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Chapter 20
Ownership Structures for
Financing and Holding Real
Estate
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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
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Ownership Structures for Real Estate
Investment
 Sole Proprietorship
 C Corporation
 S Corporation
 Partnership
 Trust
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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Factors Determining Ownership Form
 Amount of depreciation
 Holding period
 Amount of retained earnings
 Tax credits
 Use of debt financing
 Passive loss limitations
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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
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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
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