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Savvy real estate investors know that buying up properties to flip or rent is only one of many ways to make a profit.
Real estate investment trusts (REITs) own trillions of dollars in gross real estate assets, which pay out highly liquid dividends to income investors.
As an entrepreneur, you might find REIT tax benefits attractive in a potential business venture.
Here is a breakdown of the steps you need to take to set up a REIT. You can form a legitimate and lucrative REIT with a comprehensive understanding of the business infrastructure.
7 Steps to forming your own REIT
- Decide on the type of REIT
- Form a taxable entity
- Draft a Private Placement Memorandum
- Find potential investors
- Convert your management company into a REIT
- Maintain compliance
- Start investing in assets
It is imperative to know how REITs operate before taking on the task of creating one. Familiarize yourself thoroughly with the corporate compliance requirements and the asset classes available for investment.
Using investor capital, REITs manage, own or fund commercial real estate and residential properties. Mortgage REITs are lenders by financing real estate projects, and equity REITs hold real property.
Each type of trust makes its money in its own way. For example, an equity REIT profits from rental property leases or flipping resales, whereas a mortgage REIT earns from interest payments.
A public REIT does not trade on the stock exchange either, but it does register with the SEC. To qualify for REIT status, a company must abide by specific regulations concerning dividend payout and shareholder and investment sector percentages.
Some requirements do not apply in the first year but must be met by the second tax year. They include meeting the 100-shareholder threshold and the rules specifying how much stock value a certain number of individuals can hold.
In addition, it must qualify as a taxable corporation, trust or association and have trustees or a board of directors in place to ensure REIT legitimacy.
How to Create a REIT
When starting a REIT, you first need to identify the specific types of investments you want the business to engage in. Then, you can choose from a wide range of REIT assets to build your investment portfolio.
Then, you can take the next necessary steps to complete REIT formation.
Decide what type of REIT you want to form
- Apartment REIT – purchasing and operating apartment buildings, primarily large complexes.
- Healthcare REIT –facilities, such as hospitals, medical office spaces, and assisted-living centers.
- Retail REIT – investing in and managing commercial retail spaces, such as shopping malls, outlets, big box stores and grocery markets.
- Office REIT – office REITs can be central to specific markets, such as suburban or urban, and can also work within specific industries like government agencies.
- Residential REIT – apartment buildings fall into this category, as well as multi-family and single-family homes, student housing, manufactured or mobile home communities and condo complexes.
- Self-storage REIT – purchasing and leasing warehouses with individual rentable units.
- Data center REIT – facilities that provide secure data storage for businesses or individuals.
- Hospitality REIT – investing in hotels or motels.
- Infrastructure REIT – a non-traditional REIT investment option for purchasing energy, data direction and storage assets, such as oil pipelines, cellular towers and other processing facilities.
- Private REIT – REITs typically offer high accessibility to everyday people, but private REITs only work with accredited or institutional investors. Investment advisors present these REIT stock options for long-term investments with low liquidity.
- Industrial REIT – commercial facilities, such as fulfillment centers and factories.
- Timber REIT – specific investments in timber-producing properties.
- Specialty REIT – investing in specific industries that do not fit neatly into the primary categories, such as cannabis facilities, movie theaters, agricultural properties, prisons and casinos.
Form a taxable entity
The IRS has strict regulations for managing taxable income on a corporate level, and a REIT has to start by establishing a real estate management company as a taxable entity.
To start, you must select a business name, decide on a location to base the business, file the necessary paperwork and organize the financials and taxes.
Draft a Private Placement Memorandum (PPM)
PPMs mimic public offering prospectuses given to potential investors. A PPM serves as a concise report on the company that presents the most vital information so that potential investors can efficiently determine whether to contribute capital.
A strong PPM provides a brief, but complete company description and income-producing mechanisms. It also contains a corporate structure breakdown with management team details, the capital amount you seek, evidence of the business’s relevance and scalability and the possible positives and risks associated with the investment.
Begin with an introductory Executive Summary, followed by information about the management team, earnings and company history. Then, explain the capital you need, why you need it and its direct use.
Then, you need to list past and present financial reports of profits, income and expenses. Also, provide a statement of future financial projections that includes spelling out the investment risks, including any outstanding litigation, current liabilities, and competitor information.
Full disclosure is a legal requirement that provides investors additional visibility into a REIT’s finances and operations. Now, provide current capitalization and exact numbers on expected gains and return on investment in a Summary of Offering Terms.
This section also covers liquidation strategy points, such as exit strategies and investor rights. Lastly, you will express the type of investor your company is targeting in an Investor Suitability report and explain how to move forward with their investment.
Finally, close out the PPM with the proper legal disclaimers.
Find potential investors
To qualify as a REIT, the company has to have at least 100 shareholders, and five or fewer individuals cannot own more than half the REIT’s stock value during the final half of the taxable year.
To meet the requirements, you can reach out to banks, insurance companies, pension funds, and other institutional investors.
Convert your management company into a REIT
To conduct business and distribute profits to shareholders as a REIT, you must submit a REIT election via the income tax form 1120-REIT.
The IRS government website features the downloadable form 1120-REIT that your company has to utilize for documenting all income, credits, deductions, losses and gains for each tax year.
It is important to note that a real estate management business files its REIT election at the end of its first year.
To maintain REIT compliance, the company must meet the following requirements:
- Be a taxable entity that is electing REIT status.
- Be managed by trustees or a board of directors with transferable shares.
- Maintain a minimum of 100 shareholders after its first year in operation.
- Have no more than 50% of its shares owned by five or fewer individuals in the final half of its taxable year.
- Receive 75% of its gross income from real estate assets and an additional 20% from real estate sources and interest or dividends from non-real estate sources.
- Limit revenue from fees and other non-real estate sources to 5% or less of the REIT’s total income.
- Invest 75% of the REIT’s total assets in real estate.
- Own 10% or less of any other company’s voting rights, except for other REITs or REIT subsidiaries.
- Do not own stock in any non-REIT or REIT subsidiary company if the value of the shares exceeds 5% of the REIT’s assets.
- Pay at least 90% of its taxable income to shareholders in dividend payments each year and pay taxes on any retained income.
- Hold REIT election status with the IRS and mail annual requests to shareholders for beneficial ownership of shares information.
Start investing in assets
Your REIT needs to begin making investments that align with the investor prospectus.
Why You Should Start a REIT?
Steady income from long-term commercial leases, the ability to diversify and tax advantages are some reasons you might want to start a REIT.
Historically, this investment sector is consistently lucrative and low risk. REITs also hedge against inflation because rent costs can match increasing consumer prices.
As we are living in an inflation-heavy period, this is a huge business pro.
Now that you have a sharp perspective on the corporate structure, operations, and requirements of REITs and know how to start one, you can move ahead with the formation process.
Name and choose a location for your real estate management company, form a taxable entity, draft the PPM, seek out potential investors and convert the company into a REIT.
Maintain compliance so that you can continue investing in commercial real estate and passing high dividends onto your REIT investors.
REIT Formation FAQs
Do you still have concerns about REITs? Here are some common questions with answers to give you more information.
How is a REIT different than crowdfunding?
A REIT may seem like crowdfunding, as both are ways to invest in commercial real estate without owning a property outright.
Real estate crowdfunding is when investors group together through an online platform to purchase a specific property or property portfolio.
Investing in a REIT means you are investing in the real estate company itself.
What are the dividend distribution requirements for a REIT?
The law and IRS regulations dictate that REITs must distribute 90% or more of their taxable income annually in dividend payments to investors.
Dividends received by REIT investors are taxed as if they were ordinary income. Plus, whether REITs are public or private, they must pay out the standard 90% of their income.
How do REIT owners make money?
The REIT rents out space and collects money on properties and then gives that income as dividends to shareholders.
REIT owners get paid from the company’s net income. Many also serve as the Chief Executive Officer or on the Board of Directors, which are salaried positions.
How do you take your REIT public?
You have to file registration with the SEC. Select an investment bank for underwriting services and IPO advisement before filing for SEC registration.
Upon SEC approval, your REIT and underwriter determine an opening stock price.