Real estate investment trusts (REITs) have become a significant force in the investment market, offering opportunities for investors to diversify their portfolios and enjoy potential income streams. However, managing a REIT involves navigating complex statutory regulations and compliance requirements. This article sheds light on four critical areas: tenant services, prohibited transactions, REIT dividends, and unrecaptured Section 1250 gain.
Tenant Services
Tenant services are a crucial aspect of managing a REIT. REITs are designed to generate passive income; therefore, the types of services they can offer tenants are restricted. Services provided directly by the REIT must be “customary” for the property type and market and not personalized services. Non-customary services must be provided by an independent contractor or a taxable REIT subsidiary (TRS) to avoid jeopardizing the REIT’s tax status.
Section 856(d)(7)(B) of the Code provides that if the gross income from non-customary tenant services exceeds 1% of the property’s gross rental income, it could disqualify all rental income from that property as rents from real property. This exception applies to tenant services provided by the REIT’s employees. As referred to above, if the non-customary tenant services are rendered by an independent contractor or TRS, this section does not apply. It’s essential for REIT owners and property managers to carefully evaluate the services they provide and comply with these rules.
Prohibited Transactions
Prohibited transactions are another key area of concern for REITs. The IRS defines prohibited transactions as sales of property held primarily for sale to customers in the ordinary course of business. Engaging in such transactions can result in a 100% tax on the net income from these sales, which can severely impact the REIT’s financial health.
To avoid this penalty, REITs should confirm that property sales do not fit the prohibited transaction definition. One strategy is to adhere to the safe harbor provisions, which allow certain sales without triggering the penalty, such as holding the property for the production of income for at least two years and meeting other specific criteria.
REIT Dividends
Dividends are a cornerstone of the REIT structure, providing a primary source of income for investors. By statute, to maintain REIT status, REITs must distribute at least 90% of their taxable income, except capital gains, to shareholders annually in the form of dividends. In addition, REITs generally distribute 100% of their taxable income to avoid paying corporate tax. This is accomplished through the REIT’s dividend paid deduction. These dividends are taxed at the shareholder level, not at the REIT level.
Understanding the structure, timing, and taxation of REIT dividends is crucial for investors. Dividends can be classified as ordinary income, capital gains, or return of capital, each with different tax implications. Tax planning and consultation with REIT tax professionals can help enhance the benefits of REIT dividends.
Unrecaptured Section 1250 Gain
Unrecaptured Section 1250 gain is a specific type of capital gain that applies to depreciated real estate. When a REIT sells a property, the portion of the gain attributable to depreciation can be taxed at a maximum rate of 25%, rather than the standard capital gains rate. This is known as the unrecaptured Section 1250 gain.
For REIT shareholders, understanding how this gain is reported and taxed is essential. The unrecaptured Section 1250 gain is typically reported on IRS Form 1099-DIV, Dividends and Distributions, and shareholders should work with their tax advisors to help maintain accurate reporting and compliance.
Conclusion
Navigating the complexities of tenant services, prohibited transactions, REIT dividends, and unrecaptured Section 1250 gain is essential for the successful management of a REIT. By understanding these key areas and maintaining compliance with regulations, REIT managers can help enhance their operations and provide value to their investors. For more information and in-depth insights, watch our REIT webinar archive on demand. As always, consultation with tax professionals and legal advisors is recommended to navigate these intricate areas effectively. If you have questions, reach out to an experienced professional at Forvis Mazars.