Taxable REIT Subsidiary Defined
A taxable REIT subsidiary, or TRS, is a corporation in which a REIT directly or indirectly owns stock and jointly elects TRS treatment with that corporation. It pays full corporate tax on its earnings and may carry on activities that would jeopardize the parent’s REIT status if the REIT performed them itself. A REIT may own up to 100 percent of one or more of them.
What makes a corporation a TRS
Two features define the entity: its legal form and a joint election. A TRS must be a corporation, and it cannot be a REIT or a qualified REIT subsidiary. The REIT and the corporation make the election together, so ownership alone does not create TRS status.
Ownership can be direct or indirect. A REIT may hold up to 100 percent of the stock of one or more TRSs, which gives the parent full control of a subsidiary that sits in its own taxable box.
The purpose of the box is that a TRS can conduct some activities restricted for the REIT itself, subject to tax rules that vary and change. The restrictions carry as much weight as the permission, because the permission has edges.
Where the tax lands and what the REIT keeps
A TRS generally pays corporate tax on its taxable earnings. Federal tax applies, and state tax applies as well where the income is taxable there.
The trade is control over activity in exchange for a tax bill. Income earned inside a TRS can be kept for reinvestment without the requirement to distribute it that attaches to the parent’s REIT income. That retained cash has already borne corporate tax, so the comparison a veteran makes is after-tax retained earnings inside the TRS against what the REIT itself could keep and distribute.
The distribution requirement attaches to REIT taxable income. TRS earnings sit in a different corporation with its own tax return, and that boundary is the reason the structure exists.
“Taxable REIT subsidiaries are subject to full corporate level U.S. federal taxation on their earnings but are permitted to engage in certain types of activities that cannot be performed directly by REITs without jeopardizing the REIT status of their parent REIT.”
Tenant services and the 10 percent tenant test
A TRS may provide services to the REIT’s tenants without disqualifying the rent the REIT receives, subject to restrictions. The service income lands in the corporation and the rent stays in the REIT.
A separate test looks at who owns the tenant. Rent from real property can fail to qualify when the REIT, or an owner of 10 percent or more of the REIT, also owns at least 10 percent of the tenant. An exception exists when the tenant is itself a TRS and other conditions are met.
Every related-party lease therefore raises two questions: which entity provides the service, and who stands on the other side of the lease.
Prohibited transactions and the 100 percent tax
A REIT that sells certain assets at a gain can face a 100 percent prohibited transaction tax on that gain. Where that tax applies, it can absorb the full gain, leaving none of that gain to distribute.
A TRS can hold assets whose sale by a REIT could trigger that tax, and can carry on activities that generate non-qualifying REIT income. The TRS is taxed as a regular corporation on what it earns.
The decision is made before the asset is sold. The entity holding the asset at the time of sale bears the result, so placement is a planning question at acquisition or when a business plan changes.
Excess inclusion income stops at the TRS
A TRS that earns excess inclusion income pays U.S. corporate tax on it.
The effect is a block. The income is taxed inside the subsidiary, and its character does not travel up to the REIT or out to the REIT’s shareholders. The entity boundary does tax work in this direction as well.
Worked example: selling one asset inside a TRS and outside one
Consider a hypothetical asset bought for $3000000 and sold for $5000000, a gain of $2000000 (5000000 minus 3000000). For this hypothetical example, assume the sale would be a prohibited transaction if the REIT made it. Selling costs and state tax are left out so both cases sit on the same basis.
Base case, the REIT sells directly. The 100 percent prohibited transaction tax equals $2000000 (2000000 multiplied by 1). After tax the REIT keeps $0 (2000000 minus 2000000).
Alternative case, the TRS sells. An illustrative corporate rate of 25 percent serves the arithmetic only. Tax is $500000 (2000000 multiplied by 0.25), and the TRS keeps $1500000 (2000000 minus 500000).
Same asset, same price, same period: the TRS case leaves $1500000 more after tax than the direct case (1500000 minus 0). The 25 percent rate is a placeholder and does not describe any actual corporate rate.
Mistakes that distort TRS analysis
Treating a TRS as a tax shelter misses the entity-level tax. Earnings are taxed at the corporate level, so the cash available for reinvestment is the after-tax figure, which the example shows as $1500000 against a pre-tax gain of $2000000.
Calling any subsidiary a TRS skips the definition. TRS status generally depends on corporate form and a joint election by the REIT and the corporation; a REIT or qualified REIT subsidiary does not qualify. A wholly owned limited liability company with no election has not become one.
Reading the tenant services permission as unlimited ignores the words subject to restrictions. A TRS may provide services without disqualifying REIT rent, subject to the applicable restrictions.
Assuming rent from a related tenant qualifies skips the 10 percent ownership test. Rent qualification can depend on ownership relationships among the REIT, its owners and the tenant, and on the conditions of a TRS exception. The rules vary and change.
Moving an asset after a sale is in sight cannot change which entity made the sale. The 100 percent prohibited transaction tax can apply when the REIT holds and sells the asset.
Questions for a TRS structure checklist
The entity performing each tenant service determines whether the activity occurs in the REIT or its taxable subsidiary.
A joint election by the REIT and the corporation, together with corporate form, is part of the TRS definition.
The entity recording the revenue and paying corporate tax identifies where earnings are subject to subsidiary-level tax.
The rent test applies when the REIT, or an owner of 10 percent or more of the REIT, also owns at least 10 percent of a tenant.
The TRS tenant exception applies only when the tenant qualifies and the other conditions are met.
For an asset whose sale could trigger the 100 percent prohibited transaction tax, the entity holding it at the time of sale bears the tax consequences.
Excess inclusion income earned inside the TRS is subject to corporate tax there.