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Industry Insights

My REIT Partner Wants … Detailed Information on Where All (And I Mean ALL) Our Building Income Comes From

8.18.20| Industry Insights – Special REIT Edition

The basic business considerations of property ownership are quite clear: make the most money possible with the building you’ve got and (usually) try to keep the building fully leased. To these points, your REIT investor will almost definitely agree.

To achieve these goals, many savvy real estate property investors have derived ways to supplement the basic rental income generated from their portfolios. Many of these new sources of income are the byproduct of technological advancement over time, while more “old school” sources, such as advertising, can also be quite lucrative. For example, the small television monitors located in elevators in newer buildings enables owners of these buildings to derive a steam of income by selling advertising time on these screens. Perhaps the building owner is supplementing cash flow by selling building naming rights, data from their HVAC utilization or lease up activities. The possibilities are only limited by imagination (and the ability to get someone to actually pay you for it).

Additionally, as competition for tenants increases in various metropolitan centers, buildings are looking to cater to and attract both new and potential future tenants. Accordingly, many buildings now have amenity spaces often involving some type of food and drink. Perhaps there is a conference center or fitness center in the building. Parking is often available to tenants on a priority (or even exclusive) basis.

With all these new potential sources of income related to the property, the income requirements for REITs may muck things up and necessitate a little bit of additional planning and structuring that otherwise wouldn’t be necessary.

Recall that the income requirement for REITs mandates that 95% of the gross income must be derived from dividends, interest, rents, or gains from the sale of certain assets (such as real estate, cash or government securities). Additionally, 75% of the income of a REIT must be from real property; this bucket includes qualified rents, gain from the sale of real property, mortgage interest & refunds of real property taxes.

Moreover, receipt of income by the REIT for providing non-customary services to a tenant, (i.e., property management and lease-up services), may disqualify all rents from that lease for purposes of the 75% & 95% income tests. This is known as Impermissible Tenant Service Income (ITSI). However, the receipt of a de minimis amount of income for non-customary services does not disqualify rents from treatment as rental income. The limit here is 1%, after which all rent is tainted from the lease.

Presented as the inverse, as long as it isn’t ITSI, 5% of the income of a REIT can be derived from any source whatsoever. For certain properties, 5% could be a significant amount of income and the ancillary income streams could never amount to such a percentage. Very often, however, a REIT partner will want to avoid almost any type of income which falls into that bucket. Remember, the penalties for failure of these tests are extremely harsh and REITs take serious precautions to avoid toeing the line. So, what does this all mean for your real estate operation?

First, be ready for your REIT partner (particularly its attorneys and accountants) to ask many questions. They will likely show a greater than average interest in reviewing all new and/or existing leases in the building. They may even demand lease approval rights. Depending on the risk tolerance of your REIT partner, they may also request that certain income streams be operated out of a separate entity from the property owner.

If “other income” isolation is ultimately the chosen path, the REIT will likely insert a Taxable REIT Subsidiary (TRS) as its partner in the newly formed entity. A TRS is a corporate entity wholly owned by a REIT, however it does not receive the same special dividend paid deduction afforded to REITs. Rather, its income is taxed as if it were a corporation. While the double taxation (one at the corporate level and one to the shareholders upon distribution out of the REIT) is certainly a negative, disqualification of the REIT due to failure of the income test would clearly be worse.

As with most special requests in life, each has its individual quirks and it’s always wise to have a knowledgeable and experienced advisor who has been through these types of situations before.

Questions? Please contact Thea Kruger at 212-699-8865 | tkruger@berdonllp.com or your Berdon LLP tax advisor.

Berdon LLP New York Accountants