Saturday, September 6, 2014

Windstream Holdings Put What Into a REIT?



Have you heard of Windstream Holdings?

They are a telecommunications company – that is, a phone company – out of Little Rock, Arkansas. They made the tax literature recently by getting IRS approval to put some of its assets in a real estate investment trust, abbreviated “REIT” and pronounced “reet.” 


So what is a REIT?

REITs entered the tax Code in 1960. For decades they have been rather prosaic tax vehicles, generally housing office buildings, apartment complexes and warehouses.

Yep, they invest in real estate.

REITS have several tax peculiarities, one of which has attracted planners in recent years. To qualify as a REIT, an entity must be organized as a corporation, have at least 100 shareholders, invest at least 75% of its assets in real estate and derive at least 75% of its income from the rental, use or sale of said real estate. Loans secured primarily by interests in real property will also qualify.

REITS must also distribute at least 90% of their taxable income in the form of shareholder dividends.

Think about this for a second. If a REIT did this, it would not have enough money left over to pay Uncle Sam its tax at the 35% corporate tax rate. What gives?

A REIT is allowed to deduct shareholder distributions from its taxable income.

Whoa.

The REIT can do away with its tax by distributing money. This is not quite as good as a partnership, which also a non tax-paying vehicle. A partnership divides its income and deductions into partner-sized slices. It reports these slices on a Schedule K-1, which amounts the partners in turn include on their personal tax returns. An advantage to a partner is that partnership income keeps its “flavor” when it passes to the partner. If a partnership passes capital gains income, then the partner reports capital gains income – and pays the capital gains rather than the ordinary tax rate.  

This is not how a REIT works. Generally speaking, REIT distributions are taxed at ordinary tax rates. They do not qualify for the lower “qualified dividend” tax rate.

Why would you invest in one, then? If you invested in Proctor & Gamble you would at least get the lower tax rate, right?

Well, yes, but REITs pay larger dividends than Proctor & Gamble. At the end of the day you have more money left in your pocket, even after paying that higher tax rate.

So what has changed in the world of REIT taxation?

The definition of “real estate.”

REITs have for a long time been the lazy river of taxation. The IRS has not updated its regulations for decades, during which time technological advances have proceeded apace. For example, American Tower Corp, a cellphone tower operator, converted to a REIT in 2012. Cell phones – and their towers – did not exist when these Regulations were issued. Tax planners thought those cell towers were “real estate” for purposes of REIT taxation, and the IRS agreed.

Now we have Windstream, which has obtained approval to place its copper and fiber optic lines into a REIT. The new Regulations provide that inherently permanent structures will qualify as REIT real estate. It turns out that that copper and fiber optic lines are considered “permanent” enough.  The IRS reasoned, for example, that the lines (1) are not designed to be moved, (2) serve a utility-like function, (3) serve a passive function, (4) produce income as consideration for the use of space, and (5) are owned by the owner of the real property.

I admit it bends my mind to understand how something without footers in soil (or the soil itself) can be defined as real estate. The technical issue here is that certain definitions in the REIT area of the tax Code migrated there years ago from the investment tax credit area of the tax Code. There is tension, however. The investment tax credit applied to personal property but not to real property. The IRS consequently had an interest in considering something to be real property rather than personal property. That was unfortunate if one wanted the investment tax credit, of course. However, let years go by … let technology advance… let a different tax environment develop … and – bam! -  the same wording gets you a favorable tax ruling in the REIT area of the Code.

Is this good or bad?

Consider that Windstream’s taxable income did not magically “disappear.” There is still taxable income, and someone is going to pay tax on it. Tax will be paid, not by Windstream, but by the shareholders in the Windstream REIT. I am quite skeptical about articles decrying this development as bad. Why - because a corporate tax has been replaced by an individual tax? What is inherently superior about a corporate tax? Remember, REIT dividends do not qualify for the lower dividends tax rate. That means that the REIT income can be taxed as high as 39.6%. In fact, it can be taxed as high as 43.4%, if one is also subject to the ObamaCare 3.8% tax on unearned income. Consider that the maximum corporate tax is 35%, and the net effect of the Windstream REIT spinoff could be to increase tax revenues to the Treasury.

This IRS decision has caught a number of tax planners by surprise. To the best of my knowledge, this is the first REIT comprised of this asset class. I doubt it will be the last.

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