Ownership Structures for Financing and Holding Real Estate | David E Wish

Ownership Structures for Financing and Holding Real Estate David E Wish

Chapter 20 Learning Objectives ▪ Understand that the ownership form is defined by legal considerations, but that the choice of ownership form is driven by institutional and economic considerations ▪ Understand the three main determinants of the form in which real estate is held, the federal tax environment, issues of personal liability, and access to equity capital markets ▪ Understand the basic tax regulations and legal considerations that govern each type of ownership form ▪ Understand the risks and returns of various ownership forms

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Ownership Structures for Real Estate Investment Sole Proprietorship C Corporation S Corporation Partnership Trust

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Sole Ownership Simple and inexpensive to create Taxed as individual - no double taxation No access to the capital markets Unlimited liability Loss deductibility subject to passive loss restrictions

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C Corporation Articles of incorporation Separate legal and taxable entity Limited liability to shareholders Losses do not flow through to shareholders Greater access to the capital markets Double taxation of income

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S Corporation ▪ Separate legal but not taxable entity ▪ Taxable income and losses flow through to shareholders ▪ Limited liability ▪ Cannot have more than 75 shareholders ▪ Income and losses allocated based on proportion of ownership

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General Partnership ▪ Income and losses flow through to partners as determined by partnership agreement and not by proportion of ownership ▪ No double taxation ▪ Unlimited liability for all partners ▪ Fairly uncommon in real estate

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Limited Partnership ▪ Personal liability for some partners limited to equity investment ▪ Must have at least one general partner ▪ General partner has management responsibilities ▪ No double taxation ▪ Income and losses flow through per the partnership agreement

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Master Limited Partnerships (MLPs) ▪ Creates one large partnership out of many smaller ones ▪ Increases liquidity and access to the capital markets ▪ MLPs investing in real estate are treated as partnerships and not corporations ▪ Income classified as portfolio income instead of passive income

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Real Estate Investment Trusts (REITs) ▪ Created by the Real Estate Investment Trust Act of 1960 ▪ Played limited role until early 1990s ▪ Since 1992, the REIT marketplace has increased dramatically

▪ Corporations that invest in real estate ▪ Advantages include limited liability, favorable tax treatment, and access to the capital markets

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REIT Requirements ▪ Income Requirements ▪ Distribute at least 90% of its taxable income to its shareholders in the form of dividends ▪ At least 75% of gross income from real-estate-related investments ▪ 95% of income derived from dividends, interest and property income

▪ Asset Requirements ▪ At least 75% of assets in real estate, loans secured by real estate, mortgages, other REITs, cash, or government securities ▪ No more than 25% of assets invested in taxable REIT subsidiaries

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REIT Requirements ▪ Ownership Structure Requirements ▪ Jointly owned by at least 100 shareholders ▪ Issue transferable shares ▪ No more than 50% of shares can be held by five or fewer investors during the last half of each taxable year ▪ Managed by one or more trustees or directors (individuals or corporations) ▪ Use independent advisory and management firms to manage its real estate properties

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REITs – Additional Regulations ▪ Cannot hold real estate property primarily for sale ▪ Sale of property under the following conditions: ▪ Property held at least for 4 years ▪ During the holding period, capital expenditures on the property <=30% of the sales price ▪ Max. 7 properties can be sold during the same year or the FV of properties sold <=10% of FMV of all REIT’s assets as of the beginning of the year ▪ The REIT must have not acquired the property through foreclosure

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REIT Types ▪ Equity REITs invest in and operate income-producing properties ▪ Mortgage REITs purchase mortgages ▪ Hybrid REITs invest in both – equity and mortgages ▪ Finite-life or self-liquidating ▪ Open-end REIT funds vs. closed-end REIT funds ▪ UPREIT or DownREIT ▪ All offer diversification and liquidity

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REIT Specialization ▪ Most REITs specialize in certain types of real estate ▪ REITs can focus on properties in a specific geographic region ▪ Some REITs specialize in residential mortgages – purchase FHA and VA insured loans and hold them for investment ▪ Few REITs specialize in derivative mortgage securities such as CMO residuals

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REITs – A Laboratory for Analyzing Capital Structure Decisions ▪ REITs’ main sources of capital: equity and debt ▪ REITs are not taxed at the entity level – no benefit from tax deductibility of interest ▪ Interesting case – opportunity to view the effect of leverage in a “no-tax world”

▪ Arguments for use of leverage ▪ Personal tax – if personal tax on equity is lower than that on debt interest more equity will be used ▪ Real estate good collateral for debt; if managers believe that equity is undervalued they will issue debt

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Factors Determining Ownership Form Amount of depreciation Holding period Amount of retained earnings Tax credits Use of debt financing Passive loss limitations

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Factors Favoring Corporate Ownership Large depreciable basis Long holding period Need to retain cash flows No tax credits available Financed by debt No passive income available

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Factors Favoring Partnership Ownership Small depreciable basis Short holding period Need to distribute cash flows Tax credits available Financed by equity Passive income available to be offset by passive losses

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Thank You

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