Nails, REITs And Coffins

I am reading an article that includes the following sentence:

If these deals become widespread, they’d be another nail in the coffin of the corporate income tax.”

That sounds ominous.

It turns out that the author is writing about real estate investment trusts, more commonly known as REITs (pronounced “reets”).

I do not work with REITs. The last time I came near one was around 2000, and that was in a limited context. My background is entrepreneurial wealth and is unlikely to include REIT practice – unless said wealth is selling its real estate to said REIT.    

REITs have become popular as an investment alternative in an era of low interest rates, as they are required to pay dividends. Well, to be more accurate, they are required IF they want to remain REITS.

REITS are corporations, but they have access to a unique Code section – Section 857. Qualify and the corporation has an additional deduction not available to you or me – it can deduct dividends paid its shareholders from taxable income.

This is a big deal.

Regular corporations cannot do this. Say you and I own a corporation and it makes a million dollars. We want the money. How do we get it out of the corporation? We have the corporation pay us a million-dollar dividend, of course.

Let’s walk through the tax tao of this.

The corporation cannot deduct the dividend. This means it has to pay tax first. Let’s say the state tax is $60,000, which the corporation can deduct. It will then pay $320,000 in federal tax, leaving $620,000 it can pay us.

In a rational world, we would not have to pay tax again on the $620,000, as it has already been taxed.

That is not our world. The IRS looks around and say “the two are you are not the corporation, so we will tax you again.” The fact that you and I really are the corporation – and that the corporation would not exist except for you and me – is just a Jedi mind trick.

You and I are taxed again on the $620,000. Depending upon, we are likely to bump from the 15% dividend rate to the 20% rate, then on top of it we will also be subject to the 3.8% “net investment income” surtax. The state is going to want its share, which should be another 6% or so.

Odds are we have parted with another 29.8% (20% plus 3.8% plus 6%), which would be approximately $185,000. We now have $435,000 between us. Not a bad chunk of change, but the winner in this picture is the government.

Think how sweet it would be if we could deduct the million dollars. The corporation would not have any taxable income (because we paid it out in full as dividends). Yes, you and I would be taxable at 29.8%, but that is a whole lot better than a moment ago. We just saved ourselves over $260,000.

Congress did not like this. This is referred to as “erosion” of the corporate income tax base and is the issue our author was lamenting. Yes, you and I keeping our money is being decried as “erosion.” Words are funny like that.

Back to our topic.

Real estate has to represent at least 75% of REIT assets. In a similar vein, rental income must comprise at least 75% of REIT income. Get too cute or aggressive and you will lose REIT status – and with it that sweet dividends-paid deduction. For years and years these entities were stuffed with shopping malls, apartments and office complexes. They were boring.

Someone had to push the envelope. Maybe it was a tax planner pitching the next great idea. Maybe it was a corporate raider looking to make his or her next billion dollars. All one has to do is redefine “real estate” to include things that are not – you know – real estate.

For example, can you lease the rooftop of an office building and consider it real estate? What about pipelines, phone lines, billboards, data centers, boat slips?

In recent years the IRS said all were real estate.

Something that started as a real estate equivalent to mutual funds was getting out of hand. Pretty soon a Kardashian reality TV show was going to qualify as real estate and get stuffed into a REIT.

In the “Protecting Americans from Tax Hikes Act of 2015,” Congress put a chill on future REIT deals.

To a tax nerd, getting assets out of a corporation into another entity (say a REIT) is referred to as a “divisive.” These transactions take place under Section 355, and - if properly structured - result in no immediate taxation.

Let’s tweak Section 355 and change that no-immediate-taxation thing:

* Unless both (or neither) the distributing and the distributed are themselves REITs, the divisive will be taxable.

* If neither are REITS, then neither can elect REIT status for 10 years.

This tweak is intended to be a time-out, giving the IRS time. It is, frankly, an issue the IRS brought upon itself The IRS has issued multiple private letter rulings that seem to confound “immoveable” with “real estate.” The technical problem is that there are multiple Sections in the tax Code - Sections 168, 263A, 1031, and 1250 for example – that affect real estate. Each may be addressing different issues, and grafting definitions from one Section onto another can result in unintended consequences.

Again we have the great circle of taxation. Somebody stretches a Code section to the point of snapping. Eventually Congress pays attention and changes the law. There will be another Code section to start the process again. There always is.