT are not eligible for the dividend received credit, the dividend received exclusion, or the intercorporate dividend deduction as provided for in the Code.

Under IRC Sec. 501, tax-exempt organizations may invest indirectly in real estate through REITs without being subject to the tax on unrelated business taxable income (UBIT). The distributions from the earnings and profits of a REIT qualify as dividends and thus escape the UBIT tax.

Evaluating the REIT as an Investment

Investments in REITs involve several key evaluation factors. Investors should diversify their holdings in REITs as they would with any portfolio. Past performance of a REIT is a good assessment of management ability, and at least three years of operating results should be evaluated. Total management fees exceeding one percent of gross assets per year would be considered high. Self-administered REITs will have lower fees since the property managers are employed by the trust. Information on publicly traded REITs is readily available in SEC filings and should be used for evaluation purposes.

Leverage Status of the REIT. The less leverage a REIT has, the safer it should be, and the greater its ability to take advantage of falling interest rates by borrowing to expand its portfolio. Total debt of the REIT should be less than five percent of the market value, calculated by multiplying share price by the number of shares outstanding.

Dividend Payments. Dividend growth of 9-10% is considered good, and dividends should constitute the bulk of the return. Excessive capital- gain distributions may indicate the REIT's income is from nonrecurring events and cannot be sustained over the long run. If the trust is selling off its properties to provide income, it will not have the future rental income needed for continuity.

Finite REITs do not provide the liquidity and dividend income of regular REITs, and the recent emergence of the finite form has not provided enough information for evaluating their appreciation potential. REITs are not usually a preferable investment for someone who has unused passive losses, since the REIT income cannot offset these losses. If an investor is subject to the alternative minimum tax, no benefit will be obtained for the passive losses with REIT income.

Evaluating the Investor's Needs. REITs can satisfy a need for current income or long-term appreciation. If one or the other is preferred, looking at how the management and trustees of the REIT are compensated to determine the direction of the REIT has importance. If compensation is based solely on asset values, the management will likely concentrate on investing in additional properties and capital appreciation. If the basis for determining compensation includes dividends or current earnings, the management may be motivated to increase dividend yield, possibly at the expense of long-term appreciation.

The market's valuation of the REIT should be compared to the actual market value of the underlying assets. Generally, share prices for REITs are under-valued, but a large valuation difference could reflect information in the market that is unfavorable to the REIT. Using outside valuations for such comparisons is advisable, and the method of the valuation is important. As with any financial instrument, the better informed the investor, the greater the chances are of locating sound, quality investments.

Risk is Relative

The riskiness of any real estate investment is directly related to the economic conditions which affect the entire economy, but the choice among the various forms of real estate ventures is tempered by the investor's desire for current income, capital appreciation, and liquidity. REITs have gained some favor over traditional real estate partnerships due to the TRA 86 and the TAMRA 88 tax law changes. In order to take advantage of the newer regulations, investors must weigh the importance of their investments in terms of return, risk, and other taxation factors. Overall, the REIT provides a sound real estate investment for those who want a current return as well as long-run appreciation without the time and capital investment requirements of traditional ownership forms.

COMPARING PUBLICLY TRADED PARTNERSHIPS

One notable alternative to a REIT is a publicly traded partnership (PTP). "Master limited partnerships" (MLPs) were forerunners of PTPs. The Revenue Act of 1987 sanctioned real estate PTPs. The label MLP is still often used as a synonym for PTP. Major tax benefits shared by PTPs and REITs relate to their flow-through nature. The double-taxation problem associated with corporate earnings distributed to shareholders as dividends is avoided because PTPs and REITs generally are not subject to an entity-level tax on their earnings. Moreover, the maximum tax rate applied to the distributed income in the hands of individual investors of 31% is lower than the maximum corporate-tax rate of 34%.

The principal advantage of PTPs is flexibility. This flexibility comes from the virtual nonexistence of statutory controls imposed by tax law on the manner in which PTPs are organized and managed and the way in which they conduct their business activities--with the exception of a 90% income test.

As a general partner, a corporation may be eligible to receive special allocations of most or all depreciation deductions. In contrast, REITs are not permitted to make special allocations of depreciation or other deductions. The special allocations of a PTP are dictated by profit and loss sharing ratios and are subject to the requirements of IRC Sec. 704(b). The amount of depreciation allocated to the corporate partner depends, in part, on its adjusted basis in its partnership interest.

No Mandatory Distributions

There are no statutory requirements with respect to distributions to PTP partners. Thus, PTPs can retain earnings for reinvestment or for other purposes. They are also free to distribute earnings pro rata or differentially among partners depending upon the partnership agreement.

Although PTPs do not have statutory distribution requirements, the market may effectively limit the freedom of PTPs in this regard. Market considerations seem to dictate that PTPs pay out most of their operating cash flows. PTPs and REITs trade largely on current yields, which generally permit little or no cash retention. Another factor is that investors (limited partners) in a PTP are taxed on their share of partnership income whether or not it is distributed. Thus, investors have a clear preference for current distributions of part or all of the earnings in order to pay the taxes on these earnings.

To avoid being taxed as corporations, PTPs must derive 90% or more of gross income from the following sources: Interest, dividends, oil and gas, commodities, real property rents, and gains from sales or dispositions of real property, capital assets, or IRC Sec. 1231 assets. For both PTPs and REITs, the term "real property rents" means rents from interests in real property, charges for services customarily furnished in connection with real property rentals, and rent attributable to personal property leased in connection with real estate to the extent such rent does not exceed 15% of total rent. Amounts contingent on "income or profits" are not treated as rents from real property. However, rent can be based on a fixed percentage or group of percentages of receipts or sales, which would permit some types of percentage rental clauses. For PTPs (but not REITs), the term "real property rents" also includes income from furnishing services to tenants or managing real properties.

Net income from PTPs is treated as portfolio income at the investor- partner level. The only way PTP investors can benefit from PTP losses is to carry them forward and offset them against future PTP income (from the same investment) or sell their PTP shares.

Losing the PTP Status

PTPs can lose PTP status by failing to meet the 90% income test. If this test is not met, the partnership would be treated as a regular corporation. This would trigger a deemed transfer of all partnerships assets (subject to liabilities) to a newly formed corporation in exchange for stock under IRC Sec. 351. The individual investors are regarded as having received the stock in complete liquidation of their partnership interests. PTP liquidating distribution rules are governed by IRC Secs. 731 and 732, which may cause income recognition to the partnership under certain conditions--generally pertaining to recapture of previously claimed tax benefits. IRC Sec. 7704(e) contains rules to preclude inadvertent PTP terminations. PTPs that no longer have their partnership interests publicly traded become regular partnerships and are not subject to PTP rules.

PTPs are considered riskier investments than REITs. The market does not have the same long-term experience with PTPs as it has with REITs. PTPs were officially sanctioned in the Revenue Act of 1987 for real estate and a limited number of other activities. Although master limited partnerships have existed since 1981, prior to 1987 there had been a risk the IRS would reclassify and tax all large publicly traded partnerships as corporations. A second reason for the market's lack of familiarity with PTPs is that there are relatively few security analysts who provide information about PTP investments. The market's relative unfamiliarity with PTPs results in investor caution, and as a consequence, PTPs must offer yield premiums to attract investors. Now that legislation has clarified the status of PTPs, the market may devote more time and energy to PTP investments.

Less Regulation Bust Also Less Liquidity

There is far less regulation of the organization and operation of PTPs than REITs. In particular, the lack of statutory requirements for independent directorships and minimum distributions out of earnings gives rise to a greater risk of conflicts-of-interest. PTP investors do not have the guarantees that their REIT counterparts enjoy, and therefore, they (or their advisors) must spend considerable effort reviewing PTP prospectuses and partnership agreements.

Partially as a result of these reasons, many non-publicly traded master limited partnership investors have had difficulty selling their shares. One analyst stated that master limited partnerships "trade almost by appointment." Sales of PTB shares could be at a sharp discount from the value of the underlying real estate assets due to the market's skepticism about public partnerships. This lack of liquidity reduces the attractiveness of PTP shares, which results in an additional yield premium.

Ray A. Knight, JD, CPA, and Lee G. Knight, PhD, are professors at Middle Tennessee State University. They have published numerous articles in professional publications, including the CPA Journal.