Tag Archives: Federal Taxation

Federal Taxation of Real Estate Investment Trusts REITs and FINCen’s Beneficial Owner Reports

General Definition of Real Estate Investment Trust:

For federal tax purposes, Internal Revenue Code Section 856 defines the term real estate investment trust as any corporation, trust, or association which is managed by one or more trustees or directors where the beneficial ownership is evidenced by transferable shares, or by transferable certificates of beneficial interest which would otherwise be taxed under the Internal Revenue Code as a domestic corporation. Financial institutions and insurance companies does not qualify as real estate investment trusts (REITs) under the Internal Revenue Code (26 U.S.C. Chapter 26). REITs must have more than five beneficial owners.

Some of the other requirements to qualify for tax treatment as a REIT are as follows:

Pursuant to IRC Sec. 856(c), a corporation, trust, or association is not to be considered a REIT for federal tax purposes for any taxable year unless-

1) It files with its return for the taxable year an election to be a real estate investment trust or has made such election for previous taxable year, and such election has not been terminated or revoked under subsection (g);

2) At least 95 percent (90 percent for taxable years beginning before January 1, 1980) of its gross income (excluding gross income from prohibited transactions) is derived from-

Dividends;
Interest;
Rents from real property;
Gain from the sale or other disposition of stock, securities, and real property (including interests in real property and interests in mortgages on real property) which is not property described in section 1221(a)(1);
Abatements and refunds of taxes on real property;
Income and gain derived from foreclosure property (as defined in subsection (e);
Amounts (other than amounts the determination of which depends in whole or in part on the income or profits of any person) received or accrued as consideration for entering into agreements (i) to make loans secured by mortgages on real property or on interests in real property or (ii) to purchase or lease real property (including interests in real property and interests in mortgages on real property);
Gain from the sale or other disposition of a real estate asset which is not a prohibited transaction solely by reason of section 857(b)(6); and
Mineral royalty income earned in the first taxable year beginning after the date of the enactment of this subparagraph from real property owned by a timber real estate investment trust and held, or once held, in connection with the trade or business of producing timber by such real estate investment trust;

3) At least 75 percent of its gross income (excluding gross income from prohibited transactions) is derived from –

Rents from real property;
Interest on obligations secured by mortgages on real property or on interests in real property;
Gain from the sale or other disposition of real property (including interests in real property and interests in mortgages on real property) which is not property described in section 1221(a)(1);
Dividends or other distributions on, and gain (other than gain from prohibited transactions) from the sale or other disposition of, transferable shares (or transferable certificates of beneficial interest) in other real estate investment trusts which meet the requirements of this part;
Abatements and refunds of taxes on real property;
Income and gain derived from foreclosure property (as defined in subsection (e));
Amounts (other than amounts the determination of which depends in whole or in part on the income or profits of any person) received or accrued as consideration for entering into agreements (i) to make loans secured by mortgages on real property or on interests in real property or (ii) to purchase or lease real property (including interests in real property and interests in mortgages on real property);
Qualified temporary investment income; and

4) At the close of each quarter of the taxable year-

At least 75 percent of the value of its total assets is represented by real estate assets, cash and cash items (including receivables), and Government securities; and
- (i) not more than 25 percent of the value of its total assets is represented by securities (other than those includible under subparagraph (A),
- (ii) not more than 20 percent of the value of its total assets is represented by securities of one or more taxable REIT subsidiaries,
- (iii) not more than 25 percent of the value of its total assets is represented by nonqualified publicly offered REIT debt instruments, and
- (iv) except with respect to a taxable REIT subsidiary and securities includible under subparagraph (A)-
  - Not more than 5 percent of the value of its total assets is represented by securities of any one issuer,
  - The trust does not hold securities possessing more than 10 percent of the total voting power of the outstanding securities of any one issuer, and
  - The trust does not hold securities having a value of more than 10 percent of the total value of the outstanding securities of any one issuer.

Obviously Internal Revenue Code Section 856 is an extremely complicated tax accounting provision and requires an extensive understanding of accounting concepts and practices. Organizations who might qualify under IRC Sec 856 will have to go through the various factors and accounting analysis that is depicted above. In addition, there are additional nuisances about qualifying for REIT tax treatment that I cannot go into in this blog. And before I turn to discussing the tax benefits from REIT tax treatment, take note that IRC Sec. 856 refer often to the term ‘beneficial owners’ of the organization.

Upcoming Beneficial Owners Information Reporting Requirements:

As we have seen so far during our discussion of United States taxation of Real Estate Investment Trusts pursuant to Internal Revenue Code Sec. 856, the term “beneficial owner” is extremely important for federal tax purposes since a Real Estate Investment Trust is a near pass-through entity. What I mean is that normal corporate tax status applies to REITs income as computed by the rules set forth in the Tax Cuts and Jobs Act of 2017. Typically, the bulk of a REITs income is passed through to the beneficial owners and are taxed at the beneficial owners’ personal tax rate. The tax effect of this favorable treatment is the avoidance of double-taxation. Remember, corporate earnings are taxed at the entity level and again when the earnings are distributed to the beneficial owners of the corporation. REITs avoid this double taxation by electing to be taxed as Real Estate Investment Trust. This in a nutshell is one of the main reasons why it’s extremely important to know the identity of the ‘beneficial owners’ for federal tax purposes. Now let’s talk about a legal development that every REIT and those who structure them must be fully aware.

On September 30, 2022, the Financial Crimes Network, “FINCen” issued a final rule requiring certain entities to file with FINCen beneficial owner reports that identify two categories of individuals: (1) the beneficial owners of the entity, and (2) individuals who have filed an application with specified governmental authorities to create the entity or register it to do business. These final FINCen regulations implement Section 6403 of the Corporate Transparency Act (CTA) enacted into law as a part of the National Defense Authorization Act for Fiscal Year 2021 (NDAA), describes who must file a report, what information must be provided to FINCen, and when the beneficial owner reports are due. The effective date of the rules is January 1, 2024. So beneficial owners and those who help them structure their entities, such as attorneys and other advisors must comply with these FINCen regulations effective January 1, 2024.

This upcoming change is important since many states’ business entity organizational codes do not require disclosure of beneficial owners when, say articles of organization are filed with, say the Secretary of State or some equivalent state agency in formation of, say a corporation, limited liability company or other legal entity structure. The term beneficial owner is defined in the FINCen rules as “the individuals who actually own or control and entity – or individuals who take the steps to create an entity. The Public Policy expressed in implementing the Corporate Transparency Act and these new FINCen regulations is stated to “help prevent and combat money laundering, terrorist financing, corruption, tax fraud, and other illicit activity….” FInCen is a department of the United States Treasury. FInCen is the same organization where financial interest in certain foreign bank accounts are reported annually pursuant to the Bank Secrecy Act. Those reports are known as FBARs and they are filed with FINCen on April 15^th of each year. In recent years there has been an automatic extension for FBAR (Form 114) to be filed. Remember, FINCen and the Internal Revenue Service are not the same federal agency; although over the years, they work together on FBAR and foreign account matters. As for the beneficial ownership reports, it is to be seen how closely the two agencies will work together with respect to these new ‘beneficial owner” reports. But it is clear, FINCen reports do not enjoy the privacy protections afforded tax returns filed with the IRS. They can be shared throughout the government and perhaps be made public. Therefore, the beneficial owners’ reports are likely to give the IRS very useful information when investigating tax fraud and tax evasion cases. Corporate transparency is the goal; so lots of organizations, agencies and individuals could benefit from the exposure on beneficial owners of American businesses. These recent legal and regulatory development are very important for anyone doing business in the United States subject to the new FINCen beneficial owner regulations and those who are starting new entities and their advisors, past, present and future. The beneficial owner regulations even apply to the smallest of companies if they are structured under a state’s business entity structuring laws, such as, mom and pop limited liability companies. For right now, let’s turn to discuss some specifics regarding how REITs are currently taxed under the Internal Revenue Code.

Federal Taxation of Real Estate Investment Trusts “REITs”:

The most significant thing about the taxation of REITs is that they are not taxed like regular corporations. Unlike regular domestic corporations, REITs are not taxed on its regular taxable income. Instead, REITs are tax on several categories of income at normal corporate tax rates applicable for the specific annual reporting period. Since The Tax Cuts and Jobs Act of 2017, REITs taxable income is the organization’s taxable income with the following adjustments and considerations:

Exclude net capital gains;
Required to comply with Internal Revenue Code Sec. 443(b);
Include dividends paid deduction for amounts paid to beneficial owners, but excluding net income contributed to foreclosure property transactions;
Exclude net income contributed by sales or transactions related to foreclosure property;
Exclude any income associated with REIT prohibited transactions;
Exclude dividend received in computation of REIT taxable income; and
Deduct taxes paid pursuant to Internal Revenue Code Sec. 857(b)(2).

Conclusion:

Real Estate Investment Trusts are just a business model used by real estate investors to pool their resources to invest in real property. The legal structure typically used by these real estate investment businesses are corporation, or limited liability company or trusts. Our federal tax laws treat REITs primarily as pass-through entities; similarly, to, but to a lesser extent, the way our federal tax laws treat partnerships, where the majority of the increments in wealth associated with REITs are passed-through to the beneficial owners and taxed presumably at the more favorable tax rates of the individual beneficial owners of the REIT. There is an awful lot of tax policy and tax accounting involved in structing and operating a business using this business model. And the new FINCen rules governing beneficial owners and those that aid in structuring them could likely make structuring an entity and operating in the REIT business model much more complex and cost intensive.

This law blog is written by the Taxation | Litigation | Immigration Law Firm of Coleman Jackson, P.C. for educational purposes; it does not create an attorney-client relationship between this law firm and its reader. You should consult with legal counsel in your geographical area with respect to any legal issues impacting you, your family or business.

Coleman Jackson, P.C. | Taxation, Litigation, Immigration Law Firm | English (214) 599-0431 | Spanish (214) 599-0432 | Portuguese (214) 272-3100

Federal Taxation and Cutting Horses: It’s Not Just About The Horses

Leave a reply

By: Coleman Jackson, Attorney, Certified Public Accountant
December 16, 2019

Recently I came across a United States Tax Court memorandum decision dated November 25, 2019 involving a South Dakota farmer with a cutting horse and seed business. The issues in the case that struck me were (1) whether the taxpayer’s cutting horse activity was an activity “not engaged in for profit” within the meaning of Section 183 of the Internal Revenue Code, and (2) whether the taxpayer should be required to pay the accuracy-related penalties under Section 6662(a) of the Internal Revenue Code. The case was Lowell G. Den Besten, Petitioner v. Commissioner of Internal Revenue, Respondent, T.C. Memo 2019-154 (November 25, 2019). Note that Tax Court Memo decisions cannot be used as precedent by other taxpayers. So this blogs aim is to pull general observations from the Besten case because federal taxation and cutting horses is not just about the horses.

The taxpayer won on two of the three issues argued before the U.S. Tax Court. The significant thing for other individuals and businesses who find themselves tangled in a spirited horse race with the IRS is not whether they are in the cutting horse business or whether or not they are in the seed business. The significant points of this case are (a) the IRS holds a presumptive correctness in all tax deficiency matters, and (2) the taxpayer always bears the burden to prove that; more likely than not, they are entitled to the deductions claimed on their tax returns. That means that the taxpayer must always maintain and produce credible substantiation of all items recorded on their tax returns. This has been operative tax law governing IRS deficiency cases ever since the United States Supreme Court ruled on these two points in a pair of federal tax cases known as Welch v Helvering, 290 U.S. 111, 115 (1933) and New Colonial Ice Co., v. Helvering, 292 U.S. 435, 440 (1934). Guy Tressillain Helvering, a Democrat from Kansas was the Commissioner of the Internal Revenue of the Bureau of Internal Revenue from 1933 to 1943. This is the legacy agency of the Internal Revenue Service. Today, typically tax cases are styled “Taxpayer v. Comm’r”. Anyway, locks on doors are preparatory. Folks put locks on their doors to prepare for when the thief comes. The same way, taxpayer’s must collect, summarize, and maintain substantiation for all deductions claimed on their tax returns in the event the IRS examiner visits. In the 2019 Besten case, we see the U.S. Tax Court applying the rules established in the 1930s. In tax law and in law in general, predictability matters; there is little benefit of surprise, duplicity and uncertainty in law. Taxpayers can prepare and comply with the law if they know the applicable law because federal tax law is not just about the horses.

Internal Revenue Code Section 6662 permits the IRS to assess a 20% accuracy penalty on tax deficiencies. The accuracy-related penalties can be imposed by the IRS when tax deficiencies are due to the taxpayer’s negligence, recklessness or willful violations of the federal tax laws. In the Besten case, the taxpayer avoided paying the accuracy-related penalty because he was able to adequately convince the U.S. Tax Court that he acted reasonably and acted in good faith by relying on the professional advice of his tax professional. This is often a viable defense for the taxpayer who can meet the burden that they (a) relied on the advice of their tax professional, (b) their tax professional was competent and experienced, and (c) they gave their tax professional accurate and complete information and documentation regarding the tax issue. So this particular reasonable cause defense (reliance of the tax professional’s advice and guidance), like the other reasonable cause defenses that might be applicable, depends on all the facts and circumstances because federal taxation and cutting horses is not just about the horses. Reasonable cause defenses are not automatic relief; but like cutting horses, every reasonable defense should be explored when confronting additional taxes, penalties and interest, because cutting cost is another way of saving money.

This law blog is written by the Taxation | Litigation | Immigration Law Firm of Coleman Jackson, P.C. for educational purposes; it does not create an attorney-client relationship between this law firm and its reader. You should consult with legal counsel in your geographical area with respect to any legal issues impacting you, your family or business.

Coleman Jackson, P.C. | Taxation, Litigation, Immigration Law Firm | English (214) 599-0431 | Spanish (214) 599-0432

Federal Taxation of Old Age, Survivors and Disability Insurance Relief