One of the major attractions of real estate investment trusts is that they pass-through income that sidesteps corporate double taxation. In order to qualify for tax benefits, REITs must comply with a set of asset and income tests. A taxable REIT subsidiary (TRS) is a corporation that gives REITs some compliance wiggle room, enabling REITs to compete with other real estate properties without jeopardizing their tax benefits.
Purposes of TRS
REITs can directly or indirectly own TRS, allowing REITs to perform certain activities that would be otherwise proscribed. TRS also allow REITs to acquire short-term holdings without triggering prohibited transaction tax.
For a REIT to maintain its beneficial tax status, it must adhere to the following rules regarding permissible sources of income:
- The 75% Test: At least 75% of a REITs gross income from real estate must come from rents on real property, mortgage interest, dividends from other REITs, and gains from property sales. Rent income includes fees for certain customary services (more on this below).
- The 95% Test: At least 95% of REIT real estate and portfolio income must come from the same sources as those for the 75% test, plus stock/security dividends, interest, and sales.
The customary services that REITs can provide and still remain in compliance with the income tests include charges for the following:
- Application fees
- Common area cleaning
- Security services
- Sprinkler and fire safety
- Trash collection
A TRS can earn taxable income from services that REITs cannot perform directly, including:
- Car washing
- Maid service
- Personal training
- Valet parking
If a REIT performed any of these “bad” services directly, it would be subject to a 100% penalty tax on the income and lose its REIT status. Furthermore, a REIT will trigger the penalty if it tries to unreasonably shift rents, deductions, or interest between itself and a TRS in order to avoid federal income taxes (a practice known as income arbitrage).
Thus, a TRS allows a REIT to compete with other real estate firms by offering services that non-REIT competitors offer. The TRS pays taxes on its income and shields the REIT from compliance violations. Note that a REIT cannot provide non-customary services directly, even if it doesn’t charge for those services.
The following tests apply to REIT assets:
- The 75% Test: At least 75% of total asset value must consist of real estate, government securities, and cash/equivalents. Real estate assets include real property and interests in mortgages on real property and REMICs (real estate mortgage investment conduits).
- The 25% Test: No more than 25% of REIT total assets may be securities.
- The 20% Test: No more than 20% of REIT total assets may consist of securities held in one or more TRS.
- The 10% Test: REITs can hold no more than 10% of the total value or outstanding vote of any one issuer’s securities. TRS are exempt from this test.
- The 5% Test: No more than 5% of REIT total assets may be the securities of any one issuer, not counting TRS.
- Prohibited Transactions: A REIT must hold property for long-term investment. Therefore, a REIT, but not a TRS, cannot dispose of property primarily held for sale. A violation carries a 100% penalty and possible loss of REIT status.
A TRS allows a REIT to hold assets that would either trigger a violation of the asset tests or constitute a prohibited transaction. For example, a REIT might want to buy a property portfolio that includes properties that the REIT doesn’t want to own. A TRS can buy the unwanted assets from the REIT and then sell them without triggering the prohibited transaction penalty.
Rules for Hotels and Health Care Facilities
The nature and level of services required to run a hotel or health care facility clearly exceed the customary services that a REIT can perform directly. For this reason, REITs cannot directly run a health care facility or hotel. Nor can a REIT license, franchise or provide other rights to a branded hotel or health care facility. To work around the problem, a REIT can lease such a property to a TRS. The TRS engages a third-party manager to operate the property and pays taxes on the income generated (less lease expenses paid to the REIT).
A TRS cannot directly manage a hotel or health care facility. Instead, The TRS in turn must hire external property managers, known as eligible independent contractors (EIKs). An EIK must manage multiple, unrelated properties.
To avoid the appearance of illegal income-shifting, the intercompany lease between a REIT and TRS must reflect an arms-length arrangement, lest the REIT incur the 100% penalty tax. In practical terms, this means the REIT should use a transfer pricing specialist to ensure that the intercompany leases (and other arrangements) are economically comparable with other, similar third-party agreements.
A corporation must elect to become a TRS. This is no problem when a REIT owns 100% of the corporation’s stock. However, the corporation can elect to become a TRS even if the REIT owns only one share of the corporation’s stock. To make a TRS election, the REIT and the corporation must jointly file IRS Form 8875, Taxable REIT Subsidiary Election. The election effective date must occur within the following time window:
- No more than 45 days before the filing, and
- No more than 12 months after the filing.
Extensions may be available under certain circumstances.
If a REIT acquires more than 35% of another corporation (by vote or stock value), the IRS will consider the target corporation to be a TRS, although the REIT must update its Form 8875 filing. A TRS cannot revoke election unless both parties complete a new filing of Form 8875.
TRS vs QRS
A TRS is different from a qualified REIT subsidiary (QRS). While both are subsidiaries of a REIT, they pay taxes differently. As mentioned earlier, a TRS pays taxes on its net income. A QRS is a wholly-owned subsidiary that the IRS disregards for tax purposes. The REIT owns the QRS’ income, deductions, assets, and liabilities. Therefore, a REIT must include a QRS when applying the asset and income tests.
The 1999 Ticket to Work Incentives Improvement Act provided for the creation of TRS to give REITs a level playing field when it comes to services they can render to lessees. A TRS allows a REIT to compete with non-REIT properties without violating certain income and asset tests.