By nature, a Real Estate Investment Trust, or REIT, is meant to hold a passive investment in real estate and receive rental income. In an age of rapidly expanding non-traditional REITs and increasing competition among traditional REITs, services begin to play a bigger role in attracting tenants and creating new revenue streams. Without careful planning, however, the income generated from these services can cause unintended tax consequences for the REIT.
In order for an entity to maintain REIT status, it is subject to a series of quarterly and yearly tests, including two income tests: a 75% test and a 95% test. If the REIT has too much non-qualifying income it is at risk of failing these tests. It would then be in jeopardy of losing its status as a REIT and its dividends paid deduction – its most valuable tax attribute.
One aspect of income testing is the 1% de minimis test, which examines how much impermissible tenant service income (ITSI) there is in relation to gross income. If a REIT has as little as 1% or more of this “bad” income, then all of the REIT’s income becomes tainted as non-qualifying income, which will cause the REIT to fail the yearly income test. If ITSI is under 1% of total gross income, then only the ITSI is considered non-qualifying – the remaining qualifying income remains untainted. What about services where the REIT derives no income, but still bears the cost of providing a service? The REIT is required to gross up 150% of the costs incurred in providing that service as gross income. This is then included as income subject to the 1% test.
A TRS is a C corporation that makes an election to become a taxable REIT subsidiary. One great feature of a TRS is that it “washes” the tainted service income for the REIT. A TRS will run the services of the property for the REIT, receive income from those services (and bear the expenses), and pay tax on that income (21% tax rate for 2018 and later). If the TRS pays a dividend to the REIT, then that income is considered qualifying dividend income for purposes of the 95% income test. The REIT no longer has tainted income and is still able to provide competitive services to its tenants. The services can also be run through a 3rd party independent contractor in order to avoid ITSI.
There are two questions to consider when determining whether a service falls under ITSI – both of which are facts and circumstances driven.
The first question is a two part question that depends on what is considered a customary service and what is considered the geographic region. What might be considered a customary service in Los Angeles might not be considered customary in Chicago. A customary service for an office building might not be considered a customary service in a residential setting. Additionally, the geographic region in New York City may be a few blocks versus a geographic region in Texas of a few square miles. After making these determinations, if the service is not customary in the geographic region, the service must be provided through a 3rd party independent contractor or TRS. If the service is customary in the geographic region, move on to the second question.
The second question is aimed at determining if the service is so specialized that it is outside the scope of basic services that need to be provided as part of an operational building. Of course, each building needs to provide basic services to its tenants such as electricity, water, HVAC, telecom, trash collection, etc. If the service is primarily for the convenience of the tenant (for example, maid services or picking up dry cleaning) then the service should be run through a 3rd party independent contractor or a TRS. If the service is not primarily for the convenience of the tenant, then the income generated from that service is not ITSI and can be provided directly by the REIT.
Even though the income test is a yearly test, a best practice is to perform the income test on a quarterly basis. This way the REIT has a better understanding of the type of income being generated and can plan a cure by year-end so there is enough qualifying income to pass the income tests. Additionally, when performing due diligence on a property that will later be put into a REIT, current services provided by the property and ITSI are carefully scrutinized so measures can be taken once the REIT is set up to avoid failing the income tests. Incorporating a TRS into the structure during the planning stages should be a priority when setting up a REIT to alleviate any potential threats of ITSI. The benefit is, as the REIT increases its service offerings to tenants, a TRS is already in place to run through the income from those services. With careful planning and structuring, any type of REIT can ensure from the get-go that the income generated will be qualifying income.