A good guess as to how the several trillion dollars of private US investment real estate is owned would be that maybe 75%-85% is through limited partnerships and limited liability companies or Sub-S corporations, perhaps 10% by general partnerships and “C” corps which may by “checking the box” elect partnership tax treatment, and less than 5% by private REIT’s.

Limited partnerships, LLCs and SubS corps are effectively equal in terms of economic and tax consequences, but there are some practical considerations that dictate the use of one or the other.

The United States Congress created REITs in 1960 to make investments in large-scale, significant income-producing real estate accessible to investors from all walks of life. Congress decided that the only way for the average investor to access investments in large-scale commercial properties was through pooling their capital into a single economic pursuit geared to the production of income through commercial real estate ownership.

Hence, the idea that REITs are in fact “mutual funds for real estate.”

Why Not a REIT?

REITs were designed primarily as publicly traded, widely held corporation-like vehicles. Notwithstanding the “average investor” objective, when REITs first rose to prominence in the early 1970’s the well-founded perception was that they were Wall Street’s way to enter the hot real estate market of that day. In fact, it is worth thinking of a REIT as being a corporation that invests in real estate without paying corporate tax.

Today, REITs still occupy the primary role of allowing stock market investors, 401 retirement plans, public pension funds, and like institutions the opportunity to move in and out of various real estate sectors (both geographic and by type—office, hotel, apartment, warehouse, and retail) or to “diversify” their portfolios.

There is no reason they cannot be privately held, but their disadvantages relative to the flexible LP form is clear. It is a truism for tax and business planning lawyers that while an entity created by legislation to accomplish a specified objective can be tailored to achieve another purpose, doing so will create its own series of problems and must furthermore address the requirements inherent in the original structure.

Hurdles to Overcome

Among other issues, the following are some inflexible hurdles that the organizer of a REIT must overcome:

High maintenance and accounting costs to assure compliance with complex Internal Revenue Code provisions. The REIT exists solely as a creature of the IRC. If you don’t comply, you are then a regular corporation and will in consequence have created double taxation for your investors. Such a “C” corporation (the standard form of publicly held corporation) is the most disadvantageous way to hold real estate.
A REIT must have 100 owners.
A REIT must comply with the “5/50 rule”—no more than 50% can be held by 5 people (affiliate rules apply, meaning no cute ways to avoid this).
90% of all REIT taxable income must be paid out as dividends (complex definitions of “REIT taxable income” means requiring the hiring of pricey accountants and lawyers). This is the most important requirement imposed on REITs, and is the basis for allowing for what is essentially a pass-through tax structure similar to that of partnerships and LLCs, so that although a corporation, the REIT does not have a corporation’s double taxation structure.
95% of income must be derived from real estate type income—complex regulations and definitions here as well.
75% of all investment assets must be in real estate (as likewise defined).
75% of the REIT’s income must come from “real estate interests.”
“Dealer transactions” are prohibited and therefore subject to double taxation as non-qualified income. Meaning that no property can be held primarily for sale—this under another guise is the old tax law issue, usually found in disputes about capital gain vs. ordinary income, of investment property as opposed to dealer property.
There is a four-year holding period on each of the REIT’s property investments, following which the REIT can only sell 10% of its portfolio at any time. Because of this, as well as other straight-jacket-type limitations imposed by the IRC, REITs are not designed for appreciation, but rather for holding and generating income from higher-yielding property types. For example, the Blackstone group in 2007 acquired one of the largest REITs, Executive Office Partners, and then privatized it in order to sell off about 60% of its portfolio at a $500 million profit. The REIT would not have been able to itself have made such sales.

In sum, REITs are properly “property income vehicles” rather than being “property investment vehicles”.
The REIT must be run by a Board of Directors or Trustees. Given that there is liability inherent in acting as a director, this means some degree of independence and some significant cost.
Contrast That with a Limited Partnership

NONE OF THE ABOVE REQUIREMENTS APPLY. Meaning you do not have to concern yourself with any of that and can violate each and every one of those restrictions.
Complete pass-through of all earnings, capital gains, etc.
Pass-through of losses—not available for REITs.
Almost total flexibility as to agreement between partners—meaning partners determine how they run affairs, under what restrictions the General Partner operates, when and what properties are acquired, when and how disposed of, what compensation for principals, what capital contributions, what rules apply as to additional capital contributions, when partners can transfer interests, how and when additional partners can be admitted, and countless other issues.
As to structure, it is just like a general partnership, which everyone is familiar with, in terms of control of the enterprise, and direction of the business, except with limited liability (just as though they were shareholders or REIT investors).
The general partner controls are subject to restrictions in the partnership agreement and also subject to votes by limited partners on various “important matters” as pretty much determined by the limited partners. Beyond that, the investors can in fact control the general partner (usually a limited liability company that can be owned by one or more of the limited partners), so the control can be exercised from two pressure points—direct and indirect.

But My Prospective Foreign Investors Want a REIT!

This has been the most persistent and recurring moving force among clients. Many of our clients come to the USA from overseas and have strong ties to their overseas communities which they can tap for investment in US real estate. Several of those investors have “heard that the way to go is through a REIT.”

However, foreign investors have been making substantial real estate investments directly into US real estate for decades. Whether done through their home entities (usually not) or via US-established entities or off-shore entities is a matter of proper structuring under the so-called “800 sections” of the Internal Revenue Code dealing with taxes imposed on foreign persons and entities.

There are of course complexities and the structuring must take into account the investor’s personal facts and preferences and the existence of, and scope of, any tax treaty, among other factors. But German, Japanese, British, French, Mexican, and Chinese investors all buy real estate through the same direct ownership routes as do Americans, although there is, for many tax reasons applicable to foreign investors, greater use of regular corporations.

It is far too complicated an area to deal here with the IRC’s taxation of foreign persons on US businesses and real estate. But what a client needs to know is the basis for the supposed need for a REIT, so the following should suffice.

Foreign investors in US stocks have for a long time been treated as subject to either 30% or 15% tax (where a tax treaty is in place) on both dividends and capital gains. The investor in a REIT (an easy way for a foreign investor who is not a “real estate investor” to own real estate) has since 1997 likewise paid 30% or 15% on its REIT dividends. But until 2003, a non-US investor who received a REIT capital gain distribution was treated as engaged in a US business under the Foreign Investment in Real Property Tax Act (FIRPTA) provisions of the Internal Revenue Code.

Accordingly, the distributing REIT was required to withhold a 35 percent tax on the distribution, while the investor, if treated as a corporation for US tax purposes, arguably was required to file a US tax return and required to pay an additional “branch profits” tax solely because of such distribution. That ended with the REIT Improvement Act (incorporated into the Jobs Act) of 2003 so that a portfolio investor receiving a capital gain distribution from a US-listed REIT was no longer required to file a US tax return, the branch profits tax does not apply, and the distributing REIT will withhold at a 30 percent rate or a lower rate prescribed by bilateral treaties (including the zero percent rate applicable in some treaties to pension plans). This provision conformed tax policy to the general FIRPTA rule for sales of REIT stock and to the tax treaty policy concerning REIT ordinary dividends in effect since 1997.

Although these provisions in fact apply only to listed (public) REITs, a client’s investor is unaware of that. What that investor, assuming he or she is not a real estate person but rather holds various liquid investments or a stock portfolio or has trust in the US, and his or her advisor has heard (a little knowledge being dangerous) is that because of liberalized rules applicable to foreign investment in a REIT, he or she wants to use a REIT. That is of course because (i) he or she wants the same treatment on real estate that applies to the stocks, and/or (ii) they believe that direct ownership involves tax returns, branch profits taxes, and other complications.

So What is To Be Done?

Formation of a REIT, especially without ironclad assurances that the group of investors will actually materialize and their promises of contributions will in fact be made, is extraordinarily expensive, constricting, and almost certainly the wrong choice. Direct investment through the investor’s own controlled entity is not only the simpler and more flexible choice, but it is also in the investor’s best interest.

The client should accordingly arrange a meeting at which this can all be laid out, and if necessary, the client can offer to reimburse the investor at the closing for some of the tax advisory services necessary to set up a compliant and tax-minimizing structure by which this is accomplished.