By Edward Hannon, Attorney/Partner, and Everett Ward, Partner, at Quarles & Brady LLP
Over the past few years, many real estate professionals have seen significant expansion in the number of entities that are organized as real estate investment trusts (REITs). According to the National Association of Real Estate Investment Trusts, there are more than 40,000 properties across the United States that are owned by REITs. In light of this statistic, it is becoming more likely that many real estate professionals will find themselves involved in some type of transaction that involves at least one party that is a REIT.
What Is a REIT? The allure of a REIT is that—if certain qualifications are met—it will not be subject to an entity level tax on its net income. In addition, a REIT is not a flow-through entity for income tax purposes. Thus, unlike a limited liability company that is taxed as a partnership, if the entity maintains its status as a REIT, the income tax liability arising from the REIT’s activities can be limited to the tax imposed on the REIT shareholders on the dividends received from the REIT.
In order to obtain the special tax status afforded to REITs, the entity must satisfy certain organizational tests. In addition, throughout its existence as a REIT, the entity must satisfy various income tests and asset tests. The specific tax rules that apply to REITs, or the various circumstances in which a REIT will be subject to tax at the entity level, are beyond the scope of this article. However, as the number of properties owned by REITs expands, real estate professionals will need to obtain a basic understanding of how the tax rules that apply to REITs will affect how transactions are structured.
Leasing Property to a REIT In order to qualify as a REIT, at least 95 percent of a REIT’s annual gross income must be passive income — e.g., rents from real property, interest, and dividends. In fact, under this 95 percent gross income test, not all rents will qualify. In general, a REIT will be focused upon avoiding what is known as income from “impermissible tenant services.”
There are several recognized structures that can be adopted to address the impermissible tenant services issue, such as the use of a wholly owned taxable REIT subsidiary to perform these services. By way of example, a hotel REIT can enter into a master lease of the hotel property with a REIT affiliate or unrelated third party, under the terms of which the tenant will (i) manage (or hire a third party to manage) the hotel property, and (ii) receive all of the rental income from the operation of the hotel; in exchange, the tenant agrees to pay the REIT landlord a fixed monthly rental (usually based on some estimate of expected average collected monthly hotel rents) under the lease. This relatively straightforward structure allows the REIT to receive income (i.e., the rents under the master lease) that does not violate the “impermissible tenant services” standards.
Lending to a REIT If a REIT is the borrower, the loan documents will also need to be modified to address the requirements imposed on REITs under the Internal Revenue Code. For example, in order to qualify as a REIT, at least 90 percent of a REIT’s taxable income must be distributed to its shareholders annually. Thus, if the loan agreement includes the typical provisions that restrict the borrower’s ability to pay dividends or prohibits such dividend distributions altogether, this prohibition would impair the REIT’s ability to maintain its special tax status.
Two loan document provisions that, while not tax-specific, have great importance to REIT borrowers are financial reporting covenants and entity transfer rights. REIT borrowers typically negotiate the timing and substance of key financial reporting obligations (e.g., quarterly and annual income reporting) to coincide with the reporting of such matters to the SEC and/or other governmental agencies having jurisdiction over REITs. REITs also need great flexibility in their loan documents with respect to the ability to (i) transfer umbrella partnership REIT (or “UPREIT”–a limited partnership structure where the REIT is the general partner) limited partnership interest and transfer, (ii) issue new ownership interests at the REIT, and/or (iii) undertake mergers or other forms of consolidation at the REIT and/or UPREIT.
Selling Property to a REIT In some circumstances, the involvement of a REIT as the purchaser of real estate can provide some tax-savings opportunities to the seller. A REIT that is in a position to provide sellers with the opportunity to adopt this tax-deferral strategy will have all of its real estate assets held indirectly through a multi-member limited liability company (the “Umbrella Partnership”) which in turn will own the single member LLCs that hold title to the real estate (the use of the Umbrella Partnership structure is typically referred to as an “UPREIT”). In this tax-deferred strategy, the seller of the real estate will receive membership interests in the Umbrella Partnership (“OP Units”) or, in some cases, a combination of cash and OP Units.
If properly structured, the receipt of the OP Units will allow the seller to defer all or a substantial part of the taxable gain that the seller would have recognized had it sold the property in an all-cash deal. However, sellers contemplating this tax-deferred structure will see some or all of their tax deferred end upon a subsequent sale of the property. In some circumstances, this tax deferral could also end upon a refinancing of the debt on the contributed property or the reduction in the seller’s “partner’s share of partnership liabilities.”
Parties contemplating a sale of property to a REIT must understand the circumstances in which the tax deferral will end and what can be done to in order to maximize the benefits of this tax-deferral structure. Typically, if a seller receives OP Units, the parties will enter into a Tax Protection Agreement. The tax protection agreement will set forth various restrictions on when the REIT can sell the subject property, the amount of payment, if any, that the REIT will make to the seller up on the sale of the property and describe what specific protective action that the REIT will allow the seller to undertake in the event of a refinancing or a reduction in the seller’s “partner’s share of partnership liabilities.”
Conclusion As illustrated above, regardless of whether you’re a lender, tenant or seller, as more properties become REIT-owned, many real estate professionals will be required to understand how the application of the various rules imposed on REITs will affect the terms of the transaction.
