What Is a Captive Real Estate Investment Trust?
A captive real estate investment trust is simply a real estate investment trust (REIT) with controlling ownership by a single company.
A company that owns real estate associated with its business may find it advantageous to bundle the properties into a REIT for the special tax breaks. This tax mitigation strategy can be used by retailers and banks with many stores or branches.
- A captive REIT is any REIT with greater than 50% ownership stake by a single company.
- Captive REITs are usually subsidiaries of other firms.
- As REITs, captive REITs enjoy all of the tax advantages of a standard REIT.
- Comprehensively, captive REIT accounting can be complex for a parent company and the captive REIT subsidiary.
- Accounting and tax professionals should ensure they are fully compliant with all federal and state laws encompassing captive REITs.
Understanding Captive Real Estate Investment Trusts
A captive real estate investment trust can be created to take advantage of the tax breaks offered by a real estate investment trust (REIT). Companies may choose to develop or take controlling ownership in a REIT for captive status. Controlling or captive status is defined as more than 50% of the voting ownership stake of a REIT.
Companies that build a captive REIT to manage their own real estate properties will typically characterize them as either rental or mortgage REITs. Mortgage REITs (mREITs) provide mortgage capital for the promise of reciprocal income, which is often the basis for a REIT’s revenue. Companies may also use captive real estate investment trusts by transferring real estate into a REIT, and then renting the properties from those REITs.
Real Estate Investment Trusts
A captive REIT is a REIT with controlling ownership from a single company. Beyond that, captive REITs are simply REITs. An entity can be classified as a REIT if it meets certain requirements of the Internal Revenue Service and Title 26 of the Internal Revenue Code. REITs can be trusts, associations, or corporations—but regardless they must all elect to be taxed as corporations.
The Internal Revenue Code allows all REITs to distribute all of their income to their shareholders. This makes REITs similar to partnerships under the tax code since partnerships generally have no income and distribute all of their income through a K-1.
REITs must meet several requirements to qualify for the income distribution tax deductions that characterize REITs in general. Specifically, a company must meet the following requirements to qualify as a REIT:
- Taxable as a corporation
- Pay at least 90% of taxable income in the form of shareholder dividends each year
- Derive at least 75% of gross income from rents, interest on mortgages that finance real property, or real estate sales
- Invest at least 75% of total assets in real estate, cash, or U.S. Treasuries
- Have at least 100 shareholders (controlling companies may name executives as shareholders in order to meet this requirement)
If an entity meets the REIT requirements, it must pay at least 90% of its income to shareholders and is therefore allowed to take the income distribution as a deduction. Any remaining balance after the required distribution is taxed at the necessary corporate tax rate.
Captive REITs are considered subsidiaries and therefore their ownership must be accounted for in some way on the parent company’s financials. Generally, there are three ways to account for subsidiaries and subsidiary ownership on a parent company’s financial statements. Companies can report consolidated financial statements, or they may account for the ownership through either the equity method or the cost method.
Under Generally Accepted Accounting Principles (GAAP), companies have the option to create consolidated financial statements that integrate all aspects of a subsidiary's financials if the parent company owns greater than 50% of the ownership rights. Typically, it is not beneficial or applicable for a parent company to include a captive REIT in consolidated financial statement reporting. That's because of the tax benefits the captive REIT gets on its own, which are often the reason for creating it. Therefore, captive REIT ownership is typically accounted for on a parent company’s financials through either the equity method or the cost method.
Captive REIT Tax Benefits
There can be several tax benefits associated with captive REIT taxes. Federal taxation of REITs is discussed in Internal Revenue Code Title 26, but states may also have their own tax rules for REITs that can increase or decrease the tax benefits.
In general, the parent company of a captive REIT can deduct rent or mortgage payment costs it pays to its captive REIT, which reduces its taxable income. This is not necessarily a huge benefit because it would typically deduct these expenses anyway. Still, it can create some helpful advantages in payment processing, etc. One of the biggest advantages is that the parent company receives a part of the dividend distribution from the captive REIT, which can potentially be taxed at a lower rate.
The captive REIT enjoys all of the tax benefits of REIT status. It can deduct the 90% or greater amount of its income it distributes to shareholders. It also pays the federal corporate tax rate on any remaining income.
Laws Governing Captive REITs
Because captive REIT subsidiaries can potentially create several advantages, there are some federal and state provisions that target them. In general, most legislation defines captive as controlling ownership of 50%. Federal laws require that any treatments are fair and in line with property valuations and arm’s length negotiations.
Some states have their own special requirements. In some cases, there are limitations that may eliminate tax avoidance tactics comprehensively. Overall, accounting and tax professionals should ensure that captive REITs and captive REIT accounting are compliant with all federal and state laws.
Why Would a Company Form a Captive REIT?
REITs afford certain tax advantages, and so a company may seek to take a controlling stake in a real estate investment trust in order to enjoy those advantages. A captive REIT can also allow a corporation to more easily control and manage properties that it already owns.
Why Are Captive REITs Scrutinized by the IRS?
Because it can be a tax minimization strategy, accounting for a captive REIT properly and in compliance with state and federal tax guidelines. Moreover, since these entities are often structured as corporate subsidiaries, additional layers of tax consideration are warranted. Because captive REITs have been used before to avoid state or federal taxes, they are often scrutinized.
What Is a Non-Captive REIT?
A non-captive REIT is one that is not defined as captive; i.e., it does not have a single majority shareholder.