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Navigating the REIT asset tests

ARTICLE | January 17, 2021

Authored by RSM US LLP

A REIT—real estate investment trust—is a corporate investment vehicle for real estate that allows both small and large investors to acquire ownership in commercial and residential real estate in a tax efficient manner with reduced reporting requirements at the investor level as compared to other vehicles. Despite its competitive tax advantage, REITs are subject to a complex set of compliance rules, including organizational requirements, ownership requirements, distribution requirements, asset tests, income tests, record-keeping requirements and many others. Asset tests are one of the core compliance requirements. Unlike income tests, which are required on an annual basis, asset tests are required to be performed on a quarterly basis.

The primary requirement under the asset tests provides that at least 75% of a REIT’s total assets must consist of real estate, cash and cash items (including certain receivables), and government securities.  Real estate assets include real property, shares in other REITs and debt instruments issued by publicly offered REITs.

Real property has a detailed definition under the final regulations released in 2016 (T.D. 9784, 81 Fed. Reg. 59,849).  In general, real property is land and certain improvements thereon. Improvements include “inherently permanent structures” and “structural components.” Buildings are one of the main categories of inherently permanent structures.  Examples of buildings include houses, apartments, hotels and enclosed shopping malls, to name just a few.  The term “inherently permanent structure” means any permanently affixed building or other permanently affixed structure, which serves a passive function (i.e., to contain, support, shelter, cover and protect) and does not serve an active function (i.e., to manufacture, create, produce, convert or transport). Structural components are distinct assets that are integrated into the inherently permanent structure and support the inherently permanent structure in its passive function.  Examples of structural components include wiring, plumbing systems, central air-conditioning, elevators, escalators, floors and ceilings. For assets not specifically addressed in available guidance, a facts and circumstances analysis is required to determine if they are inherently permanent structures or structural components.

Based on the above definition, some traditional REIT assets include office buildings, warehouses, industrial complexes, shopping centers, multifamily residential properties, health care facilities and hotels.  Depending on specific facts and circumstances, some less traditional REIT assets may include billboards, cold storage facilities, data centers, document storage, electric transmission and distribution systems, farms, prisons, and rooftop sites.

Generally, personal property that is leased with real property will be treated as a qualified real estate asset, for purposes of the 75% test, provided the rent attributable to the personal property does not exceed 15% of the total rental income of that property where such rents are split based on the average fair market value of the personal property relative to the average FMV of all assets of the property. If the rent attributable to the personal property exceeds the 15% threshold, then the personal property will be treated as nonqualifying for the 75% asset test.

Besides the 75% test, there are five additional requirements, commonly referred to as the REIT securities tests, which include:

  • Not more than 25% of the value of its total assets is represented by securities
  • Not more than 20% of the value of its total assets is represented by securities of one or more taxable REIT subsidiaries (TRS)
  • Not more than 5% of the value of its total assets is represented by securities of any one issuer
  • The REIT does not hold securities possessing more than 10% of the total voting power of the outstanding securities of any one issuer, or having a value of more than 10% of the total value of the outstanding securities of any one issuer
  • Not more than 25% of the value of its total assets is represented by nonqualified publicly offered REIT debt instruments

There are remedies available that will allow a REIT to maintain REIT status even if it fails one of the above asset tests.  The available remedy depends on the timing of the discovery of that failure, the type of failure, the reason for the failure and the materiality of the failure.

Generally, a REIT has a 30-day period to cure any failure after the end of each quarter, provided it satisfied all the tests in the prior quarter. If it passes the 30-day period, and the failure is not related to the 5% or 10% securities tests, the REIT can cure the failure by: (i) showing that the failure was due to reasonable cause (rather than willful neglect); (ii) filing a description of each asset that causes the REIT to fail the requirements; (iii) disposing of the nonqualified assets (or otherwise satisfying the tests) within six months; and (iv) paying a penalty tax equal to the greater of (1) $50,000 or (2) tax computed on a certain amount of net income generated by the bad asset.

For any failure related to the 5% or 10% securities tests, if the failure is due to the ownership of securities, the total value of which does not exceed the lesser of (1) 1% of the total value of the trust’s assets at the end of such quarter and (2) $10,000,000, and the bad securities are disposed of within six months after the close of the quarter in which the issue is discovered, or the requirements are otherwise met within such time frame, then the REIT is considered to have passed its securities tests.

REITs must always be compliant with the above assets tests. As a result, it is essential that a REIT not only analyze its assets upon acquisition but also during the operation of the assets to ensure that its asset composition continues to meet the requirements as stated above. Being diligent will ensure the REIT is able to maintain its tax-favorable REIT status.

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This article was written by Jill Circ, John Luksis, Jing Li and originally appeared on Jan 17, 2021.
2022 RSM US LLP. All rights reserved.

The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.

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