The Tax Cuts and Jobs Act created several new tax incentives for small and large businesses.
In the non-conventional lending industry, it created the possibility for a 20% deduction for pass through entities. This excited many lenders. But, the restrictions and limitations surrounding it made it very unlikely for non-conventional lenders and their investors to benefit. Thankfully, there was one part of this new pass through deduction that was very clear and unequivocal that has caused significant repercussions in the non-conventional lending industry. Real Estate Investment Trusts or REITs qualify for this 20% pass through deduction.
For the uninitiated – a REIT is a company that owns real estate or real estate related assets, including mortgages and is able to qualify for pass through taxation by meeting certain key requirements set forth in the tax code. Most REITs are designed as pooled funds with real estate assets.
The Key Requirements to Qualify as a REIT:
- Must be an entity taxed as a corporation.
- 90% of its taxable income must be distributed to shareholders in the form of dividends each year.
- 75% of its assets must be in real estate, cash or US Treasuries.
- 75% of its gross income must come from real estate related assets.
- It must not be “closely held” meaning no 5 investors may own more than 50% of the REIT.
- It must have a minimum of 100 shareholders.
REITs can be publicly traded or privately held – including exempt under Regulation D. Since REIT dividends are taxed at the individual shareholder’s rate, and REITS always qualify for the new pass through deduction – REIT shareholders are able to reduce their dividends from 39.6% to 29.6% at the highest tax bracket. Another added benefit of REITs are they are NOT subject to Unrelated Business Taxable Income (UBTI). So for those funds that have IRAs or other qualified plans – this is an additional added benefit to pursue a REIT structure. However, REITs are not for everyone. The cost of maintenance and ongoing compliance are quite significant compared to a traditional mortgage pool or fund model.
In the non-conventional lending industry, many traditional mortgage funds exempt under Reg D have begun exploring the idea of converting to a REIT to benefit from this 20% pass through deduction and UBTI elimination. Added benefits for offshore investors also incentivize many mortgage funds and pools to convert to a REIT.
However, conversion is not as simple as it sounds. At first blush, many mortgage funds and pools think about simply converting the fund on its own. Switching an existing LLC that is taxed as a partnership to a corporate taxation model is significantly challenging, especially when a fund is comprised of over 100 members.
Today, most mortgage funds and pools are opting to create a Sub-REIT. A Sub-REIT is partially-owned subsidiary which is jointly owned by the parent mortgage fund/pool and 99 other investors. Provided the Sub-REIT meets the other REIT qualifications, this model will allow the parent mortgage pool/fund to benefit from the Sub-REIT’s tax structure.
An Alternative to REITs
Set up a new Sub-REIT to your existing mortgage fund to pass the tax savings to the fund’s investors.
This method is optimal because it not only allows the existing mortgage fund/pool to maintain its status quo, but it also allows the parent mortgage fund/pool to be able to pivot in the event these new tax rules are repealed or amended by a subsequent administration.
Now, REITs and Sub-REITs are not for everybody. Starting fresh with a REIT can prove to be a challenge due to the added cost of maintenance and compliance. We recommend existing funds that have reached roughly $40 to $50 million in assets under management to consider this route as this is the point at which the benefit begins to outweigh the costs to the fund.
One final consideration to make is to ensure you transfer the assets to the Sub-REIT in compliance with local lending regulations. This is essential as REITS must be comprised of 75% of real estate related assets. This may require the Sub-REIT to become licensed in some states such as California. We have seen many Sub-REITS pursue a California Lenders License to ensure they can compliantly transfer loans between the parent fund and the Sub-REIT.
With the recent amendments to the tax code, Sub-REITS have become the go-to method for mortgage funds/pools to optimize their lending business. The pass-through tax benefits, elimination of UBTI and benefits for offshore investors make it a significantly powerful option for non-conventional lenders. However, most funds will want to wait until they exceed $40 million to $50 million in assets under management to ensure the benefits outweigh the costs.