REITs have unique compliance requirements that add complexity to operations. They become especially important during a downturn or economic crisis.
Much like mortgage funds, mortgage REITs are suffering from the volatility created by the COVID-19 outbreak. Many REIT trustees are contemplating suspending redemptions, preserving capital, and building reserves. Furthermore, many REITs are strategizing how to manage the onslaught of modifications, workouts, and forbearances caused by uncertainty surrounding the ability to foreclose.
This article will outline specific issues unique to REITs surrounding suspending redemptions and portfolio issues surrounding forbearances, modifications and foreclosures.
Many REITs and SUBREITs are contemplating suspending withdrawals. When it comes to investor counts and capital contributions, REITs must keep in mind two key rules for REITs to maintain REIT status:
(1) The 100 Investor Rule
The 100 investor rule requires the REIT to have 100 or more investors for at least 335 days in a 12 month taxable year or a prorated equivalent.
The 100 investor rule is paramount for REITs and SUBREITs that do not use shareholder accommodation services. While the REIT may be freezing redemptions during the COVID-19 crisis, is it prepared to prevent redemptions as things calm down and stabilize, to ensure the REIT stays above 100 investors?
(2) The Closely Held Rule, also known as the 5 and 50 rule
The 5 and 50 rule state that after the first taxable year as a REIT, the REIT cannot be “closely held”, meaning 50% of the value cannot be owned directly or indirectly by 5 or less individuals.
The Closely Held Rule is more important than the 100 investor rule. During a redemption freeze, investors still may be receiving distributions/ dividends. They may be electing to reinvest. Does this continued reinvestment create the possibility of any investor increasing their position, such they may be owning 1/10 or more of the REIT?
In addition, as the COVID-19 crisis stabilizes and investors begin to come in with more capital or redeem, are there proper monitoring and prevention safeguards to ensure the REIT does not violate the 5 and 50 rule? It may require REITs to suspend redemptions even further to ensure they do not jeopardize REIT status.
The Impact of Forbearances, Modifications and Foreclosures
The impact of forbearances, modifications, and eventual foreclosures on REITs and SUBREITs are a bit more nuanced. As the portfolio’s default rate increases, it is important to keep advisors close to ensure that the volume of modifications and foreclosures do not become prohibited transactions or cause the REIT to be deemed a dealer in the eyes of the IRS.
“Fund managers with mortgage REITs and borrowers in default will need to be more diligent under this economic situation. Loan modifications or foreclosures could result in not meeting the required REIT income or asset tests. Loan mods or foreclosures which do not meet safe harbor guidelines may also result in prohibited transactions. Both situations may result in the loss of REIT status. There are workable solutions around these matters if the manager is proactive and plans in advance to avoid problems.”Beeta Lecha, Principal, Tax & Fund Accounting for Speigel Accountancy
Furthermore, income recognition is supremely important, because the REIT should dividend at least 90% of its taxable income to retain REIT status. As loans become impaired and non-performing, it becomes a big question as to whether the REIT is making the appropriate dividends/distributions to investors in accordance with REIT compliance rules.
“If some of the performing loans in a REIT become partially performing or nonperforming, there may be some significant timing differences in book versus taxable income. We recommend, as the year progresses and we gain line of sight into the impact of COVID-19 (and any other relevant considerations), that clients work with advisors on taxable income projections and the associated impact on the amount of necessary REIT dividends. There are a number of tools available to help manage these issues, and identifying the issues early will provide you with the greatest amount of certainty and flexibility toward the end of the year.”David Erard, Tax Partner at Armanino LLP
On the whole, for mortgage funds who have added REITs to their business model, we strongly recommend you keep your attorney and your CPAs closeby to ensure the strategies you elect to pursue during this COVID-19 crisis do not jeopardize your fund, your REIT and your investors.
If you have any questions about REITs and COVID-19, reach out to Geraci Law Firm’s Corporate and Securities team here.
Special thanks to Beeta Lecha and David Erard for their comments.