REIT Definition

by REIT Wrecks on August 28, 2008

A REIT is an entity organized as a Real Estate Investment Trust (REIT) for federal income tax purposes. In order to maintain REIT status on an on-going basis, a REIT must also operate in conformity with the requirements for REIT qualification under the Internal Revenue Code. The advantage of operating as a REIT is that entities organized and operating as REITs are generally not taxable at the corporate level.

REIT Taxable Earnings Must Be Distributed to Shareholders

Because of the generally tax-free status at the corporate level, REIT dividends paid to shareholders are typically taxed at ordinary income rates. However, for individual investors, the most important requirement related maintaining REIT status is the obligation of the REIT to distribute at least 90% of taxable income to shareholders. This gives shareholders a legal claim to at least 90% of the REIT’s taxable earnings (assuming the REIT is able to maintain qualification under the Code).

Under the Code, “REIT Taxable Income” excludes net capital gains and certain non-cash income. As a result, a REIT generally may choose to retain all or part of its long-term capital gains and as much as 10% of its ordinary income and short-term capital gains. However, a REIT that chooses to retain capital gains or operating income in excess of 10% would be subject to tax on the undistributed amounts at regular corporate tax rates (currently, the maximum federal corporate rate is 35%). Accordingly, REITs generally distribute at least 90% of all taxable income, regardless of it’s composition, and many REITs distribute more.

This distribution requirement is central to the REIT Wrecks investment thesis: To the extent that secular real estate values and associated cash flows are heavily discounted by the broader market, for those REITs with healthy portfolios, the requirement to distribute 90% of taxable earnings creates a compelling investment opportunity in the form of sustainable high yields, followed by capital appreciation as market dislocations ease.

The key to successful investing is the ability to evaluate the credit quality and earnings power of REIT portfolios, which is much discussed here, and the ability of the REIT to maintain its REIT qualification under the Code, and therefore the obligation to distribute at least 90% of taxable earnings to shareholders in the form of dividends. The ability to pay REIT Dividends in cash, not stock is obviously paramount.

REITs Must Comply With Income & Asset Tests

The ability to maintain REIT status is also often directly related to the credit quality of the portfolio, since the majority of the REIT’s income and assets must also be derived from “real estate sources”. To the extent that a REIT portfolio deteriorates, income and assets from real estate sources will decline as “real estate” assets are written down in value and income from “real estate sources” evaporates. In constrained capital markets environments, REITs in this situation are unable to raise funds to replace these “real estate” assets and can no longer meet the REIT asset and income thresholds. Accordingly, they will, in all likelihood, fail to meet the requirements for REIT qualification.

Specifically, at least 75% of the REIT’s gross income must be from real estate-related sources, such as rents from real estate and interest on loans and notes from mortgages on real estate. An additional 20% the REIT’s gross income can include other passive forms of income such as dividends and interest from non-real estate sources (like bank deposit interest). Consequently, no more than 5% of a REIT’s income can be from nonqualifying sources, such as income from management fees or other non-real estate business income. (However, a REIT can own up to 100% of the stock of a “taxable REIT subsidiary” (“TRS”), a corporation with which a REIT makes a joint election that can earn such income, provided such investments do not exceed 20% of assets). In addition, at least 75% of a REIT’s assets must consist of real estate assets such as real property or loans secured by real property.

To the extent that income and/or assets related to “real estate sources” fall below the above thresholds, the REIT will be disqualified.

REIT Taxable Earnings vs. Operating Earnings

REIT taxable income is adjusted by deducting any net operating loss carryforwards that have been utilized, after offsetting any net realized capital gains with capital loss carryforwards. This may create opportunities for some REITs to shield themselves from the 90% distribution requirement, since taxable earnings could therefore be less than actual operating earnings. For more on why this is so interesting, see REIT Taxable Income Definition Unlocking Opportunities?

In addition to the requirements noted above, REITs must also:

– Be structured as a corporation, trust, or association;
– Be managed by a board of directors or trustees;
– Have transferable shares or transferable certificates of interest;
– Otherwise be taxable as a domestic corporation;
– Not be a financial institution or an insurance company;
– Be jointly owned by 100 persons or more;
– Have no more than 50% of the shares be held by five or fewer individuals during the last half of each taxable year (5/50 rule)

Since most REIT by-laws require majority shareholder approval to “de-REIT”, REITs that meet these tests will continue to be required to distribute at least 90% of taxable earnings to shareholders. This claim on earnings is central to succesful high yield REIT investing, and any REIT stocks that are in danger of losing REIT status will quickly lose their appeal as an investment.

Click here for a list of Apartment REITs
Click here for a list of Healthcare REITs
Click here for a list of Hotel REITs
Click here for a list of Industrial REITs
Click here for a list of Mortgage REITs
Click here for a list of Retail REITs
Click here for a list of Storage REITs
Click here for a list of all REITs
Click here for a list of REITs paying dividends in stock

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