The Wall Street Journal reported Saturday on an IRS effort to police the misuse of REITs. See A.D. Pruitt & Amos Sharma, IRS Puts Brakes on Corporate Push to Capture Real-Estate Tax Break, Wall St. J. (June 7-8, 2013), at B1.
A REIT is a "real estate investment trust", a special-status entity created by Congress in sections 856 -859 of the Internal Revenue Code to provide a way for ordinary retail investors to share in a big investment in real estate that would be impossible for them to do individually. REITS avoid the corporate tax so long as they distribute most of their income as dividends to shareholders.
The Journal story notes that private prison operator Corrections Corp of America has already completed conversion to REIT status. Now a flock of corporations operating various businesses that one wouldn't ordinarily think were intended to be covered by the REIT exception to corporate taxation are applying for REIT status--including Iron Mountain Inc. (document storage operator), Lamar Advertising Co. (outdoor billboards), Equinix Inc. (data-center operator), and Penn National Gaming Inc. (casino operator). CBS submitted a letter ruling request for its outdoor advertising division's bid for REIT status and an IPO, a move that would save it $145 million in 2014 taxes (and more in later years), according to Davenport Research, as reported in the Journal.
In addition to the distribution requirement, REITs avoid corporate taxation only if they satisfy a complex set of eligibility requirements, including the following gross income and asset requirements.
- The first gross income requirement mandates that at least 95% of a REIT's gross income must come from dividends; interest; real property rents; gains from property sales; income or gain from foreclosure property; abatements and refunds of real property taxes; amounts received as consideration for entering into agreements to make loans secured by mortgages on real property or to purchase or lease real property;gain from disposition of a real estate asset (other than prohibited transactions).
- The second gross income requirement mandates that at least 75% of a REIT's gross income be derived from rents from real property; mortgage interest; real property dispositions; dividends or gain from disposition of shares of other REITs; abatement and refund of taxes on real property; income and gain from foreclosure property; consideration for entering into agreements to make mortgage loans or purchase or lease real estate; certain gain from dispositions of real estate; and "qualified temporary investment income". (The latter term is used for other types of investments that are used as temporary parking places for money.)
- The first asset test requires that at least 75% of the total assets of a REIT be represented by real estate, cash and cash items (including receivables) and government securities.
- The second asset test requires that (i) no more than 25% of the assets represent other securities; (ii) no more than 25% of the total assets be represented by securities of taxable REIT subsidiaries; and (iii) except for those taxable REIT subsidiary securities (I) no more than 5% represent securities of any one issuer; (II) the assets do not include more than 10% of the voting power of any one issuer and (III) the assets do not include more than 10% of the value of any one issuer.
A special rule permits "timber REITs" for logging businesses where more than 50% of the assets are used in a timbering business. And there are many more details to the rules than briefly outlined here.
Already, one can see two things about the REIT rules:
(1) that this is a very complex set of rules for which the discernible intent of Congress was to cover entities that made most of their money from being landlords--holding and leasing real estate;
(2) that the real estate (and logging) businesses undoubtedly lobbied hard to get this kind of break for their property businesses--a break that isn't ordinarily available for corporations that run grocery stores or distribution businesses or manufacturing businesses.
Aside: Real estate developers/owners/leasers are--like Big Oil and other natural resource extractive industries--businesses that exploit natural assets. For reasons likely dating back to the very different circumstances at our founding when people tended to think of America as a vast frontier with almost unlimited resources which required incentives to get people to development them (and of course at the same time overlooking the Native Americans who were already there and using those resources quite differently), Congress has historically lavished largesse in the form of tax expenditure subsidies on businesses that exploit land and minerals and other natural assets.
So why would a prison operator like Corrections Corp of America or a casino operator like Penn National Gaming Inc. that have active business income from operating prisons and casinos be eligible for the REIT break if REIT status is supposed to be for landlords that get rent income? It all depends on whether the business can successfully define its income as "lease" income from real estate (with incidental service income) rather than business income from providing services or running businesses(that take place on physical properties owned or leased by the companies). The IRS has actually been rather flexible in its application of the REIT rules to date, considering cell phone towers "real property" for this purpose, etc. As the journal notes, "some analysts argue that some companies are stretching the definition of landlord." But "stretching definitions" is the key to the tax minimization game, and tax lawyers, accounting firms, and others will keep doing it unless Congress or the IRS narrows the definition (or eliminates the issue entirely).
It seems quite appropriate that the IRS has launched a review "to define what type of companies can qualify as real-estate firms" for this purpose. Even more appropriate is the House Ways and Means Committee's review of the wisdom of providing this preferential tax expenditure for any industry, even if they really are landlords. The SEC has already noted that companies that hold lots of interests in real estate mortgage investment conduits (REMICs) might better be treated as mutual funds rather than REITs, for the safety of the financial system. Id. Rethinking REITs could lead to better securities regulation policy and better tax policy. Elimination of this tax subsidy --which amounts to tax favoritism for these real estate companies, casino and prison operators, and outdoor space advertising businesses--would be the fair thing to do.