Mythbusting: Common Myths Regarding Mortgage REITs for Private Lenders

August 20, 2020 by Kevin S. Kim, Esq.

Since 2018, mortgage REITs have become an immensely popular strategy for funds in the private lending space. The primary reason for this is the 20% Qualified Business Income deduction granted to REIT dividends.

There are a lot of myths floating around regarding REITs as they relate to the private lending industry and the commonly used mortgage fund model. We’re here to put those myths to the test.

MYTH #1: A fund must have hundreds of investors to even consider becoming a REIT.

FALSE. There are two key “ownership” rules for REITs: the “Closely Held” Rule and the “100 Investor” Rule.

The 100 Investor Rule

The 100 Investor Rule does require a REIT to have over 100 investors. However, this rule only applies in the following tax year after electing as a REIT, for at least 335 days. What does that mean?

If an existing mortgage fund converts to a REIT or installs a Subsidiary REIT, the REIT must onboard 100 investors by the following tax year. So, if a REIT elects to be a REIT on January 1, 2020, and it uses a calendar tax year, then it must have onboarded 100 or more REIT investors by the end of January 2021, to ensure that it will have 100 or more investors for 335 days in the following tax year.

It’s important to note that this 100 Investor rule does not apply to the fund if the fund were to install a REIT Subsidiary, or “SUBREIT.” It only applies to the SUBREIT. Notably, many REITs utilize shareholder accommodation services for this requirement, so it is not challenging to conform with this rule.

The Closely Held Rule

The Closely Held rule is a bit more complicated. The Closely Held rule prohibits 50% or more of a REIT to be owned by 5 or less people. Also referred to as the “5/50 Test”, this rule calculates REIT ownership on a fully diluted basis. So, for mortgage funds in the private lending industry, the use of REIT Subsidiaries will require an analysis of the parent fund to evaluate compliance with the 5/50 test.

However, this does not require the fund to have hundreds of investors. It simply requires that the fund have enough investors such that no 5 or fewer investors own 50% or more of the fund’s equity.

Also, from a timing standpoint, a REIT must conform with this requirement during the last 6 months of the following taxable year. Meaning, after a REIT elects REIT status, it must ensure it meets the 5/50 test in the following tax year.

As you can see, the IRS installed these buffers to allow REIT time to qualify. So, this REIT myth is busted.

MYTH #2: Mortgage REITs can’t have carried interest splits with the fund manager

TRUE. A REIT is required to distribute at least 90% of its taxable income to its investors annually. The tricky part with this is that the remaining undistributed 10% would be taxable. This contradicts a REIT’s mandate of being a tax-efficient investment vehicle, which makes it challenging for a REIT to offer any real carried interest.

However, in the private lending space, the commonly used SUBREIT strategy allows funds to maintain their carried interest, profit splits, or distributing excess cash after the preferred return. How? The SUBREIT is the entity that needs to conform with the REIT rules. It will inevitably dividend 100% of its taxable income to the parent. That is then pushed through the fund’s pre-existing waterfall, allowing investors to get the same tax benefits of being in the REIT, while allowing the fund manager to earn its desired income stream.

MYTH #3: New funds cannot start as a REIT

FALSE. This is like Myth #1, which we busted above. We’ve run into this misconception with many clients who want to start a fund with a SUBREIT or a REIT itself. We advise clients that it is often easier to start this process with a new fund because we don’t have to conduct any diligence on the fund’s existing portfolio, upcoming foreclosures, and investor pool. With the time buffers we discussed above, it is totally possible for funds to start as a REIT or have a SUBREIT upon formation.

In Conclusion

These were some commonly held misconceptions about REITs and SUBREITs for mortgage funds. There are a ton of other misunderstandings about REITs in today’s market, and we here at Geraci’s Corporate & Securities team are happy to help you through the confusion. One thing we can tell you for certain is that the REIT strategy is a very attractive solution for mortgage funds in today’s competitive market.

If you have any more questions about REIT or SUBREIT myths, reach out to Geraci Law Firm here.

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