President Eisenhower and Congress created real estate investment trusts in 1960. The innovative legislation, known as the REIT Act and contained in broader legislation known as the Cigar Excise Tax Extension of 1960, provided a means for the average investor to participate in the real estate market with the same tax benefits as those enjoyed by mutual fund investors. Here is a rundown of innovations in the legislative history of REITs, up to the present day.
Prelude to REITs
Double taxation. The phrase invokes the feeling that something bad is going on. How can it be fair to tax the same profits twice? Well, we do that in the United States through corporate taxes. A C-Corporation must pay income taxes on its profits, and then shareholders must pay income tax on the dividends they receive from the corporation. It has been this way since 1913. Although earlier remedies were tried for a while, they didn’t stick. The ratification of the 16th Amendment in 1913 opened the door to the income tax system that all Americans enjoy today. In those early years, both individuals and corporations were taxed at the same rate, 1%.
The real estate industry, through the use of private trusts, wasn’t subject to the double taxation rule until 1936. Private real estate trusts had come into being in the 1880s. After 1913, these trusts could avoid income taxes by passing through their income to their shareholders. In 1936, double taxation was imposed on these trusts, kindling a 30-year struggle to rid the real estate industry of this onerous tax. One of the most powerful arguments was made by way of analogy. That is, mutual funds representing debt and equity holdings bypassed federal income tax. This created great frustration in the real estate industry, which wanted to create a similar pass-through entity, the REIT.
President Eisenhower, American Hero
President Eisenhower signed the 1960 Real Estate Investment Trust Act, and the real estate industry rejoiced. The act followed the mutual fund model by allowing investors to invest in diversified, large real estate portfolios, known as REITs, through the public trading of units, or shares. To qualify for exemption from corporate taxes, REITs had to meet several conditions. The first was that they were to distribute at least 95% (now 90%) of their taxable income to shareholders. This includes rental income and capital gains. Undistributed earnings are taxable to the REIT.
The 1960 legislation solved a few problems:
- Access: The law opened up the real estate industry to small investors. Public REIT shares would be listed and traded on stock exchanges. The public could buy and sell shares in the same manner as stocks. This opened the possibility of diversifying into a new, professionally managed asset class.
- Liquidity: Real estate is notoriously illiquid, but public REIT shares are highly liquid because they are exchange-traded. Furthermore, investors inject liquidity into the real estate market by investing in REIT IPO shares. This makes it easier for REITs to finance the purchase or construction of properties.
- Taxation: The new law freed REITs from the burden of corporate taxation. Investors pay the taxes on dividends at their marginal tax rate. They also pay capital gains tax on the REIT’s sale of long-term holdings at a profit. Any return of capital is not taxed and reduces capital gains tax when then the underlying property is sold.
Developers, investors, and financial advisors must have viewed the 1960 legislation with excitement and wonder. Before the new law, only wealthy individuals and large financial intermediaries enjoyed the benefits of commercial real estate investments. Now, millions of small investors could participate in the real estate market without suffering the curse of double taxation. Furthermore, REITs held the promise of creating vast new funding for new projects.
The first REIT to come into existence was American Realty Trust, which began trading in 1961. The industry grew slowly at first, but excitement mounted in 1965 as many new REITs were launched. The decade of 1965 to 1975 was dominated by mortgage REITs, in which interest income earned by the REITs is distributed as dividends to shareholders. Equity REITs soon gained popularity among investor looking for passive income.
A 1975 Amendment removed a mortgage REIT disadvantage. Because of the way the original REIT law was written, mortgage REITs that foreclosed on a property and then sold it within two years could lose their REIT status. The amendment removed this rule. This put equity and mortgage REITs on an equal footing.
Tax Reform Act of 1976
The early 1970s saw a downturn in the real estate market. At that time, REITs were not allowed to be corporations, and they were not allowed to deduct net operating losses (NOLs). This motivated many trusts to terminate their status as REITs to enable them to carry back NOLs. The Tax Reform Act of 1976 addressed some problems REITs had regarding operating losses:
- Structure: Corporations were allowed to be REITs, extending to them the advantages of being a REIT.
- Carryovers: REITs and former REITs were allowed to carry over NOLs for five years. The Act lengthened the carryover period to eight years. This gave them more opportunity to fully deduct NOLs going forward.
The effect was to allow REITs to have the same carry period as former REITs that renounced REIT status. In other words, it encouraged REITs to remain REITs even in bad times.
1985 Mutual Fund REIT
1985 saw the introduction of the first mutual fund for REITs and other real estate securities. Today, there are more than 200 such funds.
The Tax Reform Act of 1986
This act relaxed some restrictions on REIT activities. Because of the Act, REITs could now provide management and leasing services internally rather than hiring outside companies do perform these tasks. Thus, REITs had better control over their activities.
The 1986 Act also included rules to prevent the use of partnerships by taxpayers looking to shelter earnings from other sources. Passive investors were no longer able to deduct real estate losses from taxable income. The removal of real estate tax shelters was said to have contributed to a real estate bust in 1989 because many investors sold their assets following the passage of the Act.
Additionally, the Act removed the deductibility of personal interest, except for mortgages and home equity loans. Many incentives for investment in rental housing were removed.
1993 Pension Funds
In 1993, legislation was signed that made it easier for pensions funds to invest in REITs.
REIT Simplification Act of 1997 (REITSA)
REITSA packaged together a bevy of rules that helped REITs:
- The Act allowed REITs to perform a small amount of formerly prohibited services, such as the installation of cable TV.
- Capital gains retained by the REIT were no longer taxed at the shareholder level, only the corporate level.
- The Act deleted the rule that threatened the loss of REIT status if a REIT made more than 30% of its income from certain proscribed property sales, known as dealer sales.
- The penalties for a breach of the 5/50 rule were reduced. The 5/50 rule prevents five or fewer persons from owning more than 50% of a REIT.
- The rules allowing REITs to hedge against interest rate risk were liberalized.
- Technical adjustments were made to rules governing hypothetical ownership, phantom income, qualified REIT subsidiaries, safe harbor rules, and pre-REIT earnings distributions.
The effect of these innovations was to simplify REIT management and reduce overhead costs.
REIT Modernization Act of 1999 (RMA)
The RMA made three significant changes:
- The amount of taxable earnings that REITs were obligated to distribute to shareholders fell from 95% to its current value, 90%.
- REITs were allowed to own up to 100% of the stock in a taxable REIT subsidiary (TRS). A TRS may deliver certain services as long as they are delivered on an arm’s length basis.
- REITs were allowed to hire an independent contractor to run health care properties without a lease for up to six years after a REIT re-assumes ownership after a lease expires.
These changes helped REITs improve their efficiency.
REIT Improvement Act of 2003 (RIA)
The RIA contained three titles with numerous changes:
- Title I liberalized a REIT’s ability to make certain loans and protected timber REITs from a prohibited transaction tax.
- Title II rationalized foreign investment in REITs to match the rules for foreign investment in other publicly traded U.S. corporations.
- Title III reduced the penalties for certain violations due to reasonable cause.
REIT Investment Diversification and Empowerment Act of 2007 (RIDEA)
The Act, signed in 2008, had four major provisions:
- The rules concerning dealer sales were relaxed in terms of holding period and additions to the property tax basis before the dealer sale.
- The Act increased the limit on taxable REIT subsidiary (TRS) ownership to gross assets of 25%.
- The Act rationalized the rules concerning the use of independent contractors to run health care facilities to match the rules for lodging facilities. The effect is to make the management of health care facilities more efficient.
- Penalties were relaxed regarding violation of certain rules regarding the composition of assets and gross income, especially concerning foreign currency gains and hedging income.
Tax Cuts and Jobs Act of 2017 (TCJA)
The TCJA provided a 20% tax reduction on pass-through income, including REIT dividends. The full reduction applies to individuals with income below $157,000, or $315,000 for joint filers. Partial benefits continue up to taxable incomes of $207,000 for single filers, $415,000 for joint filers. Withholding tax on foreign REIT investors dropped from 35% to 21%. The upshot is that the TCJA provides ample opportunity for REITs to attract additional capital.
REIT legislative history reveals a mostly unbroken string of improvements to the original REIT enabling law, the 1960 Real Estate Investment Trust Act. The result has been a stronger REIT industry and investment opportunities for millions of individuals.
We have chosen in this article to concentrate mostly on innovations in REIT legislative history. Naturally, while this is an important facet of REIT history, it is hardly the only one. We refer you to NAREIT for an inclusive timeline of REIT events from 1960 to the present.