REIT prohibited transactions

Real estate investment trusts (REITs) have long been an attractive alternative to pass-through structures for certain real estate funds, with attributes that help mitigate tax and reporting obligations for individual, tax-exempt and foreign investors. The Tax Cuts and Jobs Act (TCJA) further enhanced the REIT appeal by allowing ordinary dividends to qualify for a 20% pass-through deduction regardless of the wage and qualified basis limitation rules. This, combined with REITs’ existing benefits, has fueled their growth and increased attention from real estate owners and investors looking to reduce the overall tax burden on their real estate holdings.

However, while the TCJA introduced favorable tax treatment, it did little to alter the myriad rules and requirements that REITs must navigate. One particularly complex area is the prohibited transaction tax. Here is what to know about the safe harbor rules and disposition options that can help a REIT avoid such tax.

Background and safe harbor rules

A REIT generally avoids paying federal income tax by distributing all of its REIT taxable income in the form of dividends annually. However, even though a REIT may distribute or pay out all its income, in some instances it may be liable for federal tax. For example, if a REIT engages in a prohibited transaction, any gains generated are subject to the 100% prohibited transaction tax, designed to discourage REITs from engaging in dealer transactions.

A prohibited transaction does not include the sale of a real estate asset if the following safe harbor rules are satisfied:

Determination of dealer versus investment property

A REIT may consider taking the position that the property sold was not inventory and that the REIT is not a dealer in such property. In general, inventory or property held by a taxpayer primarily for sale to customers as part of its business is not considered a capital asset. Accordingly, if a REIT were deemed to have sold dealer property, the sale would be considered a prohibited transaction.

While the Internal Revenue Code contains no guidance distinguishing between inventory and investment property, hundreds of cases have analyzed the broader dealer versus investor issue, each of which references certain factors (e.g., the frequency and number of sales). It is important to note that each sale must be evaluated separately, and some factors may be given more weight than others. When everything is taken into consideration, it really depends on the facts of the case.

Disposition options

The analysis of whether a sale is a prohibited transaction is performed on an annual basis. Failure to meet all of the safe harbor requirements does not automatically mean that any sale is a prohibited transaction and that a REIT is left without options to mitigate. Proper planning and well-documented facts can help minimize prohibited transaction tax risk. Consider the following strategies that allow a REIT to dispose of multiple assets in a year, including:

Liquidation

• When a REIT is winding down or nearing the end of its lifecycle, its assets may be sold to several unrelated buyers over a period of time or in its final year of existence. It is possible that the REIT could conflict with the safe harbor rules.
• Under IRS rulings, a proposed sale of real estate properties by a REIT under a plan of liquidation will not constitute a prohibited transaction. Accordingly, a REIT's gains on sales, made pursuant to a plan of liquidation, will generally not be subject to the 100% prohibited transaction tax.

Like-kind exchanges—IRC section 1031

• In previous rulings, the IRS determined that a taxpayer’s like-kind exchanges were not treated as a sale for prohibited transaction purposes and would not be treated as a sale for purposes of the prohibited transactions limitation (i.e., seven sales).
• However, any boot received may be treated as a sale for purposes of the safe harbor.

Negotiated sale of portfolio to single buyer or limited number of buyers

• Selling multiple properties to a single buyer as part of one transaction counts as only one sale for safe harbor purposes.
• For example, a REIT that owns 70 real estate assets (each of which was held for more than two years) may sell 10 assets each to seven different buyers and stay within the safe harbor.

Transfer of property to a TRS

• A REIT could transfer a property or multiple properties to a TRS, which could then sell the assets.
• While the TRS is subject to tax (up to 21%) on any gain, this is preferable to the 100% tax.

The takeaway

The prohibited transaction tax presents a significant risk to REITs engaging in property sales. Careful planning, adherence to safe harbor rules and consideration of disposition options can help REIT taxpayers avoid a property sale characterized as or deemed a prohibited transaction. RSM’s comprehensive REIT services can help REITs track, monitor and substantiate their sales to help mitigate the 100% prohibited transaction tax on such assets sold.