Real estate owners seeking capital are increasingly encountering a different kind of prospective partner – a real estate investment trust, or “REIT.” While REITs generally make good partners from an operational standpoint, it is important to be aware of the possible tax issues a REIT may have and how legal mandates affecting REITs are likely to result in a set of special requirements when partnering with a REIT. Due diligence and negotiations for transactions with REITs can be made easier if these requirements are clearly understood.
Simply put, a REIT is a business entity (corporation, limited liability company (“LLC”) electing to be taxed as a corporation or business trust) that meets a series of requirements set forth in the Internal Revenue Code and has elected REIT treatment. The requirements relate to the composition of its ownership, the nature of its income and assets, as well as some other tests. In certain circumstances, a REIT is an attractive investment vehicle because it avoids the double taxation that is normally part of a corporate structure by allowing the REIT a deduction for dividends paid to its shareholders. Thus, there generally is only one level of federal income tax – to the shareholders. On the negative side, however, there are onerous continuing qualification requirements and a REIT does not pass out tax losses to its owners. Also, any return of capital in excess of the original investment will be taxable as a capital gain.
Publicly traded REITs are well known, but many REITs (sometimes called “private REITs”) are privately held. There are substantial tax advantages for certain types of investors using a REIT to make investments in U.S. real estate, the most prominent of which is that foreign persons -- individuals, corporations or pension plans -- are not subject to tax on gain from a sale of stock of a “domestically-controlled REIT” (commonly referred to as a “DREIT”). Domestic pension plans also can find it advantageous to make use of a private REIT when dealing with the tax on unrelated business income to which tax-exempt entities may be subject.
Owners and developers seeking capital from REITs should be aware that bringing in a REIT partner will result in some requirements and restrictions that otherwise would not exist. First, due diligence done by a REIT will go beyond the usual in order to verify that it will satisfy the requirements necessary to maintain its REIT status. More importantly, a REIT partner invariably will insist that the joint venture operating agreement contain covenants restricting the types of income the partnership may have and imposing distribution requirements.
The requirements that must be met to obtain and continue REIT status are many and detailed. Two types of requirements are most likely to affect an owner or developer with a prospective REIT partner. At least 95% of the REIT’s gross income must be considered “rents from real property,” gains from the sale of real property (but not if the real property is held for sale, such as a condominium project) and certain other types of income. Where the REIT is a partner in a partnership or a member in an LLC, these tests are applied to its share of partnership or LLC income.
What precisely is included in the definition of “rents from real property?” Generally, this includes rents as well as charges for services customarily furnished in that geographic market. Many owners, for example, receive tenant service income, overtime HVAC, and other income from tenants in addition to base rent which may not qualify as local practice. If the property has retail tenants, the REIT will also be concerned about rent based on the tenants’ income: a percentage of gross income is acceptable, but a percentage of income net of certain expenses is not. Income from parking, signage income, and kiosk rentals may also not qualify as “rents from real property.” These rules typically result in the partnership or LLC agreement containing covenants that the partnership or LLC will generate little or even no income of the type that is not “good” income under the REIT rules. To some extent, problems with “bad” income can be solved by causing a taxable subsidiary of the REIT, rather than the REIT itself, to realize the REIT’s share of this income. This plan, however, typically creates additional administrative costs, has adverse tax consequences, and requires restructuring leases and other agreements prior to the REIT becoming a partner.
Another aspect of the REIT regime that will affect its partners is cash flow. As noted, a REIT avoids tax by distributing its income to shareholders. In general, a minimum distribution of 90% of the REIT’s taxable income must be made to maintain REIT status and avoid corporate tax on all of the REIT’s income; a distribution of less than 100% of income, however, will result in the REIT paying tax on its undistributed income. A REIT therefore is likely to insist that the partnership or LLC distribute an amount equal to nearly all of its taxable income for it to have the cash to make the required distributions to its shareholders. Naturally this will raise issues if the property’s budget and business plan would otherwise have dedicated the property’s cash flow to fund reserves or capital projects or make principal payments on debt. While the REIT may be able to avoid losing its REIT status by having the shareholders agree to pick up the income as a “consent dividend” even though there is no cash distribution, this practice is usually not viewed favorably by most shareholders and it may not be easy to get all the shareholders to agree on this solution.
A REIT will often require very detailed reports and other information that a non-REIT partner may not have needed. A REIT will almost always seek information regarding leases and other sources of revenue and will likely require that the REIT’s consent be obtained before the joint venture executes any lease or other revenue-generating agreement (so that the REIT can ensure its compliance with the REIT regulations).
Any party considering investing with a REIT partner should be mindful of the level of responsibility that it is assuming with respect to the maintenance of its partner’s REIT status. Even if the owner/developer is familiar with the various requirements that a REIT must satisfy, it should avoid any implication that it is promising that its partner will meet all of these requirements. Instead, the owner/developer will want to disclaim any obligation to make any independent inquiry into REIT-related matters and laws, while agreeing to do its part by seeking the REIT’s consent to the specified matters that require approval and complying with the disclosure and notice provisions of the joint venture agreement. Additionally, where applicable, the owner/developer may request a representation from the REIT as part of the due diligence phase of the acquisition/joint venture that the manner in which the property and the joint venture are currently being operated and managed is REIT-compliant (allowing the owner/developer freedom to continue the status quo until the REIT provides notice otherwise).
Allocating the cost of REIT compliance is often negotiated by the parties. There are at least two schools of thought here: (1) if the owner/developer wants the REIT’s money, then the venture should pay these costs (meaning the parties will share the costs ratably) and (2) the REIT should be responsible for all costs associated with its unique requirements. The parties should fully understand what reporting and other obligations must be satisfied and the anticipated related costs before going into the negotiation.
Lastly, use of a REIT may complicate the exit strategy for the property. Often it is advantageous for the owners of a REIT to sell the stock of the REIT, rather than have the REIT receive sales proceeds when the actual real estate is sold. This process, however, will eliminate some potential buyers and hence may lower the sale price for all of the owners of the property. To ensure a stock sale, the investor may even demand a put option to sell the REIT stock to the REIT’s partner in the venture. Even if, as an economic matter, the investor is willing to grant this put option, the entity will still be subject to REIT ownership and compliance rules, and a REIT would normally not be the best way for a U.S. owner to hold a real estate investment. Also, the buyer of the REIT stock may not get an increase in the tax basis of the building, so the buyer may be giving up depreciation deductions annually. The owner may be able to liquidate the REIT prior to the sale of the building in order to own the interest outright, but this, too, can complicate the sale of the real estate.
Owners and developers considering a REIT partner should examine all issues with their financial and legal advisors who have a deep understanding of the real estate industry and the complexities of the REIT structure.