2.2.21 | Industry Insights – Special REIT Edition
Real Estate Investment Trusts (REITs) came into existence in the 1960s, as a way for individual investors to earn income through ownership of commercial real estate. REITs have always been intended as vehicles for passive investments. Recall the previously discussed REIT income rules whereby 75% of the REIT gross income must be from rentals (which is deemed passive by nature according to the IRS), and 95% of gross income from a combination of the aforementioned rentals rule, plus other passive sources like interest dividends, and gains from the sale of certain assets. Thankfully, real estate investments usually fit neatly into this box. Or do they?
As we’ve covered in previous blogs, a REIT typically avoids paying any income taxes by distributing all its REIT taxable income in the form of dividends. However, certain “prohibited transactions” result in a penalty tax of 100% on the gains they generate! Sale of property “primarily held for sale” to customers is one such instance where a REIT will be subject to this 100% penalty tax. Whether property was held for sale is based on a facts and circumstances test, not any hard-wired law. Courts consider many factors, including:
- Number, frequencies, continuity of sales
- Extent and timing of improvements
- Promotional activities
- Holding period
- Purpose of acquisition, holding, disposition
Thankfully, the Internal Revenue Code, in Section 857(b)(6)(C), provides a safe harbor under which a prohibited transaction will be deemed to have not occurred. These rules, expanded by the PATH Act of 2016, mandate that all the following are met:
- The REIT has held the property for greater than two years;
- The aggregate expenditures made by the REIT, or any partner of the REIT, within the two-year period preceding the sale of the property that are includible in property basis do not exceed 30% of the sales price;
- (a) No more than seven sales of property have been made by the REIT during the tax year, or, (b) the total adjusted basis of the property sold by the REIT during the tax year does not exceed 20% of the aggregate basis held by the REIT at the beginning of the tax year, or (c) the FMV of the property sold in a tax year does not exceed 20% the total FMV of all assets held at the beginning of the tax year;
- If the property is land or improvements not acquired through foreclosure or lease termination, the property was held by the REIT for at least two years for the production of rental income; and
- If the seven sales test noted in 3 (a) is not met, substantially all marketing and development expenditures relating to the property sold were made through an independent contractor, from which the REIT does not receive any rental income, or a taxable REIT subsidiary.
Let’s review some hypotheticals and see how a couple of relatively common real estate transactions could potentially run afoul of the prohibited transactions rules for REITs.
First, imagine a situation where you and your REIT partner formed a joint venture to purchase a residential building. Perhaps due to fantastic market timing, or other previously unforeseen forces, the property is worth considerably more money within 6-12 months and an unsolicited offer arrives at your office. The offer is fantastic, and you would love to sell. However, the REIT partner wants to have an extended discussion with both their legal and accounting teams first. A sale would require unanimous approval and you can’t imagine they’re going to turn it down, right?
In this instance, the safe harbor rules discussed above are not met, so it will be a facts and circumstances determination as to whether the sale would constitute a prohibited transaction. Thankfully, your joint venture has well documented models and correspondence outlining your intention to acquire and hold the property for rentals into the future. Additionally, the property was not marketed, and the REIT does not have a history of quick turnaround sales. In all likelihood, a situation like this would not constitute a prohibited transaction.
Alternatively, what if you found a deal that involved buying a residential property, but also mandated the purchase of the adjoining vacant lot. Your acquisitions analyst underwrites this deal to a very significant profit, which accounts for a quick sale of that vacant lot for which your joint venture has no use or plans. In fact, your analyst has already sought out and identified multiple buyers who would love to use that parcel for development.
Once again, the safe harbor rules are not met. In fact, the property has not even been acquired. Assuming the transactions are both consummated (the purchase and vacant parcel sale) it again will be a facts and circumstances determination as to whether a prohibited transaction occurred. Things do not look as good this time around. That vacant lot was purchased with the expectation of a quick sale. Furthermore, your analyst actively sought out buyers prior to close (and well within two years). For these reasons, your REIT partner may veto the vacant parcel sale entirely, or perhaps proactively look to restructure the deal, such that the purchase occurs in separate entities with the vacant lot owned by either a taxable REIT subsidiary or another non-REIT vehicle (perhaps an AIV owned by the REIT investors, or a subset of them, directly).
The variety of acquisition, development, and divestiture scenarios, which could create some prohibited transaction uncertainty, are as vast as the imagination and are more common than you may think. Understanding the prohibited transaction rules can help real estate investors partnering with REITs both potentially plan in advance for these types of situations, or better understand when situations begin to arise that require additional research and counsel.
Questions? Please contact Thea Kruger at 212-699-8865 | email@example.com or your Berdon LLP tax advisor.
Berdon LLP New York Accountants