section-ads_high_impact_1

Demystifying REITs: A look at benefits, costs of conversions

Interest in real estate investment trusts, commonly known as REITs, has surged. REITs are not new, but they are arising in new contexts.

Created in 1960 under the Internal Revenue Code, a REIT is defined as a corporation, trust or other entity taxable as a corporation that meets a number of tests intended to ensure it is primarily a real estate investment vehicle.

REITs were intended to be a kind of mutual fund for real estate investors. However, in recent years they have expanded their popularity, becoming structural components of a diverse range of businesses including hotels, casinos, telecommunications, storage facilities, and even prisons.

REIT conversions in the gaming industry started with Penn National Gaming Inc., operator of the M Resort Spa Casino and other properties. In November 2013, most of the company’s real estate assets were contributed to a new REIT subsidiary. The shares of the REIT were then distributed to the company’s existing shareholders in a tax-free spinoff. The company now leases its properties from the REIT, known as Gaming and Leisure Properties Inc.

Following suit, Pinnacle Entertainment, Inc. announced a similar proposed restructuring in November 2014. MGM Resorts International, Boyd Gaming Corp. and Caesars Entertainment Corp. have also announced exploring REIT spinoffs.

Benefits of REIT status

Interest in a REIT election is driven primarily by the promise of substantial income tax benefits. By way of background, an ordinary corporation is subject to federal income tax at rates of up to 35 percent. Dividend distributions to its shareholders are subject to a second tax hit, this time on their individual returns. This double taxation can be a substantial drag on the shareholder’s investment.

A REIT election eliminates double taxation, because a REIT can deduct its dividend distributions. Because a REIT is required to distribute virtually all of its income, a REIT typically pays no corporate-level income tax, and its distributed profits are subject to tax only once, at the shareholder level. Shareholders should be mindful, however, that they may be subject to a higher rate of tax on the REIT dividends. REIT dividends generally are taxed as ordinary income, not as “qualifying dividends” that are eligible for lower capital gains rates.

A REIT’s high-dividend payout can be attractive to investors, especially in the current low interest rate environment, which may give the stock a higher market value. As a further bonus for shareholders, a corporation that is converting to a REIT is often required to make a significant dividend distribution of all of its previously undistributed earnings and profits.

Potential Downsides

These tax benefits come at the cost of greater complexity. In order to meet the requirements of the Internal Revenue Code, an existing company often must significantly restructure its operations and devote resources to maintaining its favored tax status. The statutory requirements include the following:

1. Ownership requirements. A REIT must be owned by 100 or more shareholders. This broad ownership requirement excludes many privately owned corporations from REIT status.

In addition to having more than 100 shareholders, the stock of a REIT cannot be “closely held,” meaning that no five individuals may collectively own more than 50 percent of the value of the outstanding stock. In order to ensure satisfaction of this ownership agreement, a REIT’s articles of incorporation typically prohibit any individual from owning more than 9.9 percent of the stock.

2. Income tests. A REIT must meet a number of income and asset ownership requirements. At least 95 percent of the REIT’s gross income must be investment-type income, such as dividends, interest, rents, and gains from securities or real estate. In addition, at least 75 percent of income must come specifically from real estate-type assets.

3. Asset test. Consistent with its intended status as a real estate investment vehicle, at least 75 percent in value of the REIT’s assets at the end of each quarter must consist of real estate assets, cash, and government securities.

4. Distributions. A REIT is also required to distribute annually at least 90 percent of its taxable income. This distribution requirement essentially prohibits corporate management from reinvesting earnings. If the company needs to raise capital, it must do so through additional stock offerings or by incurring debt.

In sum, REIT status can be tempting for any corporation with significant real estate holdings. However, the rigid qualification requirements and the potential complexity involved should lead prudent members of company management to look before they leap.

Steven E. Hollingworth is a partner in the Las Vegas law firm of Solomon Dwiggins &Freer, Ltd. Reach him at shollingworth@sdfnvlaw.com.

section-ads_high_impact_4
NEWS
ad-315×600
News Headlines
pos-2 — ads_infeed_1
post-4 — ads_infeed_2
high_impact_5