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Finding Great REITs in Lodging and Hospitality

In 1960, Congress created the Real Estate Investment Trust (REIT) to provide investors with access to commercial real estate. After the establishment of the REIT, the government passed the 1986 Tax Reform Act. This legislation allowed REITs to own, operate, and manage real estate. Today, many well-known brand names in the lodging industry operate some or all of their businesses out of buildings that are owned by a REIT. There are also many REITs that only hold lodging real estate, and some of these REITs are traded on public markets. A REIT can be structured so that its investors can profit from the operation of the day-to-day business of the hotel and the appreciation in the value of the facilities and the hotel operation.

A REIT can be used to attract various kinds of investment, including from public markets, private investors, foreign investment, and pension investments. REITs are required to pay its shareholders dividends for the taxable income of the entity. While this particular dividend is not taxed at a lower tax rate, compared to other dividends, it has some advantages over other ownership structures – from investments by IRAs, pension plans, and other tax-exempt structures to advantages in State taxation. If the REIT stock is not traded on a public market and is held by private investors, the stock is generally held by a partnership. Since the REIT pays dividends, any losses incurred from operations or depreciation do not pass through to the partners.

How to qualify as a REIT

A REIT needs to meet certain criteria to officially qualify as an REIT. These criteria include having at least 100 shareholders and ensuring that no 5 or fewer shareholders own more than 50% of the REIT’s stock. These tests are required regardless of the ownership structure. In addition, the REIT must pass tests on the types of assets it holds and on the type of income it receives. A REIT, for the most part, can only receive traditional real estate income, which is primarily rental income. Profits from hotel rooms, food & beverage operations, and other ancillary revenue are not appropriate for a REIT.

How to profit from a REIT

Given this situation, how can REIT shareholders profit from the day-to-day business and appreciation of the hotel? Unless the REIT is purely leasing the hotel to a third party and just receiving rental income, a creative structure using a taxable REIT subsidiary (TRS) is used to circumvent this issue. The TRS is a C Corporation that leases the hotel from its parent company (the REIT) and profits from the hotel operations which are managed by an eligible independent contractor that is often controlled by an affiliate. The rent paid by the TRS to the REIT is determined on a variety of factors, including, but not limited to the cost to operate the building, the profitability of the hotel, associated depreciation, and other factors. While the TRS will pay taxes on its taxable income, its income is often sheltered by deprecation from the furniture, fixtures, and equipment (FF&E) as well as the lease payments to the parent. Thus, the shareholders of the REIT profit from the lease payments and the operations of the hotel, with the only cost being any remaining profits of the TRS (often called “leakage”) which is taxed as a C Corp.

While this structure seems simple, setting it up can be a complicated process. The setup requires numerous regular financial tests, as well as a de facto requirement for an initial Transfer Pricing Study to determine the rent amounts and/or formula between the TRS and the parent REIT. Citrin Cooperman has professionals with extensive experience in REITs and related structures who can help you navigate these complexities.

If this structure seems like the right fit for you and your shareholders or partners, please reach out to Matthew Bonney at mbonney@citrincooperman.com or Lawrence Cohen at lcohen@citrincooperman.com for more information.

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