Cost Segregation for REITs 0
What is a REIT? A REIT or Real Estate Investment Trust, is a company that owns, operates or finances income-producing real estate. Modeled after mutual funds, REITs historically have provided investors of all types regular income streams, diversification and long-term capital appreciation. REITs typically pay out all of their taxable income in the form of dividends to the investors who in turn pay income taxes on those dividends. REITs were established by Congress in 1960 but the current structures largely came about in the late 1980s and 1990s. In 2016 REITs paid out over $55 billion in dividends and had a market capitalization over $1 trillion. Two primary types of REITs exist, Equity and Mortgage. Equity REITs invests in income producing properties where rent is collected and Mortgage REITs provide financing by purchasing mortgages and mortgage backed securities. Most (if not all) of the REITs that require cost segregation would be classified as Equity REITs. 1
What is a REIT, continued REITs can be public listed on exchanges, public non listed and private. To qualify as a REIT a company must meet the following requirements: – Invest at least 75 percent of its total assets in real estate, cash and cash assets – Derive at least 75 percent of its gross income from rents from real property, interest on mortgages financing real property or from sales of real estate – Pay at least 90 percent of its taxable income in the form of shareholder dividends each year – Be an entity that is taxable as a corporation – Be managed by a board of directors or trustees – Have a minimum of 100 shareholders – Have no more than 50 percent of its shares held by five or fewer individuals 2
The Asset Tests Really 6 tests but are Test 1 and 2 saying the same thing and what do we need to worry about? – Test 1 – the 75% Asset test • Allowed to include cash, cash items and government securities for purposes of measuring the INVESTMENT made – Test 2 – the 25% test • Much more complicated and designed to ensure that a REIT does not hold that much cash but that they hold real estate and that no more than 25% of total assets are held as securities. – Test 3 – the TRS limitation (the new rule – 2008) • Not more than 20% of the total assets can constitute securities of one or more TRS – Test 4 – Single issuer test • Not more than 5% of the value of total assets may consist of securities of any 1 issuer – Test 5 – Voting test • Not more than 10% of the outstanding voting power of any 1 issuer may be held – Test 6 • Not more than 10% of the outstanding total value of the outstanding securities of any 1 issuer So – what does the above have to do with cost segregation? 3
Asset Test Easy Answer – Do not screw with the Asset Tests at a REIT as no good will come of this for anyone! The benefits of doing a study for a REIT are far lower than the issues should a REIT fail the asset test. Are the rules we use on cost segregation for treating property as real and personal the same as what would be used for a REIT? Why have I never heard the 25% (or 75%) numbers being discussed but hear about a 15% test? Answer – not so simple REIT rules date back to pre ACRS days when facts and circumstances were “argued” more and permanency was a controlling factor in most of those conversations. Definitions are not always the same as we are in 2 different code sections. 4
Example of Differences How would we treat the below for cost segregation purposes? 5
Example of Differences 6
Big Government Caveat What exactly does this mean for us as we get into why we do a study for them? 7
Why Cost Segregation? • If a REIT is not taxable, why Cost Segregation? • Cash management for the REIT! – Accelerating depreciation can cause an increase in depreciation deductions in the near term – This decreases taxable income, therefore… • Impacts cash flow • Impacts money required to be distributed to shareholders, allowing the REIT to retain cash • Cash available can be used to reduce existing debt, acquire new properties or renovate/expand existing properties • Dividend Management – Increased depreciation expense reduces overall current taxable income – Lowering the amount required to be paid in the current period allows you to better manage future dividends – Gives flexibility around decisions regarding taxable income and dividend management 8
Why Cost Segregation? • REITs can utilize cost segregation to offset gain from the sale of an existing property – Sale of an existing property for a gain can increase the dividend requirement of the REIT – Example • A REIT sold a holding, which resulted in a $5 million gain. If the REIT does not make a distribution corresponding to this gain, the REIT itself would be required to pay 35% tax on the gain. The REIT can perform a retroactive cost segregation by filing a IRS Form 3115 - Change of Accounting Method . This cost segregation/tax study should “catch up” missed depreciation deductions, and any difference in depreciation should result in an offset of the gain. • Potential Property Tax and/or Transfer Tax Impact – The transfer of a deed is typically taxed based on the value of the real property in the transaction. Cost segregation may (based on local real and personal property definitions) favorably impact this tax through the identification of personal property prior to filing the closing documents. – Certain states with personal property tax provisions may have lower rates for personal property. In addition, personal property taxable basis typically DECREASES (whereas real property taxable basis INCREASES) which could also lead to reduced taxes over the holding period. 9
Why Cost Segregation? • Leasehold Improvement Loss – In the current economic climate, the status of many tenants is uncertain and space is being abandoned at historically high rates. – A lessor who disposes of a leasehold improvement may take the adjusted basis of the improvement into account when determining gain or loss if the improvement is irrevocably disposed of or abandoned by the lessor at the termination of the lease. – A Cost Segregation analysis can provide a breakout of tenant improvements and remaining tax basis for potential retirement at lease end. – For example, if the leasehold improvement is abandoned, the lessor may claim an ordinary loss in the amount of the improvements’ remaining basis, thus reducing taxable income in the year of retirement or lease end (abandonment). • Funds From Operations (FFO) – Cost segregation will not impact the financial reporting accounting or depreciation of tangible assets – GAAP is not impacted by cost segregation with the exception of taxes 10
Cost Segregation Scenarios • Retroactively on Owned Properties A cost segregation (and purchase price allocation) can be performed retroactively for properties already owned and operated by the REIT. We will work with the client’s accounting and tax personnel to gather data and invoices necessary to explore the “re- classification” of the existing tax bases to shorter lived depreciable recovery periods. A 481(a) depreciation (“catch up”) adjustment must be calculated and an IRS Form 3115 – Change of Accounting must be filed by a tax practitioner. • Upon Acquisition A cost segregation can be performed as part of the tax purchase price allocation upon acquisition. By determining the fair market value for the land underlying the facility, the real property and the personal property the acquiring taxpayer’s depreciation will be allocated between categories of the purchase date. • Greenfield Development (New Construction), Redevelopment and Expansions A cost segregation can be performed on new construction projects. We work with client project management to gain an understanding of the project. We will utilize general and subcontractor invoices, cost estimating techniques, project plans and specifications to assess the tax bases of the project in the appropriate depreciation recovery periods. 11
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