Real Estate Investment Trusts (REITs) have gained significant traction in private lending for debt funds since 2017. With its attractive features like 20% tax savings, UBTI blocking, and state withholding blocking, it has become a staple for debt funds.
However, with the Tax Cuts and Jobs Act (TCJA) due to expire at the end of the year, the future of utilizing REITs for tax advantages remains uncertain. If Congress cannot find a resolution for the TCJA, many key REIT benefits, like the QBI deduction, will no longer be available, greatly reducing the effectiveness of using a REIT. The Trump administration aims to extend the TCJA, and as of May 2025, the extension has passed the House Budget Committee and is now on its way to a House Vote.
While the expiration of the TCJA poses the greatest risk to utilizing a REIT, there are other issues lenders must be aware of if they are considering utilizing this powerful investment tool. Below are the three most common issues REITs can cause, and how to navigate them successfully.
Loan Sales
The first issue we will explore is loan sales. This is an aspect that is often overlooked in the management of Mortgage REITs. As passive investors, REITs should not be actively involved in selling loans. Loans that were funded with the intention of selling them could trigger dealer income, which is prohibited income for REITs.
To mitigate this risk, it is recommended that funds with SUBREITs attached should consider closing and selling the loan through the parent fund. If the REIT already has the loan, it can be assigned to the parent fund for sale, but only in limited circumstances where the REIT can demonstrate circumstantial intent when it closed the loan that it did NOT intend to sell it.
Closely Held Violations
Another critical issue with REITs is closely held violations. The IRS mandates that no five individuals should own 50 % or more of the REIT on a fully diluted basis. This requirement must be met every second half of each tax year after the first year of being a REIT.
This is often overlooked by REITs that either do not perform quarterly testing or are unaware of the nuances of this obligation. It is crucial to look out for the IRS’s definition of an individual, which includes lineal ancestors and descendants as well as siblings. The best way to mitigate this risk is by ensuring the offering documents provide the necessary discretion to force redemption to meet these tests.
Inadequate Distribution of Taxable Income
The third issue that must be carefully monitored is the inadequate distribution of taxable income. REITs must distribute a minimum of 90% taxable income to its investors. However, inadequate accounting for defaulted loans, valuation allowances, or loss reserves can cause serious issues here. This is why it is imperative to work with an experienced CPA to ensure that the accounting is done correctly and to avoid violating this rule.
If the REIT is structured as a subsidiary REIT under a mortgage fund, it provides greater flexibility because the fund can serve as the loan selling party, and the SUBREIT can ensure that its dividends 100% of its taxable income to the parent fund. However, the closely held test extends to the parent fund, and the sponsor must evaluate the parent fund’s cap table quarterly to avoid violating this rule.
Looking Ahead: Are REITs A Smart Strategy for 2025 and beyond?
While mortgage REITs have proven to be an incredibly valuable strategy since their introduction in 2017, the pending status of the TCJA could drastically reduce their advantages in the future. Investors should evaluate whether their REIT structure will remain useful if the TCJA provisions sunset or consider alternative tax strategies.
However, the three issues covered in this article should still be top of mind for any lender considering a mortgage REIT for their investment strategy. There has never been a more crucial time to be aware of compliance requirements and how to effectively navigate them. If you are looking for more assistance regarding fund formation or mortgage REITs, contact our Corporate and Securities team today.
