President Bush’s recently announced proposal to abolish the double taxation of dividends has generated a frenzy of speculation among Real Estate Investment Trusts as to its possible effects on the REIT industry.
REITs have been a major player in the most recent real estate cycle, emerging in the mid-1990s as private real estate firms realized the benefits of cheaper equity capital compared to traditional debt arrangements. They have evolved as consolidation has occurred and currently enjoy a niche as a component of many portfolios.
Unlike most other corporations, REITs enjoy the benefit of a dividends-paid deduction, which typically results in the REIT incurring no income tax at the entity level. The REIT is required to distribute 90 percent of its taxable income to qualify for this deduction. Dividends paid by the REIT are taxable to shareholders to the extent of the REIT’s earnings with the balance treated as a return of capital.
REITs currently provide relatively high cash returns in the form of dividends that are only partially taxable due to significant deductions for depreciation. The typical REIT shareholder earns a high after-tax yield. REIT share prices are influenced by interest rates and the inherent inflation hedge derived from the underlying real estate assets. The typical REIT also can arguably provide some capital appreciation from the underlying real estate.
The president’s proposal, which would, in general, eliminate dividend taxation at the shareholder level, would not apply to REIT dividends. The logic being REIT income has not been subject to taxation under the rules discussed above. This proposal has led some industry watchers to speculate that REITs could suffer a significant erosion of competitive advantage as a result of the new playing field in the tax arena. The current niche they enjoy as a tax sheltered, yield driven equity will certainly become more crowded by other corporations, such as utilities, who distribute a high level of dividends, which would become entirely tax exempt.
Other analysts predict that, while most REITs will remain largely unaffected by the new tax law, some may find it more advantageous to restructure as regular old C corporations – which, under Bush’s proposal, would offer the same immunity from double taxation with far fewer restrictions on activity.
There’s no doubt that REITs’ erstwhile tax advantage has come at a considerable price. To maintain its tax status, a REIT must not only adhere to a host of IRS regulations, but also affirm its compliance with those regulations quarterly and annually. Some of the regulations, such as the requirement that REITs distribute at least 90 percent of its taxable income as dividends to its shareholders, are relatively simple for a REIT to follow and document. But others, such as the 25 percent limit on gross income not derived directly from rents or mortgages on property, often lead REITs to adopt Byzantine accounting practices in the constant effort to maintain their compliance with IRS regulations. Currently, REITs can conduct certain prohibited businesses and own non-qualified assets in a taxable REIT subsidiary, called a TRS. While this provides a certain amount of flexibility, the TRS structure still presents complexity and challenges.
C Corporation
A REIT that restructures as a C corporation gains on two fronts. First, it frees itself of the burden of maintaining and documenting compliance with REIT rules. Second, and possibly even more important, it gains the ability to pursue business in a more normal and arguably competitive fashion. It is not uncommon for a REIT to dedicate an entire department to regulatory compliance efforts, a department that could be greatly reduced or eliminated if the REIT converts to a C corporation.
Further, the C corporation structure gives an organization much more margin for error than it would have as a REIT. A REIT-turned-C-corporation that discovers at year-end that 26 percent of its income was “bad” income, such as non-rent or non-mortgage, or it held more than 10 percent of the securities of a non-qualified entity, would have no worries about losing its status or facing penalties for non-compliance. In addition, if a C corporation wants to pursue a new venture and needs additional capital it can pursue numerous, more flexible, options than the TRS structure allows.
Of course, an ex-REIT reborn as a C corporation would have to start paying income taxes at the entity level if its shareholders are to benefit from the proposed exemption at the individual level. Far from being prohibitively costly – this may actually put more money in investors’ pockets. The reason? Corporate tax rates are generally lower than individual tax rates, making entity-level taxation the lesser of two evils.
If President Bush’s proposal is passed, each REIT will have to analyze the potential costs and benefits of restructuring within the context of its size, complexity and business plan. Most obviously, REITs with substantial involvement in lodging or health care properties – neither of which can be placed in a TRS – may take a hard look at whether the provisions of the new tax law, compared to the C corporation’s greater flexibility, will make restructuring as a C corporation more attractive than remaining a REIT. Other REITs may also choose to restructure for a number of reasons: to eliminate the complexity of administering multiple TRS entities; to avoid the risk of paying hefty penalties for running afoul of the REIT rules; or to expand its business into areas prohibited to REITs.
Any decision, of course, must wait on the final form of the new tax legislation, which will almost certainly differ from Bush’s original proposal by the time it gets through Congress. The only sure thing at this point is that the REIT industry will be following developments in this area very, very closely as the government starts to work out the details.
