Many investors hold REITs in tax-advantaged accounts, such as IRAs, believing that Unrelated Business Income Tax ("UBIT") is never an issue. They are mistaken.
For those unfamiliar with UBIT, a tax-advantaged account must pay tax on UBIT if the account generates UBIT in excess of $1000. Not only can UBIT trigger tax in an otherwise tax-advantaged account, but it can trigger fees associated with the filing of additional tax forms. For these reasons, it's wise to know which assets generate UBIT.
I'll start by explaining two ways that REITs can generate UBIT, and then I'll offer suggestions for how you can protect your tax-advantaged accounts.
Mortgage REITs and UBIT
A REIT that either (1) holds a residual interest in a real-estate mortgage investment conduit ("REMIC") or (2) is treated as a taxable mortgage pool ("TMP") can, if held in a tax-advantaged account, make distributions that partially constitute UBIT. Each of these requires a detailed explanation.
1.) REIT holds a residual interest in a REMIC
A mortgage REIT engages in various mortgage-related investments, such as financing mortgages or investing in mortgage-backed securities. As part of its slate of investments, a mortgage REIT may choose to invest in a real estate mortgage investment conduit ("REMIC"). What is a REMIC? A REMIC is a pass-through entity that holds a fixed pool of mortgages. The REMIC issues interests to investors, one of which may include your mortgage REIT (i.e. the REIT will hold an interest in the REMIC). Two types of interests exist: regular interests (akin to debt) and residual interests (akin to equity). A REIT can generate UBIT if it holds a residual interest in the REMIC. Just as with other investments, this residual interest can produce a net income or a net loss for the REIT. If the residual interest produces net income and if the net income constitutes "excess inclusion income," then this excess inclusion income may qualify as UBIT (IRS Notice 2006-97). "Excess inclusion income" is a term of art, with its own definition in the Internal Revenue Code (see I.R.C. 860E). In short, the more excess inclusion income the REIT generates, the more UBIT your tax-advantaged account will generate. As a unit holder in the REIT, this UBIT will eventually flow to you. Remember that the REIT is a pass-through entity. This means that the UBIT will pass through to the unit-holder in the REIT via distributions (see I.R.C. 860E). Put simply, each distribution may contain some UBIT, and the investor cannot use losses to offset this UBIT.
2.) REIT treated as a TMP
A REIT can also produce UBIT if the REIT qualifies as a "taxable mortgage pool" (see 7701(i), 860E, and IRS Notice 2006-97). Suffice it to say that a REIT that (1) invests heavily in real estate mortgages and (2) issues securities with different maturity dates based on these mortgages may qualify as a TMP and produce UBIT (see I.R.C. 7701(i), 860E, 26 C.F.R. 301.7701(i)-1). The UBIT will pass through to the unit holder, just as it did under the REMIC rule: a portion of each distribution may contain some UBIT, and the investor cannot use losses to offset this UBIT. In some ways, this rule may be seen as an extension of the REMIC rule. Just as a REIT cannot hold an equity interest in a fixed pool of mortgages--a REMIC--without triggering UBIT, it cannot 'act' like a REMIC and issue securities based on a fixed pool of mortgages that it owns without triggering UBIT. By creating this TMP regime, the Code and Regulations create symmetry between REITs that hold equity interests in REMICs, and REITs that are effectively REMICs (i.e. mortgage pools that securatize those mortgages). Unit-holders of both REITs remain exposed to UBIT. For purposes of your portfolio, the take-away is this: you should know what your mortgage REIT is investing in to minimize your risk of incurring UBIT.
As an aside, notice that these rules differ from the usual treatment of REIT distributions. REIT distributions are not usually treated as UBIT (see Revenue Ruling 66-106). Why the unique treatment here? The mere existence of "excess inclusion income" does not explain the unusual treatment. After all, not all allocations of excess inclusion income qualify as UBIT (see Revenue Ruling 2006-58). Rather, it seems that UBIT is used as a "stick" to punish REITs that encroach on what is supposed to be the sole territory of REMICs: issuing multiple-maturity mortgage-backed debt securities (see Notice 2006-97).
Finally, keep in mind that these are only two ways that REITs can generate UBIT. Other ways exist. The Code and regulations on this topic are a nightmare. Consult a tax specialist, financial planner, and/or do your own research before making any investment decisions.
How to Minimize the Risk of Incurring UBIT
Fortunately, you do not need to scour the financial documents of your REIT to determine whether it may produce UBIT. Your REIT will disclose this risk in the risk disclosure portion of its SEC filings. Specifically, take a look at the REIT's most recent 10-K. For example, the 10-K of Annaly Capital Management (NYSE:NLY), filed this past February, reads:
We may invest in real estate mortgage investment conduit (REMIC) residuals or other CMO residuals. To the extent that we invest in REMIC residuals or other CMO residuals, we intend to hold or structure such investments to ensure that such income is not treated as unrelated business taxable income (UBTI) under the Internal Revenue Code. As a result, we might be subject to corporate level tax on such income.
As a result, you know that you can hold NLY in an IRA or other tax-advantaged account without worrying about incurring UBIT.
Let's consider another example. The 10-K of Arbor Realty Trust (NYSE:ABR), also filed this past February, states:
Certain of our securitizations have resulted in the creation of taxable mortgage pools for federal income tax purposes...Certain categories of stockholders, however, such as foreign stockholders eligible for treaty or other tax benefits, stockholders with net operating losses, and certain tax-exempt stockholders that are subject to unrelated business income tax, could be subject to increased taxes on a portion of their dividend income from us that is attributable to the taxable mortgage pool.
So, unlike NLY, holding ABR in a tax-advantaged account might expose you to the risk of incurring UBIT. A non-exclusive list of other REITs with risk exposure to UBIT include American Capital Agency (NASDAQ:AGNC), Apollo Commercial Real Estate (NYSE:ARI), Anworth Mortgage Asset Company (NYSE:ANH), Apollo Residential Mortgage (NYSE:AMTG), and Armour Residential REIT (NYSE:ARR). Before any investor begins to panic, keep in mind that the 10-K of these REITs merely discloses the presence of this UBIT risk, but often says little about the likelihood of the risk actually occurring (i.e. the risk of the REITs actually producing UBTI). Legal risk-disclosure requirements turn on many factors, which extend beyond the mere possibility of a risk occurring. It's entirely possible to hold these REITs in an IRA, for example, and never realize UBIT. But if you wanted to minimize your risk of incurring UBIT, you could consider one of these options:
First, you could decrease the number of potentially-UBIT producing assets that you hold in a single tax-advantaged account. For example, you might want to avoid holding MLPs and potentially UBIT-generating mortgage REITs in a single IRA. Rather, you could split these investments between multiple tax-advantaged accounts, such as a Roth IRA and IRA, if possible.
Second, to the extent that you want to invest in mortgage REITs, you could invest mostly in mortgage REITs that pose no risk of incurring UBIT.
Third, you could merely reduce your position size in the mortgage REITs that pose a risk of generating UBIT. By reducing your position size, you will necessarily reduce the UBIT the REIT will generate. Of course, this also means that you will benefit less from the REIT's distributions.
(Please note that these are just three options, and choosing between these options--or between these options and others--will depend on a myriad of factors, such as your individual profile).
Investors should know that mortgage REITs can generate UBIT. Fortunately, investors can minimize the risk of incurring UBIT with minimal effort. Read the risk-disclosure portion of the REIT's 10-K, with an eye towards the UBIT risk disclosure. If necessary, take the appropriate tax-planning steps to avoid the risk of incurring UBIT--either by avoiding particular REITs, minimizing your positions in those REITs, or splitting the UBIT-prone assets (including MLPs) across multiple tax-advantaged accounts.
Disclaimer: This communication is for informational purposes only. As of this writing, the author is not an attorney or a certified financial planner. Any U.S. Federal Tax advice contained in this communication is not intended or written to be used, and cannot be used, for avoiding penalties under the internal revenue code or promoting, marketing or recommending to another party any tax-related matters addressed herein. This post is not intended as a solicitation or endorsement for legal services, and all data and all information is not warranted as to completeness and are subject to change without notice and without the knowledge of the author