31.1 Real Estate Ventures

A real estate investment should provide a current income return and an appreciation in the value of the original investment. As an additional incentive, a real estate investment may in the early years of the investment return income subject to little or no tax. That may happen when depreciation and other expense deductions reduce taxable income without reducing the amount of cash available for distribution. This tax savings is temporary and limited by the terms and the amount of the mortgage debt on the property. Payments allocated to amortization of mortgage principal reduce the amount of cash available to investors without an offsetting tax deduction. Thus, the amount of tax-free return depends on the extent to which depreciation deductions exceed the amortization payments.

To provide a higher return of tax-free income, at least during the early years of its operations, a venture must obtain a constant payment mortgage that provides for the payment of fixed annual amounts that are allocated to continually decreasing amounts of interest and increasing amounts of amortization payments. Consequently, in the early years, a tax-free return of income is high while the amortization payments are low, but as the amortization payments increase, nontaxable income decreases. When this tax-free return has been substantially reduced, a partnership must refinance the mortgage to reduce the amortization payments and once again increase the tax-free return; see Examples 1 and 2 below.

In the case of a building, the tax-free return is based on the assumption that the building does not actually depreciate at as fast a rate as the tax depreciation rate being claimed by the investors. If the building is depreciating physically at a faster rate, the so-called tax-free return on investment does not exist. Distributions to investors (over and above current income return) that are labeled tax-free distributions are, in fact, a return of the investor’s own capital.

Real estate investment trusts (REITs).

The tax treatment of real estate investment trusts resembles that of open-end mutual funds. Distributions generally are reported to the investors on Form 1099-DIV as dividend income. However, distributions generally do not qualify for the reduced tax rate on qualified dividends (4.1). A distribution qualifies for the reduced rate only to the extent it represents previously taxed undistributed income or qualifying dividends received by the REIT (from stock investments) that are passed through to the investors. Capital gain distributions reported on Form 1099-DIV must be reported as long-term capital gains regardless of how long the REIT shares have been held (4.4). If the trust operates at a loss, the loss may not be passed on to the investors.

REMICs.

A real estate mortgage investment company (REMIC) holds a fixed pool of mortgages. Investors are treated as holding a regular or residual interest. A REMIC is not a taxable entity for federal income tax purposes. It is generally treated as a partnership, with the residual interest holders as partners.

Investors with regular REMIC interests are treated as holding debt obligations. Interest income is reported to them by the REMIC on Form 1099-INT and original issue discount (OID) on Form 1099-OID.

The net income of the REMIC, after payments to regular interest holders, is passed through to the holders of residual interests. A residual interest holder’s share of the REMIC’s taxable income or loss is reported by the REMIC to the interest holder each quarter on Schedule Q of Form 1066, and the investor reports his or her total share of the year in Part IV of Schedule E.