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, it is important to note that REITs come with additional compliance concerns and restrictions that need to be managed. In this article, we will discuss the top three issues we see with Mortgage REITs.
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 tat 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 it dividends 100% of its taxable income to the parent fund. However, the closely held test extends to the parent fund, and it is essential that the sponsor evaluate the parent fund’s cap table quarterly to avoid violating this rule.
In conclusion, Mortgage REITs have gained significant traction in private lending for debt funds. With its attractive features like 20% tax savings, UBTI blocking, and state withholding blocking, it has become a staple for debt funds. However, it is important to note that REITs come with additional compliance concerns and restrictions that need to be managed. The three issues highlighted in this article – loan sales, closely held violations, and inadequate distribution of taxable income – are some of the top challenges that REITs face. By being aware of these issues and working with experienced professionals, REITs can navigate these challenges and reap the benefits that come with this investment strategy.
For more information about REITs, please contact the team at Geraci Law Firm today.