There are subtle nuances in the way businesses are created and run, and they can have huge implications for investors. Federal Realty (FRT +0.00%) just announced that it is making a major shift in the way it's structured.
Don't fret -- it's not dropping its real estate investment trust (REIT) status, it's just becoming an upREIT. Here's what that means, why it's important, and why investors should be happy to see the change.
What's going on here?
A traditional company pays taxes on its earnings and then pays dividends from those taxed earnings. Shareholders then end up paying more taxes on the dividends they receive. That's a double tax on a company's earnings. REITs like Federal Realty avoid that double hit.
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The deal is that landlords structured as REITs don't have to pay corporate-level taxes so long as they distribute at least 90% of taxable earnings. Investors, meanwhile, have to pay taxes on the dividends as if they were regular income.
That said, if you own a REIT in a Roth IRA, which gets funded with after-tax money, you can avoid taxes completely because distributions taken after you retire are tax-free. So far, so good, but there's one more trick up the old REIT sleeve.
In the property market, there's a transaction known as a 1031 exchange. There are some complex rules you need to follow, but it basically means that if you "trade" a property you own for another property or quickly buy a new property with sales proceeds, you don't have to pay capital gains taxes on the sale. Landlords like this, and REITs can facilitate it if they are structured as upREITs. Traditional REIT shares don't qualify for 1031 exchanges, but upREIT shares do.
Simplistically speaking, there's a top-level holding company that owns a traditional REIT and an upREIT. The upREIT shares get used for 1031 exchanges, and traditional investors don't see any difference at all. Federal Realty didn't have this structure before, but it is now making the change.
Grabbing more tax benefits
The property markets are filled with competitors, from mom-and-pop owners to massive public landlords like Federal Realty. Small and large owners tend to have different driving forces behind their investment decisions. Notably, if a person or family owns just a property or two, they don't have the same access to capital that a REIT would. And just as important, they may have inheritance and management issues that complicate decision making. For example, not every son or daughter wants to follow their parents into the real estate market.
However, the sale of a property that's been owned for a long time can come with a major capital gains tax hit that could make a sale materially less desirable. Meanwhile, a sale would instantly reduce the cash flow coming in the door. Sure, the seller has the proceeds of the sale, but that isn't the same as the steady cash flow from the rental income from a well-located property.
A 1031 exchange sidesteps these issues, allowing for a "sale" to a company like Federal Realty that doesn't get hit by capital gains taxes and results in continued cash flows, in this case in the form of dividends. Moreover, the exchange is a property for upREIT shares, which makes it easier to break an estate up to distribute to heirs. This is a win-win for the seller and the buyer.
Historically, Federal Realty was locked out of this market because it didn't have an upREIT structure. That limited its deal-making flexibility. But once it adopts the upREIT structure, it will be able to compete more effectively against other REITs for one-off properties, where smaller sellers are being driven by more than just price.
Hitting the bullseye
This is really important for a company like Federal Realty because it has a highly focused portfolio. It basically owns a small number of especially well-positioned strip malls with material redevelopment opportunities. Being able to make deals with small landlords who bought years ago, perhaps lacked capital for upgrades, and who are looking for ways to minimize the tax hit as they face inheritance issues will potentially open up a valuable new avenue for growth.
No, Federal Realty isn't likely to turn into an acquisition machine because of this. But it is likely to see more deals than it did before, and for the exact types of properties it most likes to own. In the end, current investors won't see any difference in what they own, but the outcome of this corporate overhaul could still be hugely important.
