Mortgage REITs (real estate investment trusts) have many tax advantages with respect to operating and investing in debt securities. This article discusses some of the benefits of this business structure and addresses when a mortgage REIT should be used rather than a partnership or C corporation.
For those unfamiliar with them, a mortgage REIT specializes in providing financing for income-producing real estate by purchasing or originating residential and commercial mortgages and mortgage-backed securities (MBS), earning interest income on these assets. Mortgage REITs fund their asset investments through a combination of equity capital and debt. The equity capital can be common or preferred stock. The debt can include long-term bank loans or short-term repurchase agreements (repos). Some mortgage REITs trade on a public market, while others are not listed. A mortgage REIT can be formed as a corporation under Subchapter M or as an unincorporated entity that has made a "check-the-box election" to be taxed as a corporation.
What are the advantages of a mortgage REIT when compared to a partnership or a C corporation?
A mortgage REIT, unlike a C corporation, generally does not pay entity tax on its net earnings if it distributes 100% of its current-year taxable income to its shareholders. This is because a mortgage REIT can claim a deduction for dividends paid.
Under Sec. 199A, a U.S. individual can claim a 20% deduction for dividends received from a mortgage REIT that collects interest income. On the other hand, interest income allocated to a U.S. individual partner is not eligible for this deduction.
Foreign investors are subject to U.S. tax on effectively connected income (ECI) received through a partnership, including any gain on the sale of such partnership interest. Many tax advisers are concerned that loan origination or selling activities conducted on a regular basis in the United States can constitute a lending business and, therefore, be treated as an effectively connected business (ECB) producing ECI.
To avoid this risk, foreigners often look to invest through a U.S. blocker corporation such as a mortgage REIT. The mortgage REIT's activities, including loan origination and sales, do not flow through to the foreign shareholder, and, thus, the foreign shareholder can indirectly participate in loan origination and other business activities without creating ECI.
REIT dividends are subject to 30% withholding tax, but lower treaty rates may apply. Moreover, a sovereign wealth fund will generally be exempt from U.S. tax on such dividends. Furthermore, the sale of stock in a mortgage REIT is not taxable if:
- The REIT is "domestically controlled" (more than 50% of the REIT's stock value is owned by U.S. persons);
- The seller is a "qualified foreign pension fund";
- The seller owns 10% or less of a class of stock that is publicly traded; or
- The REIT is not a U.S. real property holding company (USRPHC); i.e., less than 50% of its assets value consists of U.S. real property interests (USRPI).
This favorably compares to owning a partnership interest where the sale thereof is treated as taxable ECI.
Tax-exempt organizations are subject to U.S. tax on unrelated business taxable income (UBTI) generated by the activities of a partnership if such income includes business income and interest income derived from leveraged investments. A mortgage REIT acts as a blocker to UBTI on the above activities, and dividends paid by the REIT are generally not taxable if the investment itself is not debt-financed.
Lastly, mortgage REITs are generally not subject to New York City's 4% tax on unincorporated business income.
What are the tax issues inherent in being a mortgage REIT?
Organizational issues: Not more than 50% of the value of shares of a mortgage REIT can be owned directly or indirectly by or for five or fewer individuals at any time during the last half of a REIT's tax year (this requirement does not apply for the REIT's first tax year).
For this purpose, organizations described in Sec. 501(c)(17) (supplemental unemployment benefits trusts), or Sec. 509(a) (private foundations) are treated as an individual.
Gross income tests: Annually, at least 75% of the REIT's gross income must be derived from real estate–related sources such as:
- Interest on obligations secured by mortgages on real property (whether senior or junior) or interests in real property (subject to limitations as to loan to value, or if based on the net income or profits of the borrower);
- Mezzanine loans secured by real estate partnership interests that meet the requirements of Rev. Proc. 2003-65 (a safe harbor);
- Real estate mortgage investment conduit (REMIC) regular interests;
- Interest from agency passthrough certificates and equity interests in grantor owner trusts that issue collateralized mortgage obligations (CMOs);
- Dividends from investments in REITs;
- Loan commitment fees in connection with making a mortgage;
- Loan origination fees not in the nature of a service fee;
- Excess mortgage servicing fees;
- Qualified temporary investment income; and
- Gain from the sale of real property including mortgages on real property.
In addition, at least 95% of its gross income must be derived from sources that qualify for the 75% gross income tests, plus dividends, interest from debt instruments not secured by real estate, and gains from the sale of stock (including stock of a taxable REIT subsidiary (TRS)), securities, and real estate not included in the 75% gross income test cited above.
Income not qualifying under the 75% and 95% gross income tests includes loan origination and other fees for services and hedging income with respect to a mortgage REIT's assets.
Income disregarded from the REIT gross income test includes income from "prohibited transactions" (see discussion below) and "qualified hedging transactions," as described in Sec. 856(c)(5)(G)(i).
Gross asset tests: At the end of every quarter, at least 75% of the value of the REIT's gross assets must be represented by "real estate assets," cash and cash items (including receivables), and government securities. Real estate assets means real property, interests in mortgages, mezzanine loans that meet the requirements of Rev. Proc. 2003-65, interests in the stock of other REITs, interests in the debt instruments of public REITs, REMIC regular interests, and "new capital" (amounts received in exchange for stock or in an offering of public debt having maturity of at least five years for a one-year period).
In addition, no more than 20% of the value of the REIT's gross assets can be stock and securities of a TRS; no more than 5% of the value of the REIT's gross assets can be in the securities of any one issuer (other than a TRS or another REIT); and a REIT cannot own more than 10% of the vote or value of the outstanding securities of any one issuer other than of a TRS or a REIT, unless it meets the "straight debt exception" of Sec. 856(m)(1)(A).
Preferred equity in a corporation is treated as a security and is subject to the above rules. Preferred equity in a partnership is treated as ownership of the underlying assets of the partnership based on the relative value of the preferred equity to total equity. Accordingly, the mortgage REIT will need to know the partnerships' gross income and gross assets to determine whether it satisfies the REIT income and asset tests.
Prohibited transaction tax/origination, securitization, and sales
A REIT is subject to a 100% prohibited transaction tax on the sale of "dealer property," which, in the case of a mortgage REIT, is generally the sale, exchange, or transfer of any debt, equity, or hedging asset in the ordinary course of business. This is a facts-and-circumstances test. Unlike an equity REIT transacting in real estate, under certain conditions, a mortgage REIT can be a "trader" in loans and therefore not be a dealer even if it makes many trades.
Whether the mortgage REIT is a "dealer" with respect to a particular transaction depends on a number of factors such as whether the mortgage REIT:
- Has unique access to the supply of securities (e.g., it originates the loan or purchases it from exclusive sources not available to the general public);
- Profits from markup in the price rather than market movements;
- Acquires with an intent to resell;
- Has the intent to sell after acquisition or, at the time of sale, the sale is not the result of a change in circumstances;
- Regularly sells to customers it finds through marketing;
- Regularly performs merchandising services by creating a market in the product by selling nonfungible, nonpublicly traded loans; and
- Has a fixed place of business and holds itself out as a dealer in loans.
Because of the subjective nature of the above factors, Sec. 857(b)(6)(C) provides for a safe harbor from characterization as a prohibited transaction for certain dispositions during the year. Among other things, the safe harbor requires that:
- The asset has been held for at least two years; and
- The trust does not make more than seven sales or sales that exceed 10% of the REIT's value or adjusted tax basis.
Securitization transactions can be either sales or financing of the mortgage REIT's assets depending on how it is structured. The basic securitization transaction involves transferring a pool of mortgages or MBS into a trust and having the trust issue securities collateralized by the pool of assets. There are two types of securitization vehicles: the REMIC and the CMO trust.
A REMIC is a statutory entity that was created by Congress to avoid issues of whether a trust was a taxable mortgage pool (TMP, taxed as a corporation) that otherwise arises from a multiclass/time tranche securitization. The REMIC issues "regular interests," treated statutorily as debt for tax purposes, and "residual interests" treated as equity for tax purposes. The regular interests are sold to investors, and the residual interest is retained. Since a sale by a REIT of "regular interests" risks being treated as a prohibited transaction, a REIT will generally conduct REMIC transactions through its TRS.
Alternatively, a REIT can directly conduct securitization through a CMO trust. This involves the REIT's creating a grantor trust into which it contributes mortgages or MBS and having the trust issue securities collateralized by its assets. The REIT owns all the equity of the trust and thus all the assets.
However, there are two tax issues with using this structure: one is whether the securities issued by the trust are debt or equity, which involves an analysis of the loan-to-value ratio of the assets/debt-to-equity ratio of the trust, and the second is whether the trust will be treated as a TMP.
Regarding the first issue, generally a well-advised REIT will obtain a tax opinion that the securities are debt for tax purposes. The TMP problem can be avoided by issuing only a single class of security.
Making informed decisions
Mortgage REITs have many tax advantages over C corporations and partnerships with respect to operating and investing in debt securities. Knowledge of the rules that apply will help the operator and investors make an informed decision.
— Craig Stern, CPA, J.D., is a managing director in the real estate group of Mazars USA LLP. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld, senior editor, at David.Strausfeld@aicpa-cima.com.