Asset managers have shown increasing interest in retail funds with private real estate portfolios over the last few years. Many of these funds are registered with the SEC under the Investment Company Act of 1940 as interval or tender offer funds. Placing certain asset classes, like real estate or private credit secured by real property (another type of real estate asset), in a 1940 Act wrapper is providing asset managers an opportunity to differentiate their product offerings.
What’s really interesting is the tax structure of these funds. Traditionally, mutual funds are structured as Regulated Investment Companies (RICs). Generally, RICs mostly invest in securities, not real estate, due to various tax law limitations. A private real estate fund, with a portfolio that is entirely real estate holdings, would have to be structured as a Real Estate Investment Trust (REIT) for tax purposes. Below sheds some light on how the REIT compares to a RIC when it comes to taxation.
Overview of REIT and RIC Taxation
Both REITs and RICs fall under the tax rules of Subchapter M and must meet certain requirements, such as distributing most of their taxable income to investors and complying with asset and income requirements. Once these requirements are met, both REITs and RICs are allowed to take a deduction for dividends paid to shareholders, thus potentially reducing taxable income to zero and resulting in zero federal tax to pay. In practice, most funds strive to distribute all income to investors and ultimately not pay any tax.
Avoiding double taxation is the biggest benefit of both of these funds, and the two tax structures are fairly similar in terms of compliance requirements and other benefits. The big difference between the two is generally in portfolio composition (asset and income restrictions are discussed in the table below).
How Do the Tax Compliance Requirements for REITs and RICs Compare?
The table below details some of the key tax compliance differences and similarities between the two structures. An interesting item to note is that the tax code allows for a wide range of real estate related investments, such as real estate debt and mortgaged-backed securities, to qualify as a “real estate asset” for purposes of REIT compliance.
||Regulated Investment Company
||Real Estate Investment Trust
||• Registered under the 40 Act
• Election to be taxed as a RIC
• Owned by 100 or more persons
• Election to be taxed as a REIT
|Annual Income Test
||• At least 90% of gross income from securities
||• At least 75% of gross income from real estate-related sources
• At least 95% of gross income from real estate-related sources plus interest, dividends and gains from securities
||• At least 90% of investment company taxable income and tax-exempt income
||• At least 90% of REIT taxable income, plus excess foreclosure income, minus excess noncash income
|Quarterly Asset Tests
||• At least 50% of total assets in cash, government securities, other RICs, and securities of issuers representing less than 5% value of total assets and not more than 10% of outstanding voting securities of an issuer
• Not more than 25% of total assets is invested in any one issuer, two or more issuers controlled by RIC, and qualified publicly traded partnerships
|• At least 75% of total assets in real estate assets, government securities and cash
• Not more than 20% in one or more taxable REIT subsidiaries
• Not more than 25% in securities or nonqualified publicly offered REIT debt instruments
• Not more than 5% of total assets is securities of any one issuer
• Does not hold securities of more than 10% voting of or value of an issuer (except taxable REIT subsidiary)
What are the Ultimate Tax Benefits of a REIT?
The combination of the type of SEC registration and the type of tax status provides 1940 Act REIT investors with similar benefits to traditional 1940 Act RIC funds — such as avoiding federal income tax at the fund level, blocking unrelated business taxable income, blocking state exposure, simplicity of reporting and others.
An investor in either tax structure would have income reported to them on Form 1099DIV. For a REIT investor, this reporting is a significant improvement to the cumbersome Schedule K-1 tax compliance generally associated with investing in a real estate private partnership.
Similar to RICs, the REIT structure blocks state tax exposure for investors. While this is less relevant for RIC shareholders, generally anyone invested in private real estate has to be concerned about state taxes and potential exposure to multiple jurisdictions.
Lastly, there is an additional benefit available to REIT investors through 2025. Taxpayers are allowed a 20% deduction on qualified REIT dividends under Section 199A.
Investment Adviser Consideration
While REITs have been around for a long time, they have not generally existed in the investment company space until fairly recently. This investment vehicle can provide numerous tax benefits, serving as a valuable option to investing in private real estate. However, deciding on the most beneficial tax structure for your investors is a complex question that should involve close collaboration with your tax advisers.
Contact Andreana Shengelya at email@example.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.