As anyone who has done business with SL Green or Vornado knows, a real estate investment trust is a tax designation for a corporate entity that invests in real estate for the purposes of reducing or eliminating corporate tax. In return, REITs are required to distribute 90 percent of their taxable income to investors. Fred Berk, a senior partner at Friedman LLP who has worked with Vornado and many other privately owned REITs, spoke to The Commercial Observer about what hurdles such entities face to comply with Internal Revenue Service regulations.
The Commercial Observer: We know the benefits, but from your perspective, what challenges do REITs face?
Mr. Berk: The potential pitfalls are that a REIT is not a pass-through entity so if you invest money into a REIT and it loses money—or, rather, creates taxable losses through depreciation or other items—the owners will receive no current tax benefit. We’ve had several situations in which REITs were formed and, based on projected incomes and realizations, they were supposed to have taxable income, which would have made the REIT very, very beneficial. But they ended up with taxable losses that get trapped in that entity and then people can’t use them.
In other words, you can’t just call yourself a REIT?
No, no, no. You have to form it as a REIT. A REIT is a physical entity. It files a corporate income tax return so whatever losses end up in the REIT, if there are losses, get trapped there. The people cannot use them until liquidation of the REIT, and upon liquidation of the REIT there would be a long-term capital loss, which is a bad thing. That’s versus if you purchase real estate through a partnership or an LLC, and there were losses, the owners could currently use them.
When do you come in? Are you there before they become a REIT?
We come in at the planning stage, before they’re even a REIT, to do the planning to ascertain if they should be a REIT. There are some very complicated, significant tax hurdles, which need to be met on a quarterly and annual basis, and we can be instrumental in making sure that they do meet those hurdles, and then, after they become a REIT, monitoring those hurdles to make sure they are in compliance with the REIT law because if they’re not there’s a significant tax.
With tax season upon us, what are you looking at with regard to REITs and their finances?
This time of year, we’re doing year-end work, and we’re ascertaining if they met all these hurdles that are required under the tax law, and then filing their tax returns and issuing financial statements.
Are there particular firms in which it’s touch and go from year to year, in terms of whether they’re able to continue to identify as a REIT?
Yes, it certainly happens. Some of the obstacles are that you have to distribute 90 percent of your taxable income, and if you don’t have the cash that can create a problem. There are certain restrictions on the type of income you can have, what services you can provide to your tenants, so you have to constantly be monitoring that. It’s very strict guidelines.
How often do you recommend non-REIT clients consider filing as a REIT?
Not often. There are certain benefits to being a REIT, and there are certain detriments. The benefit to being a REIT today, for the most part, is that if you’re going to have tax-exempt investors, a tax-exempt investor who invests in real estate has tax issues. There are certain additional taxes they would have to pay if they invest in most types of real estate. But if they invest in a restructure, they don’t have these tax issues. If you have a group of individuals going out and buying real estate I would not suggest doing a REIT format. It can get very complicated and it can get very costly.
Is the tax work more intricate when it comes to REITs?
A little more, because you have to do all this quarterly testing to make sure you’re in accordance with the REIT regulations.