A real estate investment trust (REIT) owns qualified real estate assets and pays dividends to investors, thus avoiding having to pay corporate income tax. However, in some cases it makes strategic sense for REITs to own entities or businesses that don’t qualify for special REIT tax treatment alongside their core income-producing real estate assets. This is made possible by taxable REIT subsidiaries.
What is a taxable REIT subsidiary?
A taxable REIT subsidiary (TRS) is a corporation owned by a REIT that elects to be taxed at the regular corporate income tax rate. TRSs provide REITs the flexibility to hold, up to 20% of their total assets, entities that otherwise wouldn’t be permissible in the REIT structure. In other words, REITs can keep related assets or businesses together in one corporate entity and pay tax on just the portion held in the TRS.
Taxable REIT subsidiaries in practice
Taxable REIT subsidiaries are most commonly used in three types of REITs:
- Hotel REITs
- Healthcare REITs
- Mortgage REITs
Hotels and healthcare facilities are operationally intensive real estate assets that involve activities outside the scope of the REIT structure (e.g., hotel management). Mortgage REITs often operate fee-based asset management platforms or mortgage origination/securitization businesses, which are not permissible activities within the REIT structure. Thus, all of these companies use taxable REIT subsidiaries to avoid having to separate their businesses into different pieces, based on which pieces qualify for a REIT and which do not.
Origin of taxable REIT subsidiaries
Taxable REIT subsidiaries were introduced in the REIT Modernization Act of 1999 to provide REITs with the flexibility of owning non-REIT assets or businesses. Before then, REITs with operationally intensive real estate (e.g., hotels) were restricted to owning the four walls of the building and not participating in the economics of the underlying hotel business. This led to conflicts of interest and an overall inefficient industry structure. Since then, there have been some updates over the years -- namely, in 2007, when the REIT Investment Diversification and Empowerment Act of 2007 (RIDEA) permitted healthcare facilities to take advantage of the TRS structure.
REIT asset and income tests
Before further exploring the uses of taxable REIT subsidiaries, it makes sense to step back and examine a couple of REIT rules to provide some context:
- REIT asset test
- REIT income tests
The REIT asset test requires that at least 75% of the total value of a REIT’s assets consist of real property (land and buildings), mortgages on real property, and shares or debt in other REITs.
The REIT income tests require that a certain portion of a REIT’s income comes from qualifying sources. The “75% test” requires that at least 75% of a REIT’s income comes from rents from real property, interest from mortgages on real property, gains on the sale of real property, and dividends from other REITs.
The “95% test” requires that at least 95% of a REIT’s income comes from all of the same sources as the 75% test but broadened to include a few other sources like interest income, gains from the sale of stock or securities, and all dividend income.
If a REIT is not able to meet the above tests, one solution is to set up a TRS to hold an asset or receive income that's nonqualifying under the REIT structure.
Hotel REITs were the first real estate asset class to enjoy the benefits of taxable REIT subsidiaries after TRSs were introduced in 1999. The mechanics of the TRS structure in the hotel REIT industry are that a hotel REIT leases the real estate to a TRS held within the REIT, and then the TRS hires a third-party manager to run the hotel. With this structure, the REIT participates in the full economics of the hotel, less a management fee paid to a third-party hotel manager. The top third-party hotel managers today include companies like Aimbridge Hospitality, Highgate, Crescent Hotels & Resorts, HEI Hotels & Resorts, and Pyramid Hotel Group.
In 1999, when taxable REIT subsidiaries were first created for the benefit of hotel REITs, healthcare REITs were not permitted to utilize them. At that point, healthcare REITs were viewed as “financing vehicles” that were not involved in the management and operation of their real estate. This changed in 2007 with RIDEA, which permitted healthcare REITs to participate in the full economics of their underlying businesses.
The first REIT to make use of the RIDEA structure was Health Care REIT -- now Welltower (NYSE: WELL) -- through the 2010 acquisition of a senior housing portfolio it operated via a third-party manager. Today, the top senior living managers include companies like Brookdale Senior Living (NYSE: BKD), Life Care Services (LCS), Holiday Retirement, Five Star Senior Living (NASDAQ: FVE), and Sunrise Senior Living.
A taxable REIT subsidiary (TRS) is different from a qualified REIT subsidiary (QRS) in that a QRS doesn’t have any different tax structure or treatment than the overall REIT. A QRS is simply a corporation wholly owned by the REIT and included as part of the overall REIT for the purpose of measuring the REIT asset and income tests, described above.
The Millionacres bottom line
Taxable REIT subsidiaries evolved out of the need to correct inefficient industry structures in the hotel and healthcare industries. Specifically, TRSs eliminated the need for hotel REITs and healthcare REITs to separate their business into different pieces based on REIT qualification rules. Since then, TRSs have helped facilitate the successful conversion of other industries into the REIT structure (e.g., data centers). This has benefited investors by increasing the menu of investable options in the REIT universe. As the REIT industry continues to evolve, taxable REIT subsidiaries will no doubt be an important piece of the industry going forward.