Captive REIT

What is a Captive REIT?

A Captive Real Estate Investment Trust (Captive REIT) is a financial arrangement used primarily by large retailers and banks. In this structure, a company creates a REIT to hold its real estate assets. The company then sells shares of the REIT to investors. The properties held in the REIT are leased back to the company, producing rental income for the REIT, while the company enjoys the benefit of deducting the rent paid as a business expense. This structure often results in a more favorable balance sheet and can provide tax benefits by reducing taxable income.

Examples

Furniture Is Us: This hypothetical company created a captive REIT to hold their retail facilities across the country. They sold shares in the REIT to investors, thus offloading the properties from their balance sheet. Furniture Is Us pays rent to the REIT for the use of these facilities and receives dividends from the earnings of the REIT. The proceeds from the sale improved their balance sheet, and the rent payments are deductible as business expenses, reducing their taxable income.
Big Bank Corp: This large financial institution possesses a vast portfolio of branch locations. They form a captive REIT and transfer ownership of their office buildings and branch locations to the REIT. By selling shares in the REIT, they convert real estate assets into liquid assets. Big Bank Corp then rents the same properties back from the REIT, allowing them business expense deductions and improving their financial ratios.

Frequently Asked Questions (FAQs)

Q: How does a Captive REIT benefit a company’s balance sheet?
A: By transferring real estate assets to a REIT, the company removes these significant assets from its balance sheet, potentially improving financial ratios and making the company appear more attractive to investors. The liquid assets generated from selling the REIT shares can be used for other growth opportunities.

Q: What are the tax advantages of using a Captive REIT?
A: The primary tax advantage is that the rent payments made to the REIT are considered a business expense, which can reduce the company’s taxable income. Additionally, as a REIT, the income is subject to lower corporate taxes and must be distributed to shareholders, who may benefit from lower tax rates on dividend income.

Q: Can any company create a Captive REIT?
A: Not every company is suited to create a Captive REIT. It typically makes sense for large entities with significant real estate holdings. Furthermore, there are regulatory requirements and compliance obligations that must be met to qualify as a REIT.

Q: Is there any downside to forming a Captive REIT?
A: Creating a Captive REIT involves complex legal and tax structuring, which can be costly and time-consuming. Additionally, while the company receives rental income from the REIT, it cedes control over the real assets to the REIT shareholders.

Q: Are Captive REITs only used by retailers and banks?
A: While retailers and banks are common users of Captive REITs due to their extensive real estate holdings, any company with significant real property assets may potentially benefit from this strategy, including educational institutions, healthcare organizations, and industrial companies.

Real Estate Investment Trust (REIT): A company that owns, operates, or finances income-producing real estate. It must distribute at least 90% of its taxable income as dividends to shareholders and is often rewarded with tax-exempt status at the corporate level.

Sale-Leaseback: A transaction in which one sells an asset and leases it back for the long-term; therefore, one continues to be able to use the asset but no longer owns it.

Dividend Income: Earnings distributed to shareholders from a company’s profit. REITs tend to distribute a significant portion of their earnings due to regulatory requirements.

Tax Shelter: An investment vehicle that reduces taxable income and, consequently, income tax liability. REITs can serve as tax shelters due to the tax-deductibility of dividend payments.

Business Expense Deduction: Legal tax reductions applied to the operating expenses required to run a business, including rental payments on properties.

Online Resources

References

IRS Publication 527 (2022), Residential Rental Property
National Association of Real Estate Investment Trusts
Securities and Exchange Commission

Suggested Books for Further Studies

“Real Estate Investment Trusts: Structure, Analysis, and Strategy” by Richard Garrigan and John D. Abbott
“The Intelligent REIT Investor: How to Build Wealth with Real Estate Investment Trusts” by Stephanie Krewson-Kelly and R. Brad Thomas
“Investing in REITs: Real Estate Investment Trusts” by Ralph L. Block
“Real Estate Investment Trusts: Law, Regulation, and Operation” by Richard B. Peiser and John B. Festor

Captive REIT Fundamentals Quiz

### Why do companies typically form a Captive REIT? - [x] To improve their balance sheet and obtain tax benefits. - [ ] To increase the value of their properties. - [ ] To avoid paying any taxes. - [ ] To reduce the price of their stocks. > **Explanation:** Companies form Captive REITs to improve their balance sheets by transferring real estate assets into the REIT and to gain tax benefits by deducting rent payments made to the REIT as business expenses. ### What kind of companies primarily use Captive REITs? - [x] Large retailers and banks - [ ] Start-ups and small businesses - [ ] Only tech companies - [ ] Only non-profit organizations > **Explanation:** Captive REITs are primarily used by large retailers and banks because they usually hold significant real estate assets or property loans. ### How do Captive REITs benefit a company’s tax situation? - [ ] They allow the company to evade taxes completely. - [ ] They give the company money directly. - [x] They permit the company to deduct rent payments as business expenses, reducing taxable income. - [ ] They exempt the company from all IRS regulations. > **Explanation:** Captive REITs benefit a company by making rent payments deductible as business expenses, which can significantly reduce the company's taxable income. ### What does REIT stand for? - [ ] Realistic Estate Investment Tactics - [x] Real Estate Investment Trust - [ ] Real Earnings In Trade - [ ] Rent and Equity In Transactions > **Explanation:** REIT stands for Real Estate Investment Trust, which is a company owning, operating, or financing income-producing properties. ### What must a REIT do to comply with tax regulations? - [x] Distribute at least 90% of its taxable income as dividends to shareholders. - [ ] Invest in foreign properties. - [ ] Hire only licensed real estate agents. - [ ] Hold no liability insurance. > **Explanation:** To comply with tax regulations, a REIT must distribute at least 90% of its taxable income as dividends to shareholders. ### Which is a correct description of a sale-leaseback transaction? - [ ] Leasing a property without the option to sell. - [ ] Selling a property and never using it again. - [ ] Selling a property and renting it back long-term. - [x] Selling a property and leasing it back for continued use. > **Explanation:** A sale-leaseback transaction involves selling a property and leasing it back long-term, allowing the seller to continue using the property while converting it into liquid assets. ### What happens to the proceeds from the sale when a company creates a Captive REIT? - [ ] They must be reinvested in the same property. - [ ] They disappear and are not traceable. - [ ] They are usually allocated for other growth opportunities or investments. - [ ] They must be used to pay shareholder dividends. > **Explanation:** The proceeds from the sale of a Captive REIT are typically allocated for other growth opportunities or investments instead of sitting buildings on the balance sheet. ### Who regulates REITs in the United States? - [x] The Securities and Exchange Commission (SEC). - [ ] The Federal Housing Administration (FHA). - [ ] The International Monetary Fund (IMF). - [ ] The World Bank. > **Explanation:** In the United States, REITs are primarily regulated by the Securities and Exchange Commission (SEC). ### What is a primary advantage for investors who purchase shares in a Captive REIT? - [ ] They can personally use the company's properties. - [ ] They evade property taxes. - [x] They receive dividend income and potentially lower tax rates on these dividends. - [ ] They can buy properties at a discount. > **Explanation:** Investors benefit from purchasing shares in a Captive REIT by receiving dividend income and potentially enjoying lower tax rates on these dividends. ### What aspect of a Captive REIT improves the financial appearance of the company? - [ ] The daily management of the property. - [x] The removal of real estate assets from the company’s balance sheet, turning assets into liquid cash. - [ ] The enhanced operational efficiency. - [ ] The direct increase in company’s annual revenue. > **Explanation:** When a company creates a Captive REIT, it removes significant real estate assets from its balance sheet and converts them into liquid cash, improving financial ratios and making the company appear more attractive to investors.