by Bradley Rogerson,
Hanson Bridgett LLP
You just don’t see mortgage REITs in the hard money lending world. There is nothing that says a private money mortgage fund can’t operate as a REIT. It’s just rarely done. This is mostly because the primary benefit of a REIT, elimination of entity level taxation, can also be obtained by forming a fund as a limited partnership (“LP”) or a limited liability company (“LLC”). REITs have always had one or two potential benefits over LPs and LLCs but, historically, funds that could take advantage of these benefits seldom, if ever, felt they justified complying with the additional requirements and limitations necessary to qualify as a REIT.
The treatment of REIT income under the recently enacted Tax Cuts and Jobs Act (“TCJA”) is sparking new interest in REITS, even in the private lending industry. This is because, while the TCJA promised a 20% tax deduction for income earned from all pass-through entities, private mortgage fund managers are learning that REIT investors are in a much better position to take advantage of these deductions than investors in funds formed as LPs and LLCs. Not surprisingly, this has some asking if their fund(s) can and should be REITs. The answer to this question will, of course, vary from fund to fund but if the question is being asked, a basic understanding of REITs and their requirements is a good place to start the conversation.
What is a REIT?
The obvious first question is what exactly is a REIT? The term is often used broadly or as shorthand to refer to any type of real estate investment entity; however, a true REIT is an entity that meets very specific qualifications and that elects a to be taxed as a REIT under the Internal Revenue Code (“IRC”).
The acronym R.E.I.T stands for “Real Estate Investment Trust,” however, a REIT does not necessarily need to be formed as a trust. In fact, many REITs are formed as corporations and nothing precludes a REIT from being formed as a partnership or LLC. REITs also are not required to limit their investments to ownership interests in real estate. They must own “real estate related assets” but such assets include more than just direct ownership interests in real estate. Most importantly for private lenders, loans secured by real estate have always been included in this definition, and REITs that invest in real estate secured loans (i.e., “mortgage REITs”) are both permitted and very common in financial markets.
No matter what type of legal entity is used, a REIT is treated for tax purposes like a C-corporation and pays tax on the income earned at the entity level. Nonetheless, REITs are considered a type of “pass-through entity” like partnerships, LLCs and S-corporations (referred to herein as, “Non-REIT Pass-Through Entities”) because a REIT is permitted to deduct the amount of any dividends it pays to its shareholders when calculating its taxable income. By doing so, it can effectively eliminate (through tax deductions) the entity level tax payable on the income that is earned and distributed to its shareholders as dividends.
REITS, however, have important differences from Non-REIT Pass-Through Entities. REITs do not pass their losses through to their shareholders and, while REIT deductions simulate a pass-through effect by eliminating (or greatly reducing) the REITs entity level tax liabilities, they do not pass-through the character of that income. Rather, income distributed by a REIT is corporate dividend income regardless of the character of income earned at the REIT level.1 As discussed below, this ability to distribute dividend income to investors notwithstanding the character of income earned by the REIT is the basis of several of the potential benefits of operating as a REIT.
Potential REIT Benefits
The primary benefit of becoming a REIT is the “pass-through” taxation effect discussed above. For real estate or loan funds that must (or have very compelling reasons to) operate as corporations rather than Non-REIT Pass-Through Entities, REIT status is a way to do so without being subject to the effects of double-taxation. For example, public companies often prefer to be organized as C-corporations rather Non-REIT Pass-Through Entities to facilitate the sale of their shares on national securities exchanges. REITs allow public real estate companies to operate as C-corporations while still avoiding significant entity level taxation.
Tax Exempt & Foreign Investors
Prior to enactment of the TCJA, the primary reason a private mortgage fund might consider operating as a REIT involved the effect of leverage on tax exempt investors. As many private mortgage fund managers know, the use of leverage by their funds can create “unrelated business taxable income” or “UBTI” which is taxable to otherwise tax-exempt investors such as pension and profit-sharing plans and IRAs. REIT dividends, unlike true pass-through income, are not treated as UBTI whether or not leverage is used at the entity level. Consequently, funds seeking to use leverage or otherwise generating a significant amount of UBTI benefit from REIT status where a significant part of their capital comes from tax exempt investors.
The ability to distribute REIT dividends also has certain benefits for foreign investors and REITs are a good choice for funds that raise a significant amount of their capital from investors outside the United States. In the past, facilitating foreign investment has not been a significant consideration for many private money mortgage funds, but this is changing as the industry and individual funds grow and begin to seek and receive capital from a broader spectrum of sources.
TCJA Tax Deductions & QBI
As mentioned above, the TCJA has created an additional benefit for REITs. Enacted by President Trump in December of 2017, the TCJA amended IRC Section 199A to provide a 20% income tax deduction for “qualified business income” or “QBI” received from pass-through entities including both REITs and Non-REIT Pass-Through Entities. Unfortunately, as amended, Section 199A limits the amount of QBI a Non-REIT Pass-Through Entity can distribute to its owners by the amount of W-2 wages paid and the value of the “qualified property” held by the entity. Applying these limitations and calculating the amount of QBI an entity creates is complicated and the results will vary on a fund by fund basis. For most private mortgage funds, however, the result will likely be that only a small fraction of the fund’s income will qualify as QBI and each investor’s 20% of deduction on their share of that QBI will be negligible.
The W-2 wage and qualified property restrictions discussed above do not apply to income distributed by a REIT. Rather, Section 199A treats REIT income as a separate type of income which is deemed QBI without regard to the REIT’s W-2 wages or the type of assets held. It should be understood that while 100% of a REITs income is deemed QBI under Section 199A, the ultimate ability of investors to realize a full 20% deduction on that income may still be limited by restrictions and “phase-out” provisions applicable to individual taxpayers. Nonetheless, the ability to characterize all income generated by a REIT as QBI and the potential of offering investors their full share of this 20% deduction does appear to be a significant new benefit that can be gained by operating as a REIT. Whether a private fund should elect to be a REIT, however, will depend in large part on the fund’s ability to conform to the REIT requirements and restrictions.
REIT Requirements & Restrictions
To qualify as a REIT, an investment entity must meet several tests outlined in the IRC with respect to its income, assets, distributions and structure. A brief summary of these requirements and restrictions is set forth below.
REITs are subject to two income tests: (1) at least 75% of a REIT’s annual gross income must be “real estate related” income; and (2) 95% of a REIT’s annual gross income must be “passive” income. Income sources that are deemed “real estate related” and “passive” for these purposes include “real estate related interest” (including interest on obligations secured by real property), rents from real property, real property gains, dividends and gains from other REITs, income from foreclosure properties and income from temporary (non-real estate) investments.
REITs are subject to the following asset tests: (1) at least 75% of the value of a REIT’s total assets must be comprised of “real estate assets” (including real estate secured loans), cash and government securities; (2) not more than 25% of the value of a REIT’s total assets can be attributable to securities, other than government securities; (3) except for investments in other REITs and certain REIT subsidiaries, no more than 5% of the value of a REIT’s total assets may be the securities of a single issuer; and (4) a REIT may not own more than 10% of the total voting interests or value of the outstanding securities of any one issuer.
90% Distribution Requirement
A REIT must distribute at least 90% of its taxable income annually to its shareholders. For this purpose, a REIT’s taxable income is calculated in the same manner as the income of an ordinary C-corporation, but without the benefit of the deduction for dividends taken by the REIT. To the extent that a REIT distributes less than 100% of its REIT taxable income (including the 10% the REIT is allowed to retain), a REIT must pay tax on the undistributed amount at regular corporate tax rates. Unless the REIT is publicly offered, the amount distributed must also not be preferential (meaning, every stockholder of the class of stock to which a distribution is made must be treated the same as every other stockholder of that class, and no class of stock can be treated other than according to its dividend rights as a class).
A REIT must be owned by 100 or more shareholders and no more than 50% of the value of the REIT’s outstanding stock may be owned actually or constructively by five or fewer individuals. Neither of these shareholder requirements, however, apply until after the first taxable year for which a REIT election is made to allow the stock to be acquired by the requisite number of owners.
A REIT is also subject to the following corporate restrictions: (1) REIT shares must be transferrable, however, securities law restrictions, restrictions on transferability of stock issued to employees and restrictions imposed by stockholder level agreements generally should not result in a violation of this requirement; (2) a REIT must be managed by trustees or directors and must be structured accordingly; and (3) a REIT must be taxable as a US corporation (i.e., foreign corporations cannot be REITs).
To REIT or not to REIT
A review of the REIT requirements above likely reveals that some requirements pose no issues to private fund managers while others may be “non-starters.” For traditional mortgage funds that invest solely in mortgage loans, the income tests and asset tests should not pose a problem and are likely already being met. Distributing 90% of a funds income, however, may simply not be an option for many funds.
These requirements also may uncover some questions as to the actual net benefits of a REIT election. For example, will the corporate level tax on undisbursed REIT income dilute the positive effects of the 20% TCJA deduction created for investors? Will the costs of restructuring to meet the REIT requirements be justified?
What should be clear, however, is that the structural and business considerations that must be assessed in connection to the decision to operate as a REIT are significant. In the end, the question of whether to REIT or not to REIT must only be answered when the true net benefits to obtaining REIT status are quantified and weighed against the time, costs and effort that will go into the endeavor.
1 This is a somewhat simplified description and there are, in fact, certain methods REITs can utilize to “pass-through” capital gain income to its stockholders; however, a discussion of these methods is beyond the scope of this article.