Friday, September 15, 2017
Farmers who sell farmland (or other real estate) have the option to defer gain under I.R.C. §1031. Most farmers will reinvest sold farmland into other farmland or real estate. But, with the talk in Washington, D.C. appearing to get serious about discussion among federal legislators and the Administration about limiting the scope and effect of tax-deferred exchanges, there will be interest in alternative strategies to avoid gain on the transfer of farming or ranching real estate that is commonly characterized by a low tax basis.
What other options are available? Possibilities include the Real Estate Investment Trust (REIT), the Umbrella Partnership REIT, and the Delaware Statutory Trust (DST).
REITs in General
REITs were initially authorized by the REIT Act title of the Cigar Excise Tax Extension Act of 1960. Pub. L. 86-779, Sept. 14, 1960. The purpose of a REIT is to provide a real estate investment structure similar to what mutual funds provide for investment in stocks. A REIT allows investors the opportunity to invest in large-scale, diversified portfolios of income-producing real estate in the same way they typically invest in other types of assets
A REIT is a company that owns, and usually operates, income-producing real estate. Sometimes a REIT finances real estate. The definition of a REIT contained in I.R.C. §856 illustrates that a REIT is any corporation, trust or association that essentially acts as an investment agent specializing in real estate and real estate mortgages. Consequently, REITs own many types of commercial real estate as well as agricultural land. In addition, some REITs engage in financing real estate.
Basic Tax Rules
A REIT must annually distribute at least 90 percent of its taxable income to shareholders in the form of dividends. I.R.C. §857(a)(1). Thus, a REIT is a strong income vehicle for its shareholders. A REIT is also entitled to deduct dividends paid to shareholders. As a result, a REIT often avoids incurring all or a part of its federal income tax liability. In order to achieve the result of reducing or eliminating corporate income tax, a REIT must elect REIT tax treatment by filing Form 1120-REIT (and satisfying certain other requirements). I.R.C. §856(c)(1); Treas. Reg. §1.856-2(b).
The key characteristics of a REIT can be summarized as follows:
- Be structured as a corporation, trust, or association;
- Be managed by one or more directors or trustees;
- Issue transferable shares or transferable certificates of interest;
- Be taxable as a domestic corporation;
- Not be a financial institution or a domestic corporation;
- Have the shares or certificates owned by 100 persons or more (no attribution rules apply); R.C. §856(h). This rule does not apply in the REIT’s first tax year. I.R.C. §856(h)(2).
- Have 95 percent of its gross income derived from dividends, interest and property income; R.C. §856(c)(2).
- Pay dividends of at least 90 percent of the REIT’s taxable income (excluding net capital gain);
- Have no more than 50 percent of the shares held by five or fewer individuals during the last half of each tax year;
- Have no more than 50 percent of the shares held by five or fewer individuals (attribution rules apply) during the last half of each taxable year;
- Have at least 75 percent of its total assets invested in real estate, cash and cash items, and government securities;
- Derive at least 75 percent of its gross income from “rents” from real property, “interest” from loans secured by real property or interests in real property, gain from the sale of investment real property, REIT dividends, income from “foreclosure” property,” “qualified temporary investment income,” and other specified sources;
- Maintains the statutorily required records; and
- Have no more than 25 percent of its assets invested in taxable REIT subsidiaries.
Timber gain is included under I.R.C. §631(a) as a category of statutorily recognized qualified real estate income of a REIT if the cutting is provided by a taxable REIT subsidiary, and also includes gain recognized under I.R.C. §631(b). The otherwise applicable one-year holding period does not apply. Also, for sales to a qualified organization for conservation purposes, the holding period is two years under I.R.C. §857(b)(6)(D), which provides a safe harbor from prohibited transaction treatment for certain timber property sales.
REITs are potentially subject to tax at corporate rates on undistributed REIT taxable income, undistributed net capital gain, income from foreclosure property, the income “shortfall” in failing to meet the 75 percent or 95 percent tests, income from prohibited transactions and income from redetermined rents. From taxable income is deducted an amount for dividends paid and specified other items. Shareholders are taxed on REIT dividends received to the extent of the REIT’s earnings and profits. In addition, REIT dividends of capital gain are taxable to the shareholders in the year received as long-term capital gain, regardless of holding period. I.R.C. §857(b)(3)(B).
An UPREIT is an “Umbrella Partnership REIT”. In the UPREIT format, instead of the REIT owning property directly, all of the REIT’s assets are indirectly owned through an umbrella partnership (the “operating partnership”) of the REIT and the REIT directly owns only interests in the operating partnership (“Unit”).
Typically, the REIT contributes cash to the operating partnership in exchange for Units and the real estate owners (farmers) contribute properties to the operating partnership in exchange for Units that are convertible into REIT shares at the option of the Unit-holder at a rate of one Unit per one REIT share.
Since the contributors are transferring their property to a partnership, these contributions are generally tax-free under I.R.C. §721 at the time of the contribution. However, the contributors will recognize any built-in gain in the future upon exercising their right to convert their Units into REIT shares.
If there is debt on the property contributed and the amount of debt allocated to the taxpayer decreases, gain may result from the transaction. Usually the UPREIT will allocate the same amount of debt back to the taxpayer as was transferred into the UPREIT.
A “lockout” period is usually negotiated as part of the deal structure. This lockout period prevents the UPREIT from selling the contributed property for a certain term. Without this lockout period, the UPREIT could sell the property contributed which would result in the gain being recognized by the taxpayer under I.R.C. §704(c). If the UPREIT sells the property during the lockout period, the UPREIT will usually provide an indemnity payment to the taxpayer. The UPREIT is allowed to dispose of the property in a tax-free exchange.
The UPREIT provides diversification to the taxpayer by allowing a farmer to pool his farmland with the farmland of other farmers or other real estate investments. Several public and private REITS have been formed over the last several years and the use of an UPREIT has allowed taxpayers with large farm real estate holdings to diversify their holdings and provide more liquidity without incurring an immediate tax liability.
Delaware Statutory Trusts (DST)
In Rev. Rul. 2004-86, I.R.B. 2004-33, the IRS allowed for the creation of a Delaware Statutory Trust to hold real estate. These trusts are structured as “securities” which allows the taxpayer to purchase interests in the trusts, which holds title to property. Investment in the real estate is shared amongst many investors.
The property sponsors, who are Trustees of the DSTs, are national real estate developers who purchase the property and structure it as a securities DST. There is a written offering document that provides very detailed information on tenants/leases, area demographics, financial projections, etc. The annualized income offered by the DST is usually in the 5-7% range depending on investment opportunities
There are drawbacks to the DST as follows:
- The pre-packaged trust structure and property management make this is an extremely passive investment to the taxpayer.
- The holding period for these DSTs are normally in the 2-10-year period, therefore, the taxpayer will need to “roll-over” their investment at a later time and this roll-over period will be out of their control.
- Investment returns are usually capped at the 5-7% range. An individual taxpayer who reinvests into other farmland or real estate may be able to generate a greater return on their own.
The positives of a DST are as follows:
- Exit strategies are good for the investor. When the transfer of ownership occurs, the banks are usually not involved.
- Good diversification options during the 45-day identification period.
- There can be offerings to 100 or more investors, with the minimum investment amounts in a more reasonable range of $100,000 to $250,000.
- No need to set up individual single member limited liability companies. The DST itself shields investors from any liability.
When tax legislation moves through the Congress it will move quickly. It’s not likely that tax-deferred exchanges will remain fully available, especially if full expensing of assets is allowed or expense method depreciation remains at its present high level. If the tax-deferred exchange rules are modified with respect to real estate, then the REIT, UPREIT and DST will continue to gain in popularity.