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Chapter 20 Ownership Structures for Financing and Holding Real Estate © OnCourse Learning
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 © OnCourse Learning 2
Ownership Structures for Real Estate Investment Sole Proprietorship C Corporation S Corporation Partnership Trust © OnCourse Learning 3
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 © OnCourse Learning 4
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 © OnCourse Learning 5
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 © OnCourse Learning 6
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 © OnCourse Learning 7
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 © OnCourse Learning 8
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 © OnCourse Learning 9
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 © OnCourse Learning 10
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 © OnCourse Learning 11
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 12 © OnCourse Learning
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 13 © OnCourse Learning
Measuring Operating Performance of REITs Funds from Operations (FFO) provides a more accurate measure of operating performance of REITs FFO = net income (GAAP) + Depreciation (real property) + Amortization of leasing expenses + Amortization of tenant improvements + Gains (losses) from infrequent or unusual events Adjusted FFO (AFFO) measures cash flows available to shareholders, also called cash available for distribution (CAD) or funds available for distribution (FAD) AFFO = FFO minus normalized recurring expenditures and straight-lining of rents 14 © OnCourse Learning
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 © OnCourse Learning 15
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 16 © OnCourse Learning
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 17 © OnCourse Learning
Factors Determining Ownership Form Amount of depreciation Holding period Amount of retained earnings Tax credits Use of debt financing Passive loss limitations © OnCourse Learning 18
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 19 © OnCourse Learning
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 20 © OnCourse Learning
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