Real estate investment trusts (REITs) have grown in popularity as business entities in part because they are exempt from taxation at the corporate level when they meet certain distribution requirements, which also makes them exempt from double taxation paid by C-corporations.
In order to qualify as a real estate investment trust, companies or entities must adhere to a number of organizational and operational requirements. Additionally, they must meet some annual and quarterly tests as well in order to maintain their status as a REIT.
In this article we’ll look at how REITs are formed. Although most REITs are publicly traded -- there are 179 of them listed on the New York Stock Exchange¹ -- all newly formed REITs are private entities.
According to the National Association of Real Estate Investment Trusts (Nareit), REITs can be formed in all 50 states as well as the District of Columbia. Key organizational and operational caveats include:
The rules for ownership of REIT shares are quite complicated -- there are many variations and limitations that can affect ownership. REIT organizers can ensure that ownership provisions don’t run contradictory to their organizational charters by seeking counsel from experienced tax and securities law experts.²
There are two annual income tests that must be met in order for entities to maintain REIT status:
Lastly, there’s a quarterly requirement that stipulates that at least 75 percent of the REIT’s assets must be directly tied to real estate, such as real property or loans backed by real estate.
Companies or entities seeking REIT status must file a Form 1120-REIT on their tax return. The REIT also must mail a shareholder demand letter to each shareholder every year so shareholders can provide details of their ownership interests in the REIT. This is to ensure that the REIT remains in compliance with the 5/50 and 100 shareholder ownership tests mentioned above.³ Failure to comply with the shareholder demand letter requirement could result in an IRS fine of up to $50,000.
Since private REITs aren’t publicly traded securities, they are exempt from SEC regulation and disclosure requirements. They are usually externally managed, and offerings are issued only to institutional and accredited investors since shares are highly illiquid.
There are many different rules and regulations that govern the formation and operations of real estate investment trusts. Real estate investors considering starting a private REIT should engage the counsel of accounting, legal, and investment banking firms with experience in REIT formation to ensure compliance with these stipulations.
Sources:
1. REIT Industry Monthly Data, September 2021, Nariet, https://www.reit.com/data-research/reit-market-data/reit-industry-financial-snapshot
2. Waivers of Ownership Limitation Provisions in REIT Charters, Goodwin Proctor LLP, https://www.goodwinlaw.com/-/media/files/viewpoints/alerts/2016/reit-alert_ownership-limits.pdf?la=en
3. Deadline For REIT Shareholder Demand Letters, Ernst & Young LLP, https://taxnews.ey.com/news/2021-0006-january-30-2021-deadline-for-reit-shareholder-demand-letters