REITs and Tax Deductions in 2021: What’s to Come?

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REITs have been a major trend in private lending since 2017. It’s now 2021, and we have a new government, which means changes to the tax code.

This webinar discussed the following:
• Core requirements and fundamentals of forming and managing a REIT.
• The future for this trend going into 2021 and beyond.


Kevin Kim:

Good morning or good afternoon, wherever you are in the world. My name is Kevin Kim and today it's another Geraci webinar. Today we are presenting on REITs. We've done a lot of content and webinars on REITs but today's is going to be a little bit different. We're still going to talk about some of the compliance concerns and qualification issues and so on and so forth, but we really do want to spend a lot of time on this coming year and the following years and the new administration and how coming legislation may affect things. So first of all, for quick intro to myself my name is Kevin Kim. I'm a partner here at Geraci, for those of you who do not know me, I manage the firm's corporate and securities team, I'm a nationally recognized expert at fund formation in the private lending space. My team here at Geraci, we've formed over I don't know now, over thousand.

We, we've formed thousands of mortgage funds and advertisement investment vehicles across the US and our clients are nationwide, and we are definitely focused on serving these in this industry specifically. And so the context of this discussion is going to be for mortgage REITs and specifically in the context of how it applies to mortgage funds and the industry. So without further ado, let's get started. Quick thing on housekeeping before we get started on the actual content here please put your questions in the q and a feature. So if you open the little task bar below in the video, you'll see a q and a feature there. If you ask your questions there, we'll make sure to answer them. Either myself or a staff member will answer them. If we can't get to 'em today we'll make sure to get to 'em a little bit later. Feel free to chat here in the chat function and also make sure to leave a message for yours truly.

All right, so today's agenda, we're going to get into the real. We're going to spend some time on the requirements and the structuring for a REIT as it pertains to a mortgage fund for private lenders, some basic qualification requirements. We're going to dispel some myths, but we have to talk about legislation because it is a big issue. So moving forward. So first of all, what is a REIT? REIT is a real estate investment trust. Okay, so it is a very popular strategy today because it allows for some tax savings has been a mainstay in for real estate investors, but it has really become popular in the mortgage fund world because of the tax cut and jobs act that was enacted in 17. Some key requirements to be a REIT. Number one, your tax, the REIT must be taxed as a corporation. It has to elect to be reached to have reached status.

So essentially in its tax return to the IRS, it tells the IRS, Hey, I'm a REIT now to qualify, 75% or more of its assets must be real estate related assets and it's key related assets, not just real estate assets. So mortgages do qualify, but other real estate derivatives also apply. 90% of taxable income must be distributed to investors. This is the main floor requirement, but in reality REITs will typically distribute a hundred percent of the taxable income to its investors to avoid the remaining 10% being taxed at the corporate tax rate. REIT must also have a hundred or more investors by January 31st of the following tax year of their election year. And preferred equity is acceptable. Lately since we've been doing this shareholder accommodation services have been the usual trend to meet this requirement. It does not replace your existing LPs or LLC members, but it does provide you the a hundred investors to meet the qualification to be a REIT.

Last thing here is the closely held prohibition. This is a very, very strict rule. Five investors cannot own 50% or more of the REIT, and this is on a fully diluted basis. So we look through the REIT to its parents, to the investors. We look through the investors at their companies and they have members amongst themselves. So we have to look through them and we can figure out, do any five individuals own 50% or more of the REIT? This is a prohibition. You have to meet this requirement within basically a year from your election date you until the last six months of the following tax year. So you elected in March of 2020, you have to meet this requirement by the end of 2021. If you elected right now in 2021, we have until 2022 to meet this requirement. And there are no accommodation services for this.

So we strongly recommend funds ensure that they can meet this requirement if they have elected to go in recent memory. So these are the key requirements. There are some other issues associated with REITs that you have to think about but this is the core structure that we use here at Geraci. And we do typically do a lot of sub restructuring and sub restructuring being that the parent fund is your existing mortgage fund and the REIT is a wholly owned subsidiary, which is designed to hold the REIT, the mortgages. This strategy is useful, particularly because of a disposability number one, it allows your fund to maintain in its existence. And the strategy is important because if you think about this is once you go REIT, you can't go back, right? That's very important. You can't unring the bell. So if things were to change, we'll talk about that later in this webinar.

If things were to change or if you were to fall out of compliance as a REIT and you had converted your funds, your existing fund and turned it into a REIT, then you would have no choice but to unwind the fund and start new, right? Having a wholly owned subsidiary that qualifies as a REIT allows you to have some flexibility. So in the event that the tax benefits were no longer relevant to your fund or your investors or you were to fall out of compliance, you could essentially unwind the subsidiary, move the loans back up to the parent fund and retain to return to status quo. One additional component that allows this to be much more beneficial is also it grants the funding ability to not meet the 90% test. So the 90% test must be met by the REIT itself. So as long as the REIT is distributing a hundred percent of it taxable income to the parent, which is its sole investor, it meets the test.

This allows funds to maintain their profit splits or carry interest components, but it also allows them to have other unique distribution models and allows existing funds not to have to disrupt them, not to disrupt their existing model such that in the event of rate compression or a change in the market, you may not necessarily be distributed 90%. And so we have had this discussion with many clients in the past few years. Clients saying, well, right now we are currently distributing about 95% of equitable income. While that may be true, that may not be true in a crisis in a down market where you have to increase reserves and so on and so forth. And also if you're split is higher. So to that extent, we recommend the sub REIT. I think it's now can become kind of the standard practice. So the sub REIT itself will hold all the loans.

It'll be the sole owner of the fund solely owned by the fund, and the REIT itself will also recruit the hundred investors, 125 preferred investors typically done through a shareholder accommodator or penguin company and move forward from there. And that'll allow it to maximize efficiency. When it comes to compliance, the preferred investors distributions are a second contractual arrangement with the shareholder accommodation service. And that is typically deducted as an expense. So that way you can meet the 90% distribution test as the REIT. Let's talk about the market trend really quick. One of the most important things that we've seen since this has become a trend is that a large percentage of existing funds that are over approximately 50 million in AUM have gone this route already. Some have foregone it, and the reasoning for that typically is the tax benefits are nominal to their investors primarily because we've had a lot of fund managers tell us, well, we primarily have self-directed IRA investors, non-taxable investors, and we aren't levered.

So there aren't really that many benefits. And so the benefits are really designed for taxable investors. So before we get into how this plays out from a benefit standpoint, the key structure has been just discussed. I want to kind of talk about what are the big benefits for a fund for those of you who are unaware of the tax benefits that a REIT will grant a debt fund investor. And so first of all, we have to operate under the kind of core assumption. Mortgage funds is the key structure we're talking about. An LP or LLC structure that invests in or purchases mortgages. So this strategy results in the investor receiving ordinary income, and so the distributions are received as K1 on K1s, and the investors pay ordinary income on their distributions. This has been one of the most primary complaints of our industry.

While the returns are fantastic the ordinary income component leaves things to be desired. So in 2017 when the tax cut and Jobs Act was announced, it created section 199A and created this pass through deduction for certain types of businesses, but also for qualified re dividends. And so at the time in 17, we were all, were all scrambling to figure out what's the best way to get this deduction. And we were all of the opinion that the going REIT was the best strategy, which is why you started seeing REITs emerge in 2018. Come 2021, a majority of our clientele who are mortgage fund managers who are over 50 million ish have gone this route. And I mentioned before that tax deduction applies to qualify REIT dividends, but the pre presumption is that you're paying taxes on the dividends. So that's why we talked about earlier self-directed IRA investors aren't paying taxes on their distributions right now, and so it's not really that conducive, but there are some other things that may make it worth your while and these don't have to do the tax cut jobs.

Zach, these have been deductions and benefits that RES have had all along and we'll stress this later, but I want to make sure we discuss it now. So the first additional disrupt, so the first benefit of course is that 20% pass the reduction for qualified REIT dividends, right? So what does that mean for your investors, your LPs, your members and your fund? Because the holy owned sub is the REIT and it passes through the fund's waterfall, the investors because the pass-through will receive the 20% deduction regardless of tax bracket. And so as long as they're taxable. And so what does that mean they're getting a straight 20% deduction? Well, our projection, our calculations basically put that at, if they're in a top tax bracket federal, they're paying about roughly 40%, right? 38.9 30. They're not 8.9% By applying this 20% deduction, that knocks it down to roughly 28.9%.

So think of it like this, right? If you're receiving a hundred, if your investor receives a hundred thousand dollars distribution, they're paying taxes on $80,000 of it. That's pretty impressive. It's as close to capital gains as we can get in our space. It's a very, very useful deduction. The general tax benefit across the board, even including expenses, has been seen at approximately 150 basis point to the investor. But there are instances where the tax benefits do not make a huge debt. Funds that don't have a very large distribute rates of return. So funds that are doing five 6% may not necessarily gain much of a benefit from this tax deduction. Funds that have a lot of IRA investors or non-taxable investors deduction is not that useful for them but there are others. And so REITs also grant three key things to investors that are baked into the fact that it's a REIT, right?

Number one, it blocks U B T I. And so without getting into the weeds about U B T I, because it's a very, very lengthy cal conversation, very complicated calculation for those of you who are fund managers and you have plan asset investors or non-taxable investors, IRAs, 401ks, CRTs, whatever, have key plans, whatever have you. The combination of defer tax plan asset investors and leverage will create something called unrelated business taxable income. And for a lot of investors, that's a big no-no, they don't like that. And the big of a leverage the higher, higher the U B T I bill becomes. So the fact of the matter is that REITs do block U B T I. And so that's a very nice benefit that if you have leverage and you have a lot of investors, it's worth it from that perspective. Another thing that it does is that it also reduces state withholding.

So for many of our clients who are mortgage fund managers lend in multiple states and have investors in multiple states, well that requires withholding and tax returns in multiple states. This reduces that onus and impact, and so it saves the unex expenses significantly. So from that perspective, it is a useful tool from a purely logistical and practical standpoint. And my understanding is the vast majority of the industry is now lending in multiple states or at least lending in two states. So it is considerably valuable from that perspective. Another thing that's useful, especially if you have investors who are overseas, is that REITs get a preferential withholding. So if you're an overseas investor and you're investing in a debt fund, typically speaking, your withholding is a straight 30%. Now with a REIT, REIT dividends qualify for reduced withholding based off of tax treaties of the country.

So this is not universal. You have to calculate whether the investor is from a tax treaty country and evaluate the tax treaty itself, but it does reduce their withholding significantly in certain countries. And so that is nice. I've seen it reduced by half. I've seen it reduced to as low as 5% depending on the country. There are certain countries with which the United States does not have a tax treaty, so it may not necessarily be that valuable but also blocks eci, right? So it's also useful for foreign investors. And so overall there are a myriad of additional tax benefits aside from the tax cut and Jobs Act qualified REIT dividend deduction, but that 20% is the driving force as to why and why clients and fund managers across the country have gone this direction. So let's talk about where it doesn't really make much of a difference.

So we talked about IRA only funds, we talked about funds that have lower returns, but for IRA only funds, I really want to stress if you're dealing with self-directed IRAs only or solar 401ks only, and you have leverage and you want leverage, and you may want to increase your leverage because it is pretty prevalent today, you may want to explore this purely to block U V T I because the investors especially if they're high net worth and they're retired, they may be very tax sensitive to that issue. And in certain instances it may be fatal depending on the plan. Certain certain plant assets are not built to have any U B T I. So it is a useful conversation there to have. But if you are unlevered and the majority of your investors are IRA investors is definitely not as beneficial. Also, the same thing when your fund is producing a lot less of a return.

So if you are a very conservative fund and producing five, 6% may not be worth your while. And it brought up to my attention, so I want to make sure we clear the air on this issue is it's also not really available if you're an investor note offering. So this is usually obvious to attorneys, but making sure it's very clear is that if you offer investor notes to investors, you're not a fund, you're not an LP or LLC fund format, but you're offering debt investments to your investors and you're borrowing money from your investors as the core investment. This is not a structure for you. There are other ways to obtain benefits as a note offering and there are other unique benefits to that, but that does not work with a REIT strategy. REITs are really designed to be an equity investment.

So we've covered the qualification issues, we've kind of covered the benefits of being a REIT the deductions available to you before we go into what we'll change going forward, I do want to talk about some of the additional things that have been brought up when it comes to REITs. A lot of clients have these myths in their minds that REITs aren't really designed to foreclose on loans. And so that is necessarily, that's not necessarily true. REITs can foreclose all they want. Mortgage REITs can foreclose on loans all they want. Where the challenge comes in is selling real estate in volume quickly because that tends to lead us down the path of being considered a dealer under IRS definitions. And dealer income is no good for a REIT. That is another reason why the subres strategy makes a lot of sense because you can use the parent fund as opposed to creating a taxable research subsidiary and resolve it that way.

Other issues that REITs are not really well designed for REITs aren't really well designed for selling loans. It's really not designed for that. And then also not really designed to have any kind of operator income. And this really applies to more of our commercial real estate lenders. But if you have assets in the portfolio that you may take back and operate and those assets generate operating income as opposed to rental income it may cause issues for the REIT as it pertains to bad income. And so we want to make sure we're avoiding that and it's easy to do. You just got to create a landlord tenant relationship. But it's very important that you consider that for the residential lenders out there, up transactions that may raise some eyebrows or cause some challenges for REITs or any kind of rental participation transaction, any kind of equity participation transaction where you're receiving a component of the sale of proceeds of the property.

Those types of transactions are also kind of a no-no for REITs because of the active or operating income. And so we want to make sure that we consult with not only someone like myself but also your re C P A while you're building these kind of projects to make sure you don't violate REIT rules as you operate your REIT. So let's go into this new tax year. We're in 2021 now, tax seasons behind us. We have a new administration in power. This web webinar is not designed to be political. Just play out, just put out the arguments and put out the facts there. So first of all, right now in 2021, there is no legislation that has been approved or no revisions so far. So the tax cut and jobs act is that created, the 20% deduction for dividends is set to sunset in the end of 2025.

Just to be clear, right? It's also the same thing as the Q O Z program, but as of now, in 2021, there is no legislation being presented on the floor Congress or has been approved that will eliminate that deduction. So for those of you who already have your REIT, good for you, you're going to be okay. So the core benefits still remain 20% Q B I deduction for your investors, U B T I blocker reduced foreign withholding, state withholding blocker, all that remains status quo. We do not, we're not going to face a change there, but a lot of folks I've spoken with over the past year or so and going into 2021 have been concerned with the new administration. We have a new president, we have a new Senate and congress and house. And so how does that play out? And so will this be something that is in jeopardy?

And so I want to make sure we spend some time on this. So first of all, you think of it from a legislative consideration standpoint. So the current land landscape right now as it stands is on March 15th, Bloomberg News broke the news, broke news that about the Biden administration is planning the first major federal tax increase since 1993. There is not much clarity as it pertains to what this bill will contain, but it is projected or speculated that it may include a lot of the components from the campaign. The campaign was focusing primarily on taxing high earners earning $400,000 or more a year. There have been multiple interviews with the new Fed chair, Janet Yellen, and she's also said things that seem to support what amounts to a wealth tax. Now this combined with the fact that the tax cut and jobs act Q B I deduction does sunset in 2026.

It's interesting how this will play out. So right now, at the very moment while before this webinar before two days ago, most of the concerns about potential legislation was speculative. This news did break while we were preparing for the webinar. Wanted to make sure we addressed it. So why is this important? Well, first of all I want everyone to know that the Biden administration has not actually presented a bill yet. They're currently in the proposal state, which means they're negotiating with their colleagues in Congress and crafting legislation. And so the question becomes, well, what will that legislation likely include? And then what will happen if that hot? What will happen if that legislation is presented to Congress? So first of all, we have to ask ourselves well, what will likely be in this legislation? Well, it seems to include increasing income tax, capital gains and corporate taxes and that's very important, but it's not really relevant to the webinar, but we'll quickly touch on it.

So they did talk about increasing income tax for taxpayers making $400,000 or more increasing the corporate tax rate, 28%, and also increasing capital gains for individuals making a million dollars or more annually. Now, this is relevant, but there was one point that was in there. It's briefly discussed in the article that says that they were also looking to pair back the tax preferences for pass through businesses like LLCs and partnerships. This is what we're talking about today. The QBI I deduction program that was created was designed for pass through businesses, S corp, LLCs, partnerships for certain businesses. But the interesting part about section 1 99 A was it created a lot of these deductions for these types of businesses, but then a separately created deduction for qualified REIT dividends. And so the real question becomes how far will they go with repealing or paring back the tax preferences?

So let's assume that they actually do try to do it. So that legislation does come out, a bill comes out, well then what happens from there? Another question we have to ask ourselves is, what happens from there when it hits the floor of Congress, assuming it's all in there, what happens at Congress? And so first of all, many people have asked me, well, why can't they push this through the recent covid stimulus bill, right? Because if you guys remember, they passed it through and the Senate, they had a simple vote and it got passed. Well, the issue really, the reason why that was able to get passed was because they passes as what we call reconciliation, right? Reconciliation is not eligible for cloture or filibuster. And so the Senate is not an obstacle, right? Because you cannot filibuster a reconciliation measure. And so that is the real question from my perspective.

So if the legislation gets announced as a true piece of legislation as a bill NAS reconciliation, then it is subject to filibuster and then they need a 60 vote, 60 Senate vote to break cloture, break filibuster to get past that and get it to actual vote. So really it's a question of senate procedure. So the likelihood of this passing the house is pretty high, but well, the question of whether it'll go through Senate is whether or not it's a reconciliation bill. So I'm not an expert in congressional procedure, but this has become a relevant issue because there are a lot of pieces of legislation that are material to our industry. But this is kind of an overarching tax bill that is something that has come up. And so first of all, we have to ask ourselves, number one, what will this bill include? And we have to watch it closely because a lot of folks are worried, they just see Q B I reduction.

They're worried about everything. And a lot of when I first looked at this, I was like, oh, well, what if they adjusted for income brackets for those only allowing it for those making $400,000 or less? Well, that was one perspective, but the other perspective, the way 1 99 80 is written is that it separately allows this deduction for qualified re dividends regardless of tax bracket. And so my real point is that if they attack the qualified dividend deduction, then we have to really get concerned. And so we have to make sure we keep an eye on this. Thankfully, I don't necessarily believe that this will be something that will be in play for 2021. Even if they pass the legislation, we're probably not going to see this enacted this tax year. It'll probably be enacted in the following tax year. But what's important to consider here is the likelihood of this impacting the particular carve out four qualified dividends.

So what can we do? Well, first of all, we can make sure we contact our representatives. And so through our relationship with the American Association of Private Lenders, we've been very active in doing so. I have spoken with my local congress, congressman and senator on the phone, and it's important or their staff actually, and it's important that you do that. So if you want to oppose this type of legislation, I'm not advocating one way or another right now. I will take a position soon once legislation comes out. But if you're concerned about this, we do recommend you contact representatives. We do know that calling their offices does make a difference as opposed to writing their offices. But one thing to watch for, I think it's going to be really important to watch for, is when the bill comes out. And this is going to be negotiated heavily on both sides, and it's going to be negotiated heavily and also in the core public opinion.

And so we'll see how it plays out from a legislative standpoint. And when the bill comes out, we will be putting in a lot of content on the issue to make sure that our audience and our clients and our relationships are aware of it. But for those of you who are existing fund managers that have gone REIT to the tax year 2021, it's unlikely that we're going to be seeing any massive change this tax year. We may see something in the 22 tax 2022 tax year but we have to watch this incoming legislation to make sure and also watch how they're going to pursue it, right? Are they're going to pursue it as reconciliation versus an actual piece of legislation on top of this. One other thing to think about is also top of this earlier than webinar. Well, let's just assume worst case scenario, well, what happens?

Is it still worth it for me to have my REIT? And I still think, so for a lot of clients, you're going to need the U B T I blocker. It's going to save you on the state withholding E C I and foreign tax treaty benefits are significant. And so I think that it's still a valuable component to clients and to lenders and to fund managers. So I still think it's a very valuable use. Very, very, very valuable tool, just not going to be as dramatic a tax deduction but definitely something worth considering and not something to regret as well. I firmly believe that it's still very, very valuable, and the sub strategy is really definitely useful to make sure that we have that disposability in case that it no longer is useful for the fund. So that's all I have for today for this issue.

If you guys have any questions, I haven't really seen any questions here, feel free to ask via email. My email is written right here. You can also reach me by phone. For those of you who know me, I will respond quickly. Our team will also be forwarding questions as they come in in the future. Additional housekeeping notes going forward. So we've got some upcoming events. So we've got some webinars coming up. You'll be receiving emails about that. But I really wanted to highlight our incoming live conference for 2021. As those of you, for those of you who have attended our events, 2020, we were unable to hold live events due to covid restrictions 2021. We have received the light to move forward, and so we will be doing them. And so our first conference for the year is going to be on April 15th of 16th in Newport Beach, California at the Balboa Bay Club.

We will have a very, very impressive speaker lineup and a lot of great education, but also some very, very, very powerful networking in-person networking. And be assured that the hotel and the Geraci staff will be following all California covid protocols to ensure your safety is our guests. You can learn more at our website That's And if you're interested in attending, please reach out to myself. You may be able to get a nice coupon code from yours, truly. So thank you very much for listening in. I don't see any questions popping up in the q and a. We have a little bit of time left so I can open it up to questions if you'd like but if we don't have any flowing in we can slow down the webinar and close it out for everyone there. Alright guys, well don't see any questions coming in so far, so just want to put this out there for you guys.

And if you guys have any real questions, feel free to message me. And oh, we got a question here. So can you structure a REIT via ADST? You can, but it requires some structuring, right? So ADST is not necessarily a corporate entity per se, so you want use a sub strategy there. DSTs are also very, very useful. We use DSTs for not sub strategies, but up re strategy or umbrella partnership strategies to transfer in or contribute properties or assets to REITs. And so there's a very useful strategy there. ADST is what is ADST. ADST is a Delaware statutory trust. There are other abbreviations that follow along as well, so that other folks call, I think a deferred sales transaction as ADST, but that's not relevant here. This is really designed for Delaware Hedge trust, very common amongst a lot of investors.

We're trying to tap gains and tax benefits. The question here is why are REITs not designed for selling loans? So the business of selling loans creates something that we call operating income. And so we do not want. REITs are designed to be passive investors. They're designed to own assets that produce income. They're not designed to be actively trading assets. And so selling loans creates operating income for REITs, but the transactions can easily be achieved by moving the loan to a parent fund, or for those REITs, those funds that have converted to a REIT, to a taxable REIT subsidiary. And typically in our space right now, you're not going to be realizing any gains because we're selling it par at the given time. So that is something think about. So the question here is, would that be good? Would, would that be good to have a DSC structure for when the mark changes to move REOs in and out? That's a lot more of a complicated structure because it raises the questions of contributions versus cash investing and also tax taxes for contributing assets instead of cash. And so we have to talk about that offline. So I don't have the person's name here, so that person wants to reach out to me directly. We can talk about that. A lot of those issues land on CPAs. But the corporate strategy we can definitely talk about in the security strategy. We can definitely talk about in person.

Okay, well, I think that's about it for q and a. Oh, once again, guys please feel free to email us your questions. And once again, do not forget about Innovate 2021 at the Balboa Bay Resort on April 15th. We hope to see you guys there. Thank you for attending this webinar, and we will see you soon.

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