Real Estate Investment Trusts (REITs)
Cost Segregation – Real Estate Investment Trusts, commonly known as REITs
Are Cost Segregation Studies appropriate for REITs?
Yes! By using cost segregation to assign shorter depreciable tax lives associated with §1245 personal property (while still not exceeding the 15 percent threshold from IRC § 856(c)(9)(B)), a REIT can substantially increase its depreciation deduction, while decreasing its taxable income.
IRC § 856(c)(9)(B) discusses special rules for certain personal property which is ancillary to real property.
(B) Certain personal property mortgaged in connection with real property.
(i) In general.— In the case of an obligation secured by a mortgage on both real property and personal property, if the fair market value of such personal property does not exceed 15 percent of the total fair market value of all such property
What are REITs?
Real estate investment trusts allow individuals to invest in large-scale, income-producing real estate. A REIT is a company that owns and typically operates income-producing real estate or related assets. These may include office buildings, shopping malls, apartments, hotels, resorts, self-storage facilities, and warehouses. Unlike other real estate companies, a REIT does not develop real estate properties to resell them. Instead, a REIT buys and develops properties primarily to operate them as part of its own investment portfolio.
REITs provide a way for individual investors to earn a share of the income produced through commercial real estate ownership without going out and buying commercial real estate.
There are two primary types of REITs: Equity and Mortgage.
Equity real estate investment trusts are the most common type of REIT. They acquire, manage, build, renovate, and sell income-producing real estate. Revenues are mainly generated through rental incomes on their real estate holdings.
Mortgage REITs, also called mREITs, invest in mortgages, mortgage-backed securities, and related assets. While Equity REITs typically generate revenue through rents, Mortgage REITs earn income from the interest on their investments.
IRC § 856(a) defines a real estate investment trust as:
(a) In general
For purposes of this title, the term “real estate investment trust” means a corporation, trust, or association–
1) which is managed by one or more trustees or directors;
2) the beneficial ownership of which is evidenced by transferable shares, or by transferable certificates of beneficial interest;
3) which (but for the provisions of this part) would be taxable as a domestic corporation;
4) which is neither (A) a financial institution referred to in section582(c)(2), nor (B) an insurance company to which subchapter L applies;
5) the beneficial ownership of which is held by 100 or more persons;
6) subject to the provisions of subsection (k), which is not closely held (as determined under subsection (h)); and
7) which meets the requirements of subsection (c).
Additionally, to qualify as a real estate investment trust, a company must meet the following requirements:
i. Invest at least 75 percent of its total assets in real estate, cash, and cash assets
ii. Derive at least 75 percent of its gross income from rents from real property, interest on mortgages financing real property, or from sales of real estate
iii. Pay at least 90 percent of its taxable income in the form of shareholder dividends each year
iv. Have no more than 50 percent of its shares held by five or fewer individuals
Benefits of Cost Segregation Studies for REITs
Required to distribute 90 percent of taxable income
Increased depreciation reduces taxable income
Increased depreciation reduces dividend distribution requirements
Provides an option to use retained cash for reinvestment, capital improvements, reduction of debt, etc.
Funds From Operations
Cost segregation has zero impact on Funds From Operations
Depreciation is added back to net income
CARE Act, Coronavirus and Qualified Improvement Property
The tax treatment of Qualified Improvement Property which includes Qualified Leasehold, restaurant and leasehold Improvement property was changed to qualify as 15-year property as a technical correction to the Tax Cut and Jobs Act of 2017(TCJA).
The classification as 15-year property (as opposed to 39-year property) makes these asset subject to 100% Bonus Depreciation deductions for many taxpayers.
The CARES Act adjusts the recovery period for QIP from 39 years to 15 years thus making it eligible for 100 percent bonus depreciation through 2022. This change is retroactive to January 1, 2018.