A public real estate investment trust (REIT) is a security that trades on the major stock exchanges and usually owns income-generating commercial real estate properties. Most of these REITs are registered with the Security and Exchange Commission (“SEC”). They are also known as publicly-traded REITs.
A REIT is similar to a regular corporation but has a few crucial differences. For example, REITs do not pay federal corporate income tax on REIT-level income paid to shareholders. As a result, if a REIT earns $100 of income and distributes $100 to its shareholders, the REIT does not have to pay tax on that income.
According to the SEC, a company that qualifies as a REIT may deduct from its corporate taxable income dividends paid to its shareholders. Due to this special tax treatment, most REITs pay their shareholders at least 100% of their taxable income. As a result, they do not owe corporate tax. REITs usually pay little or no federal income tax.
REITs must distribute at least 90% of their income annually to shareholders. As a result, the yield is attractive to investors. In 1960, Congress established REITs to allow individual investors to own stakes in commercial real estate, similar to investments in companies in other industries.
Real estate investment trusts are required to abide by IRS https://www.irs.gov/instructions/i1120rei regulations.
REIT regulations include:
* No more than 50% of shares should be held by five or fewer people during the second half of the taxable year.
* Each REIT must have at least 100 shareholders after the first year.
* The REIT must pass three asset tests each calendar quarter. It must invest at least 75% of its total assets in cash, U.S. government securities, and real estate assets such as investments in land, buildings, and other permanent structures (including fee ownership, easements, and leases), and loans secured by mortgages on real estate (real estate securities). Second, REIT assets cannot be more than 5% in the securities of a single issuer. Third, a REIT cannot own securities that equal more than 10% of a single issuer’s voting power or value.
* The REIT must pass a gross income test and receive at least 75% of gross income from real estate, such as real property rents, interest on mortgages financing the real property, or real estate sales.
* Each REIT must return at least 90% of taxable income in shareholder dividends annually, making these investments popular among investors.
If REITs comply with the IRS’s requirements, they won’t pay corporate-level tax. In turn, REITs can finance real estate at a lower cost than non-REIT companies. Therefore, REITs can potentially generate more profit that will be provided to investors. Over time, real estate investment trusts can expand and increase dividends.
Along with publicly traded REITs, there are also non-traded REITs. As the name implies, they are not listed nor traded on public stock exchanges. Similar to publicly traded REITs, non-traded REITs enable investors to obtain diversified real estate investments without major capital requirements and additional tax benefits.
The Up-C name is derived from the Up-REIT structure, popular in the 1990s. The structure enabled property owners to swap their property for shares in the Up-REIT, usually tax-free. What was the advantage of that arrangement? Up-REITs enabled investors to have a stake in diversified real estate portfolios and the ability to generate liquidity. The Umbrella Partnership C Corp. (Up-C) structure shares some of the same advantages.
Normally, companies established as partnerships choose a traditional path to an IPO by converting to a C corporate entity, used to accumulate capital in the public exchanges by floating shares. In contrast, the Up-C structure has several benefits: It enables pass-through entities (such as partnerships) to achieve favored tax treatment for pre-IPO investors and the newly created publicly traded corporation while also tapping the capital markets.
The UP-C structure contains two parts: one entity is taxed as a partnership, and the other is taxed as a corporation. The pass-through entity (the operating partnership or OP) owns all the business’s assets and operations. The pass-through entity has flexibility when choosing a legal entity that is taxable as a partnership by U.S. tax law. Usually, they are set up as a limited partnership (LP) or a limited liability company (LLC).
The pre-IPO owners maintain their interest in the pass-through OP, so their share of the profits is not subject to an entity-level tax. However, public investors indirectly own their interests in the OP via an entity called the PubCo, set up as a C corporation or other legal form and taxed as a C-corporation.
Once the PubCo is formed, it has two classes of common stock, Class A and Class B. Class A shares are sold to the public in the IPO and Class B shares are owned by Pre-IPO owners. Class A shares have voting and economic rights. However, class B shares are not publicly traded and are owned by the pre-IPO owners. The shares have voting rights but not economic rights.
The Advantages of the Up-C Structure
* A Up-C can tap public markets as a publicly traded corporation and keep a pass-through structure’s tax benefits.
* Pre-IPO investors can obtain significant incremental proceeds on exit by creating a tax receivable agreement (TRA).
* The arrangement creates additional liquid assets for Pre-IPO investors who can trade their interests in the operating entity for shares of the publicly traded company.
* Pre-IPO investors maintain control of the company’s consolidated operations by owning a controlling percentage of voting shares in the publicly traded company (it typically has exclusive operational control of the pass-through operating entity).
* Pre-IPO investors retain continued entrée to tax distributions from the pass-through operating entity and circumvent double taxation.
Important Up-C Advantage
Let us consider a traditional route to an IPO for a C corporation. If investors switch a partnership to a C corporation and then launch an initial public offering (IPO), that results in double taxation. The double taxation results from the “built-in gain inherent in the partnership assets at the time the firm was converted to a C corporation,” according to Jeffrey N. Bilsky, CPA, and Avi D. Goodman, CFA, CPA. The partners are taxed when they ultimately sell the shares received for their partnership interests, and the corporation is also taxed on the future disposal of partnership assets that were purchased.
In contrast, an IPO launched with the Up-C partnership structure has only a single layer of taxation on the built-in gains as part of converting the partnership assets. Pre-IPO investors receive tax distributions from the pass-through configuration, thus avoiding double taxation.
A UP-C can gain access to public markets as a publicly traded company while holding on to a pass-through structure’s tax advantages. Pre-IPO investors can obtain significant incremental earnings when deposing their shares by establishing a tax receivable agreement (TRA). Law firm Simpson Thatcher & Bartlett LLP sums up the Up-C’s tax benefits by writing: “By implementing a UP-C structure instead of more traditional IPO structures and interesting to tax receivable agreements, pre-IPO owners of businesses taxed as partnerships can receive substantial post-IPO tax benefits.”
Investors can use an Up-C structure for all industries and sectors, but private equity portfolio companies have been the largest users of the structure. Since 2018, “more than 50 [private equity portfolio] companies have gone public using an Up-C or an Up-SPAC structure,” according to pwc.
The Up-C structure has been popular among companies backed by private equity or venture capital because these companies prefer favor flow-through entities to retain their investments in portfolio companies. From 2010 to 2019, of the closely held companies that floated IPOs, 74 used the Up-C structure, as reported by the Financial Times.
The advantage of the structure is that companies with the Up-C structure can offer shares through a publicly held company that possesses a portion of the underlying limited liability company, and some corporate executives and early investors still maintain their economic interests.
Once the Up-C is public, it can obtain a step-up in the tax basis of its share of partnership assets if the Up-C’s operating partnership files a Sec. 754 election. This basis step-up, in many cases, “will be allocable to depreciable fixed assets or intangible assets, resulting in additional tax deductions,” according to Bilsky, CPA, and Goodman, CFA, CPA.
REITs are real estate companies obligated to disburse high dividends to maintain the tax benefits of REIT status. According to the SEC, a company that qualifies as a REIT may deduct from its corporate taxable income dividends paid to its shareholders. Due to this special tax treatment, most REITs pay out at least 100% of their taxable income to their shareholders and, as a result, owe no corporate tax. REITs usually pay little or no federal income tax. In contrast, most of the tax benefits in the Up-C structure is maintained by the pre-IPO investors through a Tax Receivable Agreement (“TRA”)
The Up-C structure can be an appealing, tax-efficient alternative for businesses taxed as partnerships interested in going public. An IPO launched as an Up-C avoids double taxation due to built-in-gains that occur when converting a partnership to a publicly traded C corporation. In the normal conversion of a partnership, partners are taxed on their ultimate sale of the shares they receive to compensate them for their partnership holdings, and the company is taxed on future sales of partnership assets that were purchased.
An IPO that chooses the Up-C partnership structure has one layer of taxation on the built-in gains that occur with the partnership assets during the conversion. The pre-IPO owners can keep their interests in the pass-through OP, and as a result, their share of the corporate profits and revenues are not exposed to an entity-level tax. Public investors own their shares in the OP indirectly through an entity (PubCo) established as a corporation or other legal form taxable as a C-Corporation.
About Caliber (CaliberCos Inc.) (NASDAQ: CWD)
With more than $2.9 billion of managed assets, Caliber’s 15-year track record of managing and developing real estate is built on a singular goal: make money in all market conditions. Our growth is fueled by our performance and our competitive advantage: we invest in projects, strategies, and geographies that global real estate institutions do not. Integral to our competitive advantage is our in-house shared services group, which offers Caliber greater control over our real estate and visibility to future investment opportunities. There are multiple ways to participate in Caliber’s success: you can invest in Nasdaq-listed CaliberCos Inc. and/or you can invest directly in our Private Funds.
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