There are many considerations that need to be made when forming a new real estate investment trust (REIT). With the formation of a REIT, there are a few key elections that need to be made in a timely manner to help ensure your REIT gets off to a good start. This article will examine the key elections, timing, and how to overcome a missed election.
REIT Formation
Internal Revenue Code Section 856(a) defines a REIT for federal income tax purposes. We will focus on 856(a)(3), which further defines a REIT as “… which (but for the provisions of this part) would be taxable as a domestic corporation …” Stated differently, to elect REIT status, a taxpayer will need to have an entity that is taxed as a corporation before that election can be made. It is common in these circumstances for taxpayers to organize an LLC for this purpose. For federal income tax purposes, the default treatment of an LLC with a sole owner is classified as a disregarded entity; however, if there are multiple owners, the default treatment is to classify the entity as a partnership. In this case, Form 8832, Entity Classification Election, will need to be filed to elect treatment of the LLC as a C corporation. The REIT election itself is made by filing a tax return on Form 1120-REIT.
An election made on Form 8832 cannot take effect more than 75 days prior to the date the election is filed or up to 12 months after the date the election is filed. However, what happens if you miss the due date for the period that the election is needed? This is a common pitfall, and as such, the IRS has outlined rules for late election relief under Revenue Procedure (Rev. Proc.) 2009-41.
Pursuant to Rev. Proc. 2009-41, if each of the following requirements is met, the IRS will treat the late-filed Form 8832 as effective as of the originally requested effective date:
- The entity failed to obtain its requested classification solely because Form 8832 was not timely filed;
- Either:
- A tax return has not been filed for the period in question because the due date has not yet passed, or
- The entity has timely filed all federal tax returns consistent with its requested classification;
- There is reasonable cause for the failure to file it timely; and
- Three years and 75 days have not passed from the requested effective date.
Taxable REIT Subsidiaries
REITs are subject to a couple of income tests that are in place to ensure the REIT generates passive income that is closely connected with rental real estate activities rather than active trade or business activities. A hotel is a commonly held asset by REITs; however, the income generated by the hotel would not be eligible for either of the income tests. To assist in complying with the REIT rules, an entity called a taxable REIT subsidiary (TRS) must be formed and an independent contractor engaged to manage the hotel activities. A TRS is taxable C corp that is owned 100% by the REIT. To become a TRS, a joint election must be filed on Form 8875, Taxable REIT Subsidiary Election. In addition, if your TRS is organized as an LLC, you will need to file Form 8832 as described above to have the entity treated as a C corp.
Form 8875 has similar due dates to Form 8832 and is effective no earlier than two months and 15 days prior to filing or up to 12 months after the date of filing. Unfortunately, unlike with Form 8832, if the filing date is missed for Form 8875, there is no streamlined late election relief. If this election is missed, a private letter ruling must be filed with the IRS. The cost of a private letter ruling can be significant between user fees paid to the IRS as well as the fees incurred for a CPA or attorney to draft the private letter ruling request for submission. However, the fees incurred to prepare and file the private letter ruling request likely will not outweigh the impact of losing your REIT status and having the real estate and operations held in total by a taxable C corp.
Navigating the REIT world can get overwhelming. If you are considering forming a REIT or have an existing REIT, please reach out to one of our professionals.