An Introduction to REITs.

• Author: Bakale, Anthony

A real estate investment trust (REIT) is an investment vehicle that enables small investors to invest in large-scale income-producing real estate. Congress decided that the only way for average investors to invest in large-scale commercial properties was through pooling arrangements, in which small investors pool their capital and share in the benefits of real estate ownership. As a result, REITs were created by the Real Estate Investment Trust Act of 1960.

The REIT legislation was intended to provide substantially the same tax treatment for REITs that existed for regulated investment companies (RICs). Similar to RICs, REITs are treated as conduits through which "qualified" income distributed to shareholders is not subject to a corporate-level tax. In the context of a REIT, qualified income is generally passive income from real estate investments (as opposed to income from the active operation of a trade or business). REITs, like RICs, may deduct from their taxable income dividends distributed to shareholders, thus avoiding a Federal income tax at the entity level.

REITs played a limited role in real estate investment until the 1990s. In the early years, REITs were constrained, because they were only permitted to own real estate and not to operate or manage it. This was consistent with the view that REITs were passive investment conduits for holding real estate. The Tax Reform Act of 1986 permitted REITs, for the first time, not only to own, but also to operate and manage, most types of income-producing commercial properties. Today, there are about 300 REITs operating in the U.S., with total assets in excess of $300 billion; about two-thirds of these trade on the national stock exchanges.

REITs are subject to a myriad of technical and complex rules.

A REIT is a corporation, trust or association that meets the requirements of Sec. 856 and elects to be treated as a REIT. There are two basic REIT structures in use today. In the DownREIT structure, a property owner contributes property to a REIT in exchange for REIT stock. This is generally a taxable transaction. DownREIT contributions are taxable under Sec. 351(e), which excludes contributions of appreciated property to corporations that are considered investment companies from the nonrecognition of gain provisions. An alternative to the Down REIT is the umbrella partnership REIT (UPREIT) structure, which was first used in 1992. An UPREIT is a REIT that holds all or substantially all of its properties through a single operating partnership with the REIT as the general partner and others as limited partners. The principal benefit of the UPREIT structure is that k permits real estate investors to defer built-in gains that would be recognized if appreciated properties were contributed directly to a REIT in exchange for its stock.

The basic provisions for REITs appear in Secs. 856-859; other Code sections contain special rules for REITs. A REIT is subject to certain organizational requirements and operational rules. Under the...