In this third and final installment of real estate taxation, we look at how tax considerations and strategies vary by specific types of real estate investments. As real estate is such a large and diverse asset class, there are significant differences in regulations, techniques, and applicability that have serious implications for real estate investment strategies. (See Parts 1-2: Tax Risks of Real Estate Investments and Tax Strategies of Real Estate Investments)

Vacant Land. An investor in vacant land may take various deductions, including real estate taxes, interest charges on indebtedness incurred to buy the land, and other expenses paid or incurred in connection with holding the land, subject to the “passive loss” rule or the “investment” interest limitation. If the vacant land is held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business, taxes, interest, and other expenses paid or incurred in connection with the land must be included in inventory costs. Land is not depreciable, but expenses incurred in managing, conserving, or maintaining property held for the production of income and in connection with any business use of the land are deductible.

Characterization as Passive Activity. Investment in vacant land is treated as a passive activity if the activity is (1) a rental activity or (2) a trade or business in which the investor does not materially participate. The rental of property used in a trade or business is treated as incidental to a trade or business activity (rather than a rental activity) during any year if:

(1) The taxpayer owns an interest in the trade or business activity during the year,

(2) The property was predominantly used in the trade or business activity either during the year or in two out of the five preceding years, and

(3) The gross rental from the property for the year is less than 2 percent of the lesser of

a.    the unadjusted basis of the property, or

b.    the fair market value of the property.

Characterization as Investment Activity. Investment in vacant land is treated as an investment activity rather than a passive activity during any year in which the principal purpose for holding the property during such year is to realize gain from the appreciation of the property. The rental of investment property is treated as incidental to an investment activity rather than a rental activity if the gross rental from the property for the year is less than 2 percent of the lesser of (1) the unadjusted basis of the property, or (2) the fair market value of the property.

Example 1. A taxpayer holds for the principal purpose of realizing gain from appreciation 1,000 acres of unimproved land with an unadjusted basis of $210,000 and a fair market value of $350,000. He also rents the land for $4,000 per year to a rancher who uses the land to graze cattle.  The rental of the land is treated as incidental to an investment activity rather than a rental activity.  This is determined as follows:

  • The lesser of the unadjusted basis ($210,000) or the fair market value ($350,000) is $210,000.
  • Two percent of $210,000 equals $4,200.
  • Gross rental of $4,000 is less than $4,200.

Example 2. In 2012, a taxpayer acquired vacant land for development purposes. During 2012, the taxpayer rented the land to a car dealer.  In 2013, the taxpayer began construction of a shopping mall on the land. Since the land was acquired principally for purpose of development rather than held for appreciation, the rental of the land in 2012 cannot be treated as incidental to an investment activity. Also, the rental of the land cannot be treated as incidental to a trade or business activity because the land has never been used in a trade or business. The rental of the land is treated as a rental activity subject to the passive loss rule.

Rental Income

Accrual and Cash Basis. As a general rule, an accrual-basis lessor includes rent in income as it accrues over the term of a lease, while a cash-basis lessor includes rent in income when it is received. Similarly, an accrual-basis lessee deducts rental expense as it accrues over the term of the lease, while a cash-basis lessee deducts rental expense when it is paid. Under this general rule, if rent is deferred until the end of the lease term, or the rent is stepped up over the lease term, an accrual-basis lessee could take deductions over the lease term, but the cash-basis lessor would not have to include rent in income until payment was made.  However, special rules require the accrual of rental income and expense in the case of certain deferred or stepped-rent lease agreements.

Deferred or Stepped-Rent Lease Agreements. The IRC requires lessors and lessees under certain deferred or stepped-payment lease agreements to report rental income and expense as it accrues, as well as interest on rent accrued but unpaid at the end of the period. Agreements are subject to this rule if at least one amount allocable to the use of property during a calendar year is to be paid after the close of the calendar year following the calendar year in which the use occurs, or if there are increases in the amount to be paid as rent under the agreement. However, the rule does not apply unless the aggregate value of the payments and other consideration to be received for use of the property exceeds $250,000. When Rent Accrues. As a general rule, rents will accrue in the tax year to which they are allocable under the terms of the lease. Regulations provide that the amount of rent taken into account for a taxable year is the sum of:

(1)  the fixed rent for any rental period that begins and ends in the taxable year,

(2)  a ratable portion of the fixed rent for any other rental period beginning or ending in the taxable year, and

(3)  any contingent rent that accrues during the taxable year.

In either of two situations, rent will be deemed to accrue on a level, present-value basis (“constant rental amount”) rather than under the terms of the agreement:

1.   The rental agreement is silent as to the allocation of rents over the lease period; or

2.   The rental agreement provides for increasing rents and one of the principal purposes for increasing rents is tax avoidance and the lease is either

a.    part of a leaseback transaction, or

b.    for a term in excess of 75 percent of the “statutory recovery period” for the property subject to the lease.

A constant rental amount is the amount that, if paid as of the close of each lease period under the agreement, would result in an aggregate present value equal to the present value of the aggregate payments required under the agreement. The regulations provide a formula to facilitate the computation of the constant rental amount.

A leaseback transaction is one involving a lease to any person who had an interest in the property (or related person) within the two-year period before the lease went into effect. The statutory recovery period is essentially the period provided for depreciation under the accelerated cost recovery system (ACRS), except that a fifteen-year period may be substituted for twenty-year property, and a nineteen-year period may be substituted for residential rental property and nonresidential real property.

The regulations provide comparable rules for agreements calling for decreasing rates and rules applicable to contingent payments.

Under the regulations, certain rent increases are not considered made for tax avoidance purposes. These would include increases determined by reference to price indices, rents based on a percentage of lessee receipts, reasonable rent holidays, and changes in amounts paid to unrelated third persons.

Characterizing Gain as Recaptured Ordinary Income Upon Disposition. If property subject to a leaseback or a lease longer than 75 percent of the recovery period is not subject to rent leveling (i.e., there is no tax avoidance purpose or no stepped rent) and the rent accrues according to the terms of the agreement, then any gain realized by the lessor on disposition of the property during the term of the agreement is treated as recaptured ordinary income.  The treatment of the gain as recaptured ordinary income is to the extent that the rental amount that would have been taken into account by the lessor, if the rents had been reported on a constant rental basis, is more than the amounts actually taken into account.

Master Limited Partnerships (MLPs). Master Limited Partnerships (MLPs) have reached a market capital of $400 billion, with more than 100 MLPs traded on major exchanges as of June 2013.  Generally established as LLCs with advantageous partnership flow-through tax treatment, MLPs present attractive return vehicles to attract long-term capital for investment in energy extraction, energy transportation such as pipeline ownership (“midstream”), and energy distribution (“downstream”). 

The MLP business entity allows for some corporate characteristics to persist, such as limited liability to investors and publicly traded units.  Also, the MLP provides the tax advantages of a pass-through entity partnership.  As such, partners generally are permitted to take into account any loss, deduction, or credit produced by the partnership at the individual level, while avoiding taxation at the entity level.

Distributions issued to limited partners are tax deferred as the distribution is treated as a return of capital; the distribution issued acts to reduce a limited partner’s basis to the cost basis. When that basis reaches zero, any subsequent distribution is then taxed at current tax rates.

Quarterly Distribution of Available Cash. In general, MLPs attract investors by contractually agreeing to distribute quarterly all available cash.  However, the “all available” cash provision is normally limited by the general partner’s discretion to hold a reserve required to carry on the MLP’s business operation.  As further investor enticement, the MLP agreement generally establishes a subordination period for the sponsor’s limited partner interest that allows for sufficient cash flow to be distributed so that common units receive minimum distribution levels.

Unrelated Business Income Tax (UBIT). Like individual taxpayers, certain tax-preferred entities (such as 401(k)s and IRAs) and organizations (such as charities and churches) become limited partners upon investment in an MLP.  However, any income derived from this partnership is subject to the unrelated business income tax (UBIT), as this income is classified as unrelated business taxable income (UBTI) to such entity or organization. UBTI is “gross income derived by any organization from any unrelated trade or business … regularly carried on by it.” An “unrelated trade or business” is defined to include “any trade or business the conduct of which is not substantially related … to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption.” MLP income distributed to a tax-exempt entity or organization will likely constitute UBTI.  For example, income that is passed through to a 401(k) or IRA based on an investment in a MLP is not related to a retirement account’s tax-exempt purpose of encouraging taxpayers to save for retirement and, therefore, will become subject to the UBIT.  Additionally, if a tax-exempt organization invests directly in a MLP, any partnership income is subject to the applicable corporate tax rates, because that income is not related to the organization’s exempt purpose.

Regulated Investment Companies Restrictions. In the past many mutual funds have been reluctant to invest in MLPs because of the RIC investment restrictions of IRC Section 851.  To maintain its RIC election, a RIC must derive at least 90 percent of its gross income from certain sources specified within the IRC, including dividends and interest. Because as a partnership, an MLP does not distribute “dividends,” a RIC was unable to derive more than 10 percent of its income from MLPs.

However, in 2004 Congress amended IRC Section 851 to provide that a RIC may include “net income derived from an interest in a qualified publicly traded partnership” in calculating its 90 percent income requirement. Essentially, this amendment provided mutual funds with the ability to diversify their portfolios because any income derived from the MLP does not affect its status as a RIC. A RIC still faces limitations in its ability to invest in MLPs.  A mutual fund is not permitted to invest more than 25 percent of its assets in an MLP. Nor are mutual funds permitted to own more than 10 percent of the interests issued by an MLP.

Disposition by MLP of Underlying Assets. An MLP may lose its tax advantages when there is a sale or exchange of 50 percent or more of the interest in partnership capital or profits. The sale or exchange of 50 percent or more leads to the characterization of the dissolution of the MLP and formation of a new one.  The dissolution of the former may lead to a recapture of credits that will correspondingly push down to the investors.

Real Estate Investment Trusts (REITs). REITs, like any other corporate entity, can be listed or unlisted, publicly traded or private.  Both publicly traded listed REITs and public unlisted REITs are required to file reports with the SEC, though, as the name suggests, only the shares of publicly traded listed REITs are actually traded on public stock exchanges.  A publicly traded listed REIT may choose to list its shares on any national stock exchange, though most are listed on the New York Stock Exchange.

Both publicly traded listed and public unlisted REITs are subject to traditional corporate governance rules, including rules regarding the independence of directors. A publicly traded listed REIT must abide by the rules prescribed by the stock exchange on which it chooses to list shares, while public unlisted REITs are subject to the rules adopted by the North American Securities Administrators Association, as well as any applicable state laws.  Private REITs are not subject to any external corporate governance rules.

Some smaller investors may find investing in publicly traded listed REITs more beneficial than investments in unlisted or private REITs.  Because both public unlisted REITs and private REITs are not available for purchase on a stock exchange, their shares are much less liquid than those of a publicly traded REIT.  Shares in REITs that are not publicly listed are subject to redemption rules that are set by the individual REIT and cannot be redeemed at the will of the investor. Information about the value of a publicly traded REIT’s shares is widely available, so smaller investors can make knowledgeable investment decisions based on historical performance and the investments underlying the individual REIT.

Classes of REITs. A real estate investment trust (REIT) is a corporate entity that owns, operates, acquires, develops, and manages real estate.  The investment objective of most REITs is to produce current income through rents or interest on mortgage lending. REITs can be broken down into three basic classes: equity, mortgage, and hybrid. An equity REIT actually acquires and takes ownership of real property. Most equity REITs buy and hold properties for their net rental income. Others seek profits through appreciation in property values. These often try to add value through increasing occupancy levels or by making physical improvements to the property. Equity REITs can be sub-classified by the type of real estate in which they invest. For example, investments may be confined to (or predominantly focused on) office buildings, apartments, shopping centers, warehouses, or medical care facilities, for instance. Some equity REITs may diversify their holdings among several different types of real estate.

Mortgage REITs do not own real estate, but rather, they hold mortgages on income-producing commercial properties. Mortgage REITs generally provide a higher current yield than equity REITS, but they lack the opportunity for capital appreciation through increases in property values. Instead, their market valuations are affected by fluctuations in the prevailing market interest rates. Hybrid REITs are REITs that invest in both direct property ownership and in mortgages.

Investor’s REIT Income. REITs are often compared to mutual funds because they allow smaller investors to pool capital to invest in larger and more diversified real estate portfolios than might otherwise be available. Both REITs and mutual funds are pass-through vehicles, as income earned is passed through for taxation at the investor level, bypassing taxation at the corporate level.

An important aspect of REITs is this pass-through income tax treatment. Like partnerships, REITs are not taxed at the entity level, but at the investor level. Thus, annual taxable income is allocated pro rata to all investors, and these amounts are included in the investors’ returns and taxed at their level. The amount of taxable income determined at the entity level and passed through to a REIT investor is usually less than the actual cash distribution received by the investor for that year. In most instances taxable income is reduced by depreciation, a deductible expense that does not reduce distributable cash flow. 

REIT Minimum Annual Distribution of Earnings. A REIT is required to distribute at least 90 percent of its annual earnings to shareholders.  However, a REIT is allowed to deduct from its corporate taxable income all the dividends that it pays out to its shareholders.  Because of this special tax deduction, most REITs pay out all taxable income rather than meeting the minimum distribution 90 percent requirement.  Thus, most REITs owe no tax at the corporate level. 

Assets Qualifying for REIT Investment. To qualify as a REIT, at least 75 percent of a REIT’s assets must consist of cash, cash items (including receivables), government securities, and real estate assets at the end of each quarter of a REIT’s tax year.

The term “real estate assets” includes real property (and interests therein), interests in other REITs (as long as the REIT issuing the interest was properly qualified as a REIT), and mortgage interests in real property. 

Real property includes not only the actual land investment, but also any improvements (including buildings) that are made upon that land. The term “interests in real property” includes (whether with regard to the actual land or the improvements on the land):

  • ownership interests,
  • coownership interests,
  • leasehold interests,
  • options to acquire the property, and
  • options to lease the property.

The definition of real property interests also encompasses timeshare interests (interests that grant the REIT the right to use real property only for a specified portion of each year) and stock in cooperative housing corporations.  Mineral, oil, and gas royalty interests are specifically excluded from the statutory definition of “interests in real property.”

The IRS has applied a “permanence” standard in determining whether improvements upon real property are considered real property for purposes of the REIT asset tests.  In one private letter ruling, the IRS found that manufactured homes are “inherently permanent structures.”

See related content on ThinkAdvisor’s 22 Days of Tax Planning Advice: 2015 home page.