Mortgage REITs: When should one be used? Mortgage REITs have numerous tax advantages over C corporations and partnerships with respect to operating and investing in debt securities.

• Author: Stern, Craig
• Position: Real estate investment trusts

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...