06/24/2015 10:38 am ET Updated Jun 23, 2016

REITs -- Benign, Benevolent Structures

REITs (real estate investment trusts) have come under intense scrutiny. The media and lawmakers criticize REITs because they erode the corporate tax base. A careful study reveals, however, that even though they may erode the corporate tax base, REITs do not seriously affect government tax revenue, so they are benign from a tax-revenue perspective. Study also shows that REITs provide greater transparency of real estate ownership and help stabilize real estate markets, so they provide non-tax benefits. Thus, REITs are benevolent from a non-tax perspective.

Why the Concern?

The biggest problem with REITs is that they flunk the "eye test"--they look bad to the lay observer. REITs hold only real estate assets, and they do not pay tax like regular corporations. Instead, REIT shareholders pay tax on a REIT's distributed taxable income. By contrast, regular corporations pay tax on their taxable income, and their shareholders pay tax on distributions. Distributed taxable income of a regular corporation is subject to two levels of tax (corporate and shareholder), but distributed REIT income is subject to a single level (shareholder).

Regular corporations can spin off of their real estate assets into a REIT. A REIT spinoff erodes the corporate tax base--before a spinoff, real estate income is subject to corporate tax; after the spinoff, the real estate income is not subject to corporate tax. That corporate-tax-base erosion looks bad, so it concerns some people. Corporate-tax-base erosion does not, however, necessarily cause the government to lose tax revenue, and the overall tax-revenue effect of REIT spinoffs is nominal.

Nominal Tax-Revenue Effect of REIT Taxation

The tax-revenue effect of REITs is nominal for two reasons--(1) only a small fraction of regular corporate income is subject to double tax, and (2) individual REIT shareholders pay a higher tax rate than shareholders of regular corporations. Only distributed corporate income is subject to two levels of tax. On average regular corporations distribute only about 25% of their taxable income, so most corporate income is subject to a single level of tax. By contrast, REITs distribute more than 100% of their taxable income (the law requires them to distribute at least 90%).

Individual REIT shareholders pay tax on REIT dividends at the highest tax rates, but dividends from regular corporations can qualify for lower tax rates. Consequently, the tax paid on REIT taxable income can be greater than the tax paid on taxable income of a regular corporation, and corporate-tax-base erosion is a red herring in this analysis.

An example illustrates why corporate-tax-base erosion is a red herring and why REITs may not negatively affect tax revenues. The highest corporate tax rate is 35%, and the tax rate for individual shareholders on dividends from regular corporations is about 24%. If a regular corporation had $100,000 of taxable income, it would pay $35,000 of tax ($100,000 × 35%) and have $65,000 to distribute to its shareholders. If the corporation distributed that amount to individual shareholders, they would pay $15,600 of tax ($65,000 × 24%) on the distribution. The total tax would be $50,600 ($35,000 + $15,600).

By contrast, if the corporation distributed only 25% of its taxable income, the shareholders would pay $6,000 of tax ($25,000 × 24%) on the distribution. Assuming the corporation paid $35,000 of tax, the total tax would be $41,000, which would reflect a more accurate amount of tax paid on corporate taxable income. The low distribution ratio of regular corporations significantly affects the amount of tax paid on corporate taxable income.

Now consider the tax paid on REIT taxable income. The highest tax rate on REIT dividends paid to individual shareholders is greater than 43%. If a REIT had $100,000 of taxable income and distributed that income to individual shareholders, the shareholders would pay more than $43,000 of tax on that income. That amount is $2,000 more than the $41,000 of tax typically paid on a $100,000 of taxable income of a regular corporation. Under these assumptions, even though the REIT income is not subject to a corporate-level tax, the government can raise more tax revenue from the REIT income. Corporate-tax-base erosion does not negatively affect tax revenue in this situation.

The composition of shareholders can affect tax revenue. For example, taxable income distributed to tax-exempt entities may be exempt from tax, and taxable income distributed to foreign shareholders can be subject to lower rates. Consequently, REIT taxable income distributed to tax-exempt entities may not be subject to tax at all, and taxable income distributed to foreign investors may be taxed at lower rates. The tax treatment of tax-exempt entities and foreign investors makes the tax-revenue effect of REITs slightly negative, but REITs are benign from a tax-revenue perspective because the tax-revenue effect is nominal.

Non-Tax Rationale for REIT Spinoffs

Even though REIT spinoffs do not significantly affect tax revenue, they are popular among investors and managers of some corporations for at least two reasons. First, REITs distribute all of their taxable income, and investors prefer investments with current distributions over those that retain cash. Second, REIT spinoffs provide financial benefits by removing debt from corporate balance sheets. Even though an operating corporation has a long-term lease obligation following a REIT spinoff, rating agencies treat that long-term obligation differently from typical debt, so REIT spinoffs can improve the debt ratings of a corporation. The improved ratings should lower a corporation's cost of capital, so managers of some corporations do REIT spinoffs. If a company is financially healthy, however, a REIT spinoff would not provide such benefit, and managers generally prefer to keep all assets under common control. Consequently, REIT spinoffs are very rare, and some observers believe they are the province of ailing corporations.

Benefits of REIT Taxation

The non-tax benefits of REITs outweigh their nominal tax-revenue effect. REITs provide average individual investors the opportunity to invest in real estate portfolios under a tax scenario that is similar to that available to investors who have resources to directly invest in real estate. As more REITs begin to form with more types of real estate, the opportunities increase for average investors to further diversify their real estate holdings.

REITs also channel significant amounts of capital to real estate markets and help to stabilize those markets. A study shows that commercial real estate fared much better than residential real estate during the Great Recession because of publicly-traded REITs. Publicly-traded REITs provide information to the public that helps investors make decisions about the supply and demand of real estate and the proper debt levels that real estate can sustain. Institutional investors help monitor REIT managers, which can positively affect REIT performance.

Because REITs provide greater investment opportunities to average investors, channel capital to real estate markets, help stabilize real estate markets, and react positively to institutional monitoring, they are benevolent.

Even though REITs erode the corporate tax base, they only nominally affect tax revenues, and they provide significant non-tax benefits. REITs are good, and the criticism they have received doesn't hold up under careful scrutiny. The primary shortcoming of REITs is that they look bad to the casual observer, but that is no reason to tinker with a well-functioning tax regime.