Editor: Jeff Kummer, MBA
This item discusses a potential issue that some real estate investment trusts (REITs), particularly private ones, may face due to the overlapping of the rules that govern REITs and personal holding companies (PHCs). Both the REIT and the PHC provisions set forth ownership and income requirements that must be met for an entity to be considered a REIT or a PHC. Because REITs generally look to the PHC ownership tests, it has typically been assumed that, if an entity is not considered closely held for REIT purposes, it is not closely held for PHC purposes either. However, recent analysis has shown that a REIT can be subject to the PHC tax as well as to other rules affecting PHCs. Indeed, page 1 of Form 1120-REIT, U.S. Income Tax Return for Real Estate Investment Trusts, requires a REIT to indicate whether it is a PHC. A REIT must enter any PHC tax it owes on Schedule J, Tax Computation, of the Form 1120-REIT.
The reason a nonclosely held REIT can be a closely held PHC is that Sec. 856(h)(1)(B) eliminates the PHC partnership attribution rule for the determination of REIT closely held status, but this attribution rule remains intact for purposes of PHC determinations, and there is no other provision that prevents the PHC rules from applying to REITs or their taxable REIT subsidiaries (TRSs). If a REIT or a TRS meets the PHC ownership requirements, then it is necessary both to monitor its income and to monitor and regulate its distributions so as to become comfortable either that the entity does not fall within the PHC income requirement or, if it does, that it will not have any undistributed PHC income that would give rise to a tax.
Situations in Which a REIT or TRS Meets the PHC Ownership Rules
Under the PHC partnership attribution rule, each partner is deemed to own everything each of its partners owns (Sec. 544(a)(2)). Furthermore, while the PHC rules for reattribution prevent the double application of the partnership attribution rule, they permit the application of that rule in combination with other attribution rules, such as entity-to-owner attribution (Sec. 544(a)(5)). These attribution rules make it surprisingly easy to meet the PHC closely held test (i.e., more than 50% in value held by five or fewer individuals).
The reach of these rules can be illustrated in examples that are reasonably common. Perhaps the most obvious is when a REIT is owned primarily by a partnership. This structure is used extensively in the private equity context, and it also is employed occasionally in the public REIT context, where a public umbrella partnership REIT (UPREIT) owns part of a lower-tier REIT. If a single partner in such a partnership is an individual—defined for this purpose as including not only natural persons but also certain entities such as pension trusts (Rev. Rul. 65-3)—then that partner will own everything owned by the partnership, thus causing the REIT to meet the PHC ownership requirement. By the same token, if the operating partnership in an UPREIT includes an individual, then any controlled REIT or TRS owned by the operating partnership will meet the PHC ownership requirement.
What is much less obvious is that it is possible for a REIT or a TRS to meet the PHC closely held test even if none of the direct or indirect owners is an individual. If an upper-tier REIT owns a lower-tier REIT or TRS, and the upper-tier REIT is a partner in a partnership that includes an individual, then the ownership of the lower-tier REIT or TRS is at-tributed to this individual, causing the lower-tier REIT or TRS to meet the PHC closely held test. Similarly, it is probably the case that the partners in a private equity partnership that owns a REIT have invested in numerous other partnerships, a number of which contain individual partners, and so the REIT stock attributed to each of the partners in the partnership that owns the REIT will be reattributed from them to any of their partners in other partnerships. This makes it possible for the REIT to meet the PHC ownership test based on the other activities of the partners.
There is one instance in which REITs are exempt from being classified as PHCs. If a REIT meets the ownership requirements imposed by Sec. 856 by virtue of the lookthrough rule set forth in Sec. 856(h)(3)(A), by reason of which the beneficiaries of pension trusts described in Sec. 401(a), rather than the pension trusts themselves, are considered the relevant individuals, Sec. 856(h)(3)(B) expressly states that the REIT itself will not be treated as a PHC. Even here, however, if the REIT owns a TRS, Sec. 856(h)(3)(B) does not provide relief to the TRS.
Because of the broad reach of these attribution rules, and the frequent lack of information regarding the other investments of direct or indirect owners, it may be prudent to operate on the assumption that privately held REITs meet the PHC ownership test absent clear proof to the contrary. It should also be kept in mind that if a REIT meets the PHC ownership test, then any wholly or mostly owned TRSs will also meet this test, and so they too may be PHCs. Finally, even where the REIT itself does not meet the PHC ownership test, TRSs or lower-tier REITs may meet it if they are owned through an UPREIT operating partnership or if the REIT that owns them is a partner in any partnership.
Negative Consequences of Qualifying as a PHC
A number of negative consequences result from a REIT or a TRS qualifying as a PHC. The first is that the REIT or TRS could owe PHC tax. This can occur because the determination of “undistributed personal holding company income” for a REIT is different from the determination of REIT taxable income (REITTI). For example, rent-related deductions that are allowable for REIT purposes may be limited for PHC purposes; NOL carryforwards from years earlier than the preceding year are taken into account for REITTI but not for PHC purposes; and post-year dividends may qualify for REIT purposes but not for PHC purposes. The PHC rules are complex, and a discussion of the differences between them and the REIT rules is beyond the scope of this item. What is important to keep in mind is that, in order to avoid PHC tax, it may be necessary for the REIT to make a distribution that exceeds whatever distribution, if any, might be made solely for REIT tax purposes. Also note that if an entity that is a PHC does not file a schedule showing PHC items, the statute of limitation is six years.
Second, an exit strategy for REITs—liquidation of the assets followed by distribution of the proceeds to the shareholders—may not be available to a REIT that is also a PHC. This occurs because, although a REIT is generally entitled under Sec. 562(b)(1) to a dividends-paid deduction for amounts distributed within 24 months of the adoption of a plan of liquidation (thus offsetting any gain or income on the disposition of the assets at the REIT level), the availability of this treatment is limited in the case of PHCs. Accordingly, if the REIT is also a PHC and employs this exit strategy, the extent to which the REIT is entitled to the dividends-paid deduction is not clear. Without an adequate dividends-paid deduction, the REIT would fail to meet the REIT requirements and thus would owe C corporation tax on the gains from disposing of its assets.
Monitoring the PHC Issue
The rules regarding the application of the PHC income test (at least 60% of the corporation’s ordinary adjusted gross income is personal holding income) are complex and beyond the scope of this item. There are some options that may be available to reduce and/or eliminate the risk of PHC tax exposure. Of great importance to equity REITs is that Sec. 543(a)(2) excludes rents from ordinary adjusted gross income if (1) the rents make up more than 50% of the entity’s income and (2) the dividends paid for the year exceed the amount by which PHC income other than rents exceeds 10% of ordinary gross income. Thus, an equity REIT would likely be able to avoid PHC status by ensuring that it pays dividends in excess of the amount, if any, by which PHC income other than rents exceeds 10% of ordinary gross income. In many cases, this requirement would be met by virtue of the distributions that the REIT would be making for REIT purposes anyway. There is no comparable relief for mortgage REITs, however. Moreover, in all cases, and particularly in the liquidation context, careful monitoring of income and distributions will be necessary.
It should also be noted that if a dividend is paid from a TRS to avoid personal holding company tax, when received by the REIT the dividend will not represent qualifying income for purposes of the 75% gross income test set forth under Sec. 856(c)(3).
Jeff Kummer, MBA, is Director of Tax Policy at Deloitte Tax LLP, Washington, DC.
If you would like additional information about these items, contact Mr. Kummer at (202) 220-2148 or firstname.lastname@example.org.
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Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.