REIT or partnership? A real estate owner’s decision guide

Partnership vs. REIT structure: What’s the difference?

A partnership is governed largely by what the partners agree to. A REIT is governed by what the tax code requires in order to stay qualified.

The factors that differ between a partnership and REIT structure carry different weights. Ownership concentration and qualifying income decide whether a REIT is possible, and the rest determine whether a REIT is the best fit for a property, its owners and its investors.

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Questions to ask before choosing a structure

Owners should evaluate these key questions before choosing a structure.

1. How concentrated is ownership?

A REIT needs at least 100 shareholders, and five or fewer individuals can't own more than half its value during the last half of the tax year. Both rules apply after the first taxable year, so a REIT can be formed before they're met, but it can't operate that way for long. For an owner who wants to keep control and value concentrated in a small group of partners, that can mean bringing in owners who aren't there today.

2. Who is investing?

"Your investor base plays a major role in determining the structure," White said.

Owners should consider the make-up of their investors and their priorities. Tax-exempt investors likely won’t want to sit in a partnership structure because unrelated business taxable income flows through to them. A REIT blocks that, which is why tax-exempt capital tends to point toward a REIT.

Foreign investors raise a different set of issues around withholding and what happens when they eventually sell. A domestically controlled REIT may allow a foreign investor to exit without triggering FIRPTA tax. Meanwhile, private equity funds and family offices often want the opposite. They tend to prefer negotiated economics, which a partnership provides, but a REIT doesn’t.

3. What does the business earn besides rent?

In REITs, assets have to be real estate or mortgages on real estate, and income has to qualify, so anything beyond rental or interest income generally needs to sit in a taxable REIT subsidiary or another entity outside the REIT. This structure is applicable across industries: Hotel REITs own the real estate while a Taxable REIT Subsidiary (TRS) handles day-to-day operations. Healthcare REITs holding senior living facilities face the same issue.

"The risk many owners confront is not having qualifying assets or qualifying income in the REIT," White said. “Depending on the industry, you need to ensure that activities beyond rental income are housed in a taxable REIT subsidiary.”

4. What’s the cost to move assets into a REIT?

Contributing appreciated property to a REIT is a taxable event. Owners who have held and depreciated assets for years can face tax on decades of deferred gain simply for changing structure. Owners who want to avoid that tax bill typically use an UPREIT structure: contributing property to an operating partnership beneath the REIT in exchange for operating partnership units. Section 721 lets them postpone the tax until they sell the units.

5. What do owners need to take out?

A partnership passes depreciation and losses through to its owners, who can use them against income from other sources. Owners can also refinance a property and take out the proceeds typically without paying tax because their share of the mortgage counts toward what they've invested for tax purposes.

A REIT works differently. Losses stay with the REIT and reduce its taxable income rather than passing through to shareholders' returns, and shareholders get no benefit from the REIT's borrowing. What they do receive is distributions, often more than the REIT's taxable income. That excess isn't taxed right away, but it reduces their basis, so the tax comes due when they sell.

6. Where are your properties?

An investor holding an interest in a partnership that operates across multiple states receives K-1s from each state where the partnership files, and can pick up filing obligations in all of them. A REIT blocks that. The REIT files at the corporate level, and the shareholder receives dividend income instead.

White worked with a client that had operated as a partnership for years, holding mortgages on properties across many states with more than 1,500 partners. “Every one of those partners was receiving state K-1s from each state where the partnership filed. Placing a REIT over the existing limited partnership blocked those obligations for investors and left them receiving only dividend income,” she said. “The sponsor was able to go back to investors and tell them their tax footprint was about to get much simpler, which turned out to be a strong selling point to investors on its own.”

7. How much flexibility do you need in dividing returns?

In a REIT, returns are based on how many shares an investor owns. A partnership can be negotiated. That flexibility is what allows a sponsor to earn a larger share of the profits once investors have received an agreed-on return.

8. Can the business support mandatory distributions?

A REIT has to distribute 90% of its taxable income each year. Partnerships have no equivalent requirement and typically make tax distributions sufficient for partners to cover what they owe.

"Any taxable income the REIT makes has to go out in distributions, but then the cash has to come back in if it's needed. It's almost like recycling,” White said.

9. Is your asset type well-trodden ground?

Newer property types carry more uncertainty.

“Data centers are the newest thing in the market,” White said. “A few years ago, it was warehouses, driven by companies like Amazon. Clients are asking whether data centers can fit into a REIT structure. People are still working out the logistics, and it’s playing into their decision of whether a partnership structure or a REIT structure makes the most sense.”

Data centers increasingly rely on dedicated power generation, and those facilities generally can't sit inside the REIT. Owners looking at a newer asset type have to work out which pieces of the business belong in the REIT and which have to be held somewhere else.

Federal guidance hasn't kept pace with the newer property types. When a REIT moves into an industry where rules are still being determined, there often isn't authority addressing the specific income streams involved. Owners can ask the IRS directly through a private letter ruling, which is a request for a determination on whether a particular asset or income stream qualifies, but those decisions only a-apply to specific taxpayers and are not supposed to be applied to similar businesses.

“The guidance keeps growing, which helps, but owners in newer asset classes should expect a more involved analysis than someone buying a conventional office building,” said Mary Selvanadin, Grant Thornton Partnership Tax Solutions Director.

A structuring decision isn’t permanent

A property’s ownership structure isn’t a permanent decision. Owners revisit it during acquisitions, generational transitions or when the structure no longer serves the needs of the business or its investors.

“I have a client that operated as a C corporation for more than a hundred years and fairly recently decided to transition to a REIT structure because they liked the tax benefits and the ability to raise funds through the capital markets,” Selvanadin said.
 

The Grant Thornton team worked with the client to analyze each of their asset types and relevant income streams to determine which activity belonged in the REIT and which assets needed to be moved to a TRS entity. In addition, the team conducted analysis around the determination of the entity’s earnings and profits in collaboration with the client and various service providers, including law firms.

“It's important to vet these issues up front instead of jumping in blindly,” White said. “Working through these questions early is how owners can determine the right structure.”