Potential Tax Benefits of Private REITs for Hedge Funds and Private Equity Funds
By James D. McCann, Esq., and Philip S. Gross, Exq.1
Limited partnerships and limited liability companies are generally the preferred vehicles for private investment in real estate, due to their flexibility, low cost and tax efficiency. However, despite greater cost and complexity, private REITs may produce significantly better after-tax results in the right circumstances.
This article provides a brief overview of REIT requirements and the use of private REITs as potentially tax-advantageous vehicles for private investment funds. It reviews key requirements; various tax planning opportunities, in particular for foreign and U.S. tax-exempt investors; and diligence and compliance burdens.
“REIT” is an acronym for “real estate investment trust.” REITs were created to permit tax-efficient public investment in real estate, but have also found wide use as private vehicles. Private REITs are not publicly traded.
An entity becomes a REIT by making a tax election and satisfying certain requirements. These include that its assets are primarily real estate, its income is primarily derived from real estate, and it meets ownership, operational, and other tests.
REITs are partial conduits because, unlike corporations in general, REITs may deduct dividends paid in determining taxable income. Thus, in general, a REIT owes no federal income tax if its dividends paid are at least equal to its taxable income. A REIT’s shareholders are taxed on dividends received from the REIT. To the extent long-term capital gains are distributed, a REIT’s dividends may be taxed at long-term capital gain rates; the balance of any dividends is taxed as ordinary income.
Following is an overview of the requirements and potential tax benefits, issues and risks associated with private REITs as vehicles for private investment funds.
Overview of REIT Requirements
Qualification as a REIT requires satisfying a number of tests and other conditions. Certain key requirements reflect the fact that REITs are intended as passive real estate investment vehicles.
Gross income tests. The REIT income tests must be satisfied each year.
- At least 75% of gross income is derived from real estate, including rents on real estate, gain from the sale of real estate, and interest on loans secured by real estate. There are numerous exceptions and special limitations, requiring case-by-case diligence. For example, related party rents, “percentage” rents, and interest earned on debt acquired at a discount may not qualify (wholly or in part) as real estate income.
- At least 95% of gross income is real estate income or certain categories of passive income, such as dividends and interest.
Asset tests. The REIT asset tests must generally be satisfied at the end of each calendar quarter.
- At least 75% of the value of the REIT’s assets is represented by “real estate assets”, cash and cash items, and government securities. For this purpose, real estate assets generally include, among other things, interests in real property (e.g., fee ownership, leaseholds, and purchase options in real property), loans secured by real property, and interests in other REITs. Similar to the gross income tests, there are numerous exceptions and special limitations, requiring case-by-case diligence. For example, debt acquired at a discount may be considered only partially a real estate asset.
- Non-real estate assets satisfy diversification thresholds and certain other limitations.
Minimum annual distributions. The REIT pays dividends equal to at least 90% of its taxable income each year. These dividends may be paid in cash or other property, or through a consent procedure. Consent dividends do not require an actual distribution, but are subject to withholding taxes with respect to the REIT’s foreign shareholders. Dividends paid after the close of the taxable year are generally subject to a 4% excise tax. There are carve-outs from the distribution requirement for net capital gain and for a limited amount of certain noncash income (e.g., a limited amount of original issue discount (OID)). However, to the extent that it retains any taxable income, the REIT is subject to tax on such income.
Not closely held. Five or fewer individuals cannot (directly or indirectly) own more than 50% of the value of the REIT’s stock during the last half of the REIT’s taxable year. For this purpose, private foundations, certain trusts, and certain pension and similar plans are treated as “individuals.” This requirement requires diligence, but generally is not an issue for private investment funds.
Shares freely transferable.This requirement generally is not an issue if the REIT is used as a vehicle by a private investment fund (e.g., if the REIT is a subsidiary of the fund). It generally precludes making the fund itself a REIT, however, as private investment funds generally do not permit investors to transfer fund interests except by means of redemption.
Other requirements. The following requirements generally are not substantive issues.
- Tax election. This is done by timely filing an income tax return on Form 1120-REIT for the first year for which REIT status is desired.
- Minimum number of shareholders. Have 100 or more direct shareholders. For a private REIT, extra shareholders may be obtained through a limited offering of preferred shares. These preferred shares are typically non-voting and are only entitled to a return of their investment plus a fixed annual coupon.
- Organized as a corporation, trust, or association. This requirement is an anachronism. Under the current entity classification rules, trusts, corporations, limited partnerships, limited liability companies and other types of legal entity may qualify as REITs.
- Taxable as a domestic corporation. A foreign entity cannot qualify as a REIT.
- Managed by its trustees or directors. This requirement is generally not an issue, but may require special attention to the REIT’s constitutive documents and management structure if it is organized, for example, as a limited partnership.
- Calendar year taxpayer. REITs must use a calendar tax year.
Tax Planning Opportunities & Issues
REITs present unique tax planning opportunities and issues. As compared to other vehicles, they require greater and different diligence and planning in the structuring, acquisition, holding and disposition phases. The cost of mistakes may be disproportionate. For example, even an inadvertent failure to qualify as a REIT generally subjects the REIT to corporate-level tax. Even worse, REITs are subject to a 100% tax on certain prohibited transactions.
A REIT can be a very good or very bad vehicle for foreign investment in U.S. real estate, depending on the asset and other factors.
In general, foreign persons are subject to U.S. federal income tax on income derived from U.S. real property. Foreign persons are subject to U.S. federal income tax on rents from U.S. real property and, under the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”), on gains from the sale of “U.S. real property interests.” For this purpose, U.S. real property interests include, among other things, direct ownership interests in U.S. real estate, as well as ownership interests in domestic entities (including REITs) a majority of the assets of which are comprised of U.S. real property. There are significant exceptions for sales of interests in certain publicly-traded entities by 5% or less investors, but these exceptions are generally not relevant to investments in private vehicles.
There is a significant exception from FIRPTA for sales of “domestically controlled” REITs (“DREITs”). In general, a foreign person is not subject to U.S. federal income tax on the sale of an interest in a DREIT. Thus, a foreign person may pay no U.S. federal income tax on exit from a U.S. real estate investment, if that exit can be structured as the sale of a DREIT. This can produce very substantial federal income tax savings.
DREIT qualification is tested at the time that a foreign person sells an interest in the REIT. DREIT qualification requires that, at all times during the five years preceding such sale, less than 50% of the value of the REIT was held (directly or indirectly) by foreign persons. There are technical issues with the DREIT definition, but it is generally accepted that indirect foreign ownership of a REIT through tax-transparent entities would likely preclude DREIT status. Indirect foreign ownership may present a practical issue for many private investment funds, which may have substantial foreign ownership or may not know the extent of their indirect foreign ownership, which may change over time. Some of these issues may be addressed by obtaining representations and covenants from key investors.
Structuring foreign investment through a REIT may raise other issues, however, not addressed by DREIT status. For example, as discussed above, REITs are generally required to distribute their annual taxable income as dividends, and dividends to foreign persons are generally subject to a 30% U.S. withholding tax. Tax treaty investors, who typically qualify for substantially lower withholding rates, generally get no or less relief from the withholding tax imposed on REIT dividends. The resulting withholding tax drag may make a REIT a poor vehicle for foreign investment in properties generating substantial year-to-year income (as opposed to properties producing a return primarily due to capital appreciation), although it may be possible to temper this issue through partial debt-financing.Also, if the DREIT sells U.S. real estate and distributes the sale proceeds, a foreign investor would be subject to federal income tax and would be required to file federal income tax returns.
U.S. tax-exempt investors
U.S. tax-exempt persons (such as churches, pension funds, charities and private foundations) generally are not subject to federal income tax on their investment income. However, they generally are subject to federal income tax on their “unrelated business taxable income” (“UBTI”), including UBTI arising from debt-financed investment in real estate.
There are a number of potential approaches to UBTI generated by debt-financed investment in real estate, including investing in a partnership that satisfies the so-called “fractions rule” (as such an investment would not give rise to UBTI for qualified tax-exempt entities). However, not all tax-exempt entities qualify for the fractions rule (for example, private foundations do not), and satisfying this rule may be impossible, difficult, or uncertain in many circumstances. Another approach is to structure the investment through a REIT. The REIT is not subject to tax on its UBTI, and its UBTI does not flow through the REIT to its tax-exempt investors (subject to an exception for significant pension investors in “pension-held” REITs). In other words, the REIT purges the UBTI. This is potentially an easy and effective solution.
U.S. taxable investors
REITs may solve certain state tax issues. For example, a state may tax nonresidents on gains realized from the sale of real property located in that state, including gain realized through an investment in a partnership. However, general state conformity to the federal tax treatment of REITs may provide a tax planning opportunity. That is, if a REIT distributes its entire taxable income, its federal taxable income will be reduced to zero and (in a conforming state) its state taxable income will be reduced to zero. The REIT’s shareholders generally would be taxed on these dividends only by their state of residence, not the state in which the underlying property is located. Thus, it is possible that no state income tax will be imposed on a REIT’s earnings, even though its properties are in high-tax states.
Many investments are not appropriate for REITs
REITs are subject to a number of limitations as to their permitted assets and income. Some of these limitations are simply prohibitions. For example, an entity will not qualify as a REIT if more than 25% of its assets are not real estate assets. Thus, REITs are generally not appropriate as securities trading vehicles. Less obviously, REITs cannot own and operate gas stations, due to the substantial personal property and service elements of gas stations. Even less obviously, REITs cannot act as real estate developers or engage in condo conversions, due to the 100% penalty tax on inventory sales by REITs. Of course, there are exceptions (or at least qualifications) to each of the foregoing statements.
Many investments require special consideration or structuring
Some assets, such as commercial rental properties or multifamily residential rental properties, may seem relatively “easy” for REITs (i.e., consistent with satisfying the REIT asset and income tests). However, even in “easy” cases, many issues require diligence, such as: Are any tenants related to the REIT or its beneficial owners? Rents from related persons generally do not qualify as real estate income, and the definition of “related person” for this purpose is very broad (particularly due to attribution rules). Is there on-site parking and, if so, who operates it and how is it operated? These are key terms for determining whether parking-related revenues qualify as real estate income. Do any tenants pay “percentage” rents? If even a portion of the rent paid under a lease is based on net income or profits of the lessee, then generally none of the rent paid under the lease qualifies as real estate income. Are non-customary services provided to tenants? Income from such services do not qualify as real estate income. Do the leased assets include material personal property, such as furniture or equipment? If they do, then rents attributable to personal property may not qualify as real estate income. Is there an expectation or possibility that a residential rental building might undergo a conversion to a condominium or co-op? Sales of condominiums or co-op units would generally be viewed as sales of inventory, and subject to a 100% penalty tax.
Other assets are “hard.” For example, REITs can own but cannot operate hotels. As a result, hotel REITs generally involve (at least) three parties: the REIT (which owns the hotel), a subsidiary of the REIT (which leases the hotel from the REIT), and an unrelated professional hotel manager.
Other assets may require special diligence or protections. For example, a REIT’s investment in a partnership generally is tested on a look-through basis, and a REIT may seek some degree of contractual protection against partnership activities potentially affecting the REIT’s satisfaction of the various REIT qualification requirements (in particular, the asset and income tests), or that might cause it to be subject to penalty or excise taxes.
REIT investment in debt
Debt instruments secured by real estate generally qualify as “real estate” for purposes of the REIT rules, and “mortgage REITs” primarily invest in such assets.
Mortgage REITs may or may not be tax-efficient vehicles for foreign investors. A “pure” mortgage REIT would not be subject to FIRPTA, and thus a foreign person generally would not incur any U.S. income tax on the sale of such an entity. However, care must be taken with such a structure, as even a single U.S. real estate interest (such as an equity kicker or a foreclosure) could subject the entire investment to FIRPTA and, thus, to U.S. income tax. Possible detriments to structuring foreign investment in U.S. mortgages through a REIT include converting (effectively) tax-free “portfolio interest” into taxable dividends, and cash flow issues resulting from withholding tax on dividends, particularly if the REIT has substantial non-cash interest income (e.g., original issue discount).
Mortgages require special diligence as a REIT asset class. For example, mezzanine financing, discounted mortgages, mortgages secured in part by personal property and equity kickers all present potential REIT qualification and other issues.
One or more REITs?
For an investment in multiple real estate assets, a basic issue is whether to utilize one REIT to hold all of the assets or to use a separate REIT for each asset. U.S. taxable investors may prefer a single REIT, so that gains and losses from the various assets are pooled and the REIT distributes only the net taxable income of all assets. Foreign investors, however, may prefer a separate REIT for each asset as part of a DREIT structure, to permit the sale of each DREIT as an exit strategy. A partial compromise may be found through a “baby REIT” structure, where a single parent REIT owns multiple properties through multiple baby REITs. This can effect a partial consolidation by permitting the offset of parent REIT expenses (e.g., financing costs) against dividends from profitable baby REITs, while still permitting the sale of baby REITs as an exit strategy.
As compared to most other vehicles, REITs require substantially greater and different year-to-year compliance efforts. Failure to observe these compliance requirements may terminate REIT status or subject the REIT to penalties. REIT compliance requirements include the following: payment of annual dividends, obtaining annual information statements from shareholders (and potentially indirect shareholders, such as investors in the private investment fund that owns the REIT), identifying capital gain dividends, and monitoring compliance with the various income and asset tests.
Although private REITs can be complex, in the right situations a private REIT may be an ideal vehicle for real estate investments by a hedge fund or private equity fund.
1 Jim and Phil are members of Kleinberg, Kaplan, Wolff & Cohen, P.C., where they focus on the taxation of hedge funds, real estate funds and private equity funds. Jim can be reached at [email protected] and Phil can be reached at [email protected].