REITs in Private Lending: An Honest Discussion

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This webinar discussed the most significant trend in Fund Formation Strategies since the emergence of crowdfunding: REITs. We present the core qualification requirements, the benefits, and the drawbacks of using a REIT as opposed to a standard fund. Most importantly, we explain how existing fund managers can add a REIT to their fund or new fund managers can start their fund with a REIT right away.


Kevin Kim:

All right, so let's get started guys. Welcome. So for those of you who do not know me, my name is Kevin Kim. I'm a partner here at Geraci LLP. I manage the firm's corporate and security division nationally recognized expert and mortgage fund formation. With the help of my great team, we've been very integrally focused especially on mortgage fund formation. So we've formed thousands of them over our 10 year lifecycle at Geraci here, and I'm also joined with my associate Tae Kim here. Tae, please introduce yourself.

Tae Kim:

Sure. Hi, my name is Tae Kim. I'm an associate attorney here at Geraci Law Firm specifically working in the corporate and securities division formation of funds, entities, joint ventures, debt funds, real estate funds, qualified opportunity zone funds, as well as REITs which is what we are going to be discussing today.

Kevin Kim:

All right, so right now guys, this panel is not really this focus going to be on a lot of all the technicalities. We really want to have an honest discussion about this. This has become a major trend in the space for a lot of fund managers and for folks out outside of private lending. But we want to focus within the private lending space and the reason why it's become a trend is essentially taxes. Everyone wants to save a little bit of money. So we're going to talk about some basics, so for those of you who are uninitiated, how REITs work in our space and how work in general, we'll talk about the basics the requirements, the eligibility issues, the commonly used structure in our space, so on and so forth. But where the meat and potatoes for this webinar really is we're going to kind of try to do a little bit of myth busting.

REITs are of complicated there's a lot of misconceptions out there about them and the perception is that they're very complex in reality, they're actually relatively straightforward if you structure them properly. So we're going to go over those. We're going to address some of the common commonly faced issues that we face and we're going to talk about why it's so important we go this route today. So let's get started. So number one, before we even talk about all this real estate investment trust, for those of you who do not know what that is, it is an investment vehicle designed to invest in real estate and have some kind of tax preference. And for a long time it didn't really work well for our space because funds in our space were producing interest income, thereby ordinary income and it was challenging to get much of a benefit from it.

However, at the end of 2017, Trump administration passed the tax reform and it allowed for a 20% qualified business income deduction for pass through entities and it made REIT dividends eligible for that deduction. What does all that complex language mean? Ultimately, if you have a mortgage REIT, your investor, your investors will be able to reduce the tax rate and they'll be paying basically 80% instead of a hundred percent. So they'll be paying taxes on 80% of their distributions from the fund as opposed to on a hundred percent. This is a very, very popular item because it tends to increase return naturally without having to add on additional risk or leverage. So what is a REIT? How do you become a REIT? What are the standard eligibility requirements? First things first REITs are taxes, corporations, most funds out there taxes partnerships, so that's a very big difference, c corp tax.

So you have to elect REIT status, so you're filing, you're filing a tax term with the SEC electing, I see IRS electing to be a REIT and treated like a REIT and comply with all the REIT requirements and as of course, there's some requirements of your portfolio and how much you distribute. So number one thing is 75% of your assets must be real estate related assets. Now for our space, this is not an issue because the majority of our clients primarily have mortgages in their funds, so it's never become an issue there. Now there are some unique situations we've seen preferred equity, mezzanine loans, fund to fund investing, and these are all fact-based because not all those loans kind of followed in those buckets. Preferred equity loan can be a preferred equity transaction can be structured in a hundred different ways and so can mezzanine loans and so can other transactions. So it's really important you talk to your attorney about that. We've evaluated those for our commercial clients. For resi clients, it's relatively straightforward because they're not doing much else but it also, it's important to think about that real estate related, not real estate, real estate related. So it can be a mortgage, it can be a real estate secured asset, it can also be a real estate backed asset, a lot of those

bond related assets and so on and so forth. So that's why it's a little broader than people expect and it's a relatively straightforward and easy to hit and qualify for in our sector. The other one there is a little bit trickier. So the rules require that the REIT distribute or dividend 90% of its taxable income. Now this is actually practically true, but practically not the case. REITs tend to distribute almost everything because if you don't distribute, what you don't distribute is taxable tax rate. So you have to make sure you distribute, and this is going to lead to the conversation of the structure because of the need to maintain certain holdbacks and waterfalls and existing funds. There are two other really, really important qualification requirements and Tae will talk about those.

Tae Kim:

Sure, thank you Kevin. And so the two qualifications here we're talking about is the hundred investor account as well as a closely held prohibition. And really there's a real common misconception out there that Kevin was mentioning is part of that is we have to load up these hundred investors right away. No that's not true and the main reason is because the IRS understands that it takes time to get these investors in and so they allow the REIT to gather investors to form the entity and to elect it and get the benefit of it while they're loading up the investors within a certain time period. And so on the second year, the REIT has to bring in and of course maintain that hundred investor count and preferred equity as the states here is an acceptable form of an ownership of the hundred investors. There's a couple things that we have to note here on the hundred investor count.

These investors have to be at the REIT level and provided that, I'm assuming that we are going to be doing a majority of these based upon a sub restructure, which is by far the most popular and the most convenient way to structure these sub-REITs or these REITs, we have to just note that in a sub-REIT restructure, the note of the fund is actually only one investor when it comes down to the ownership. And so we have to get these 99 or a hundred plus investors elsewhere. And so one of the easiest and the most efficient and convenient way that most sponsors and the fund managers do is hire what we call the shareholder accommodation services, also known as penguins. It's relied very heavily in our space. The main reason is because again, it's super convenient. Now, couple of the reasons why it's been very convenient is that these servicers are broker dealers registered with the SEC or FINRA and have these huge investor base and so they would actually be able to load up these investors very quickly.

Second reason that these things can be very, very convenient is because these investors at the REIT level, the investors pony up only about a thousand dollars per share. That's a typical smaller amount just to fill up that bucket or a hundred investors. And these servicers also maintain these investors for you. So you can guarantee, not really guarantee, but you can rely very heavily on the fact that these a hundred investors are going to be there. The fund manager do not really have to worry about it. I've seen from a transactional perspective, investors can be loaded up that I've seen as early as three days from the date of offering. And so this is a very, very convenient services that are out there for the fund sponsors. Of course, the negative side is that it is an expense and Kevin's going to be talking a little bit more about this later on down the road when it comes down to the cost benefit analysis.

But really the fund expenses here, as Kevin will talk about a little bit more, is that you know, do have to provide dividends to these investors. It's 12% typically cumulative preferred return to today's penguins, which rounds up to about $15,000 per year. And there's also a maintenance and compliance fees that are also involved. Just also another thing to note that these penguins are after all investors. So we do have to prepare offering documents. And again, the convenience of that is you can use your main fund documents supplemented together and supplement it with the various highlights in summary and pinpoints of these offering docs and then present it to these reap penguins and wrap it around such that your disclosure is properly done. Second note here is the closely held prohibition just in short five investors cannot collectively own 50% or more of the REIT and the surface level.

It's very, very easy, can't, very easy to understand, but there's a lot of little details. Many people have said prior the devil is in the details. And so just a couple things to note here on this five and 50 rule or the closely held prohibition is that this is number one, it's at the individual level. So it's a loop through all the way both at the parent fund level and at the REIT level that you go all the way to the individual person to look through all the entity as to who owns what. And just making sure that the five person individuals cannot collectively own 50% is one of the general rules that we do have to abide by. Again, as I noted before, the first year is waived and so you know, have to look at the second year and beyond during the life of the read.

Interestingly enough, and I don't know where the logic is behind all this, but it is second half of the second year and second year half going forward. So say that your election date is January 1st, 2020 and your fiscal year is just a calendar year, then you just have to make sure that on the second half, which is July one all the way to December 31st, you abide by that five 50 investor rule. The third thing that I want to mention here just quickly is the ownership and this own how you're owning the 50% of it, it's really upon investor's dollar amount. It depends on how much that these investor has contributed to capital, both at the fund and at the REIT level. As I mentioned before, these REITs come in at thousand dollars a share, so there's not a lot of value in it. So most of the time when these five 50 rule come into play is that the fund level. And so that's something two things that you really want to make sure that at least at the formation stage you consider these things for the read.

Kevin Kim:

Yeah, I want to also touch on the closely held thing guys. It's a fully diluted calculation. So this is a good segue into the commonly used structure in the space. And so as you can see here with these requirements, it can be a little bit tricky. And so when the code first came about when the tax reform first came about at the end of 17, we were all scratching our heads, how do we get this 20% deduction for our investors? And initially we were like, well, we have to evaluate them based on their tax tax brackets. And after clarity came out, we were certain that dividends qualify, but dividends qualify. But qualifications are a little bit tricky because of this 90% this closely held. And it's important to think about that because this led us down the path of this structure, which is called the sub structure locally speaking. And this is kind of the main way to do it in our space. This is the primary way to do it. Take and walk us through the structure real quick and then I'll kind of jump in and talk about some of the practicalities and the why behind all this.

Tae Kim:

Absolutely. Sure. So as Kevin mentioned, you're right, this is a very, very efficient, convenient and very popular way of doing the sub structure. The 125 preferred investors, as it noted here, these are the rep penguins. These are going to be coming from those shareholder accommodation services loading up to 125 investors and they are non-voting preferred equity shareholders of the subgroup. And on the middle here it says the fund where the fund is basically the a hundred percent of the common equity shareholder of the sub read. And as you see on the right is the fund manager managing both the fund and the sub read and the main investor, your fund investors that you have within the fund are at the lower end here at funds investors. And so the 125 preferred investors, as you would imply on this name, they do have preferential rights in that turn.

When you are liquidating the sub read, the preferred investors will have the priority in terms of redemption of their capital and you have to distribute their money back. But of course, because if the fact that they have a thousand dollars per share, it is a little bit easier to liquidate them out. But that's part of the arrangement with these servicers and the sub-REIT is at the top. All the lending activities as well as real estate activities are going to be sub-REIT subject to various minor details and under the internal revenue code. But nevertheless, that's where you get most of the tax benefits. And so Kevin, please tell us a little bit more about the practical aspect of this structure.

Kevin Kim:

So when we first started this journey into the REIT world in our space, the initial conversation was, well, don't only have to convert the fund into a and some of the larger funds out there did that. The challenge with that in doing so is practically speaking is you're going to have to go for a vote to your members or your LPs because you're changing the tax status. But also practically speaking, you also have an issue if your fund has any kind of waterfall with a carry, right? So after your preferred return, a portion of the income is split with the fund and the fund manager, that type of model doesn't necessarily work for a REIT because that if it quant quantifies, let's just say 10% of that, 90% of that 90 after 90% dis distribution, you qualify, you qualify as a REIT, but that 10% becomes taxable at the corporate tax rate.

That's a big no-no, right? We don't want that. So also the problem with that method was it was very clear at the time when this went into law. The issue that we were worried about was, well what happens if this law gets jettisoned in the next administration? And it also turned out this part of the tax code the tax cut and jobs act actually sunsets in 2026 A alongside the actual opportunity zones section. So this benefits sunsets in 2026. It grants a pretty significant deduction for small businesses and pastor entities until 2026. So we don't want to have to essentially go read and then figure out something else out later because once you go read, you can't go back. So the sub read became a popular item and put it simply is that the fund remains the same. We want to have a structure where we can minimize disruption at the fund level and install a subsidiary beneath it that qualifies as the REIT.

This allows for the fund to maintain its carry, not disrupt its investors and frankly have disposability. So for the fund managers that happened to screw up and mess up the issues for whatever reason, for the prohibited transactions issues which we'll get to later today or just compliance issues in maintaining qualifications, you can just dissolve that subsidiary and move forward and move the assets and stuff like that as opposed to in if the fund were wheat, we would have a problem because we can't unring that bell and convert back to a regular LP or LLC fund. So this is the reason for going sub re and frankly it also allows for usage. It allows for installment of these shareholder combinators, these penguin investors in a much simpler and cleaner fashion because now we're we're managing a subsidiary, we're managing the entity in which is wholly owned by the parent fund and these penguins own a small chunk.

It's easier to manage from a day-to-day basis. Also some practicalities associated with the penguins or shareholder accommodation services. Frankly, the only reason why we do this and we recommend this is because I don't know about you guys, but managing 125 investors is kind of a pain in the ass. And to have to manage them to maintain is also a pain. When you engage in accommodator service, they will manage the investors ins and outs and they will always maintain enough so you qualify as long as you're paying them. So that is one less headache for you to worry about. And a lot of I manage, well I've got a hundred investors, but having to manage each of your a hundred investors to sit in that position may not be the easiest task. So it's nice for a relatively nominal cost to outsource that solution to a professional and set and forget it.

So this is the structure and I do want to make sure that we touch upon the benefits really quick again before we move on to some of the mis misconceptions. So the big reason why a lot of folks in the private lending space have gone re or added a sub to their fund. Number one, it's that 20% qualified business income deduction. So your fund investors are paying ordinary income on their distribution, your taxable investors, they are. And the issue becomes how do we reduce that and get the benefit of this Q B I deduction? So REIT dividends qualify, the REIT will push all income less expenses to the penguins up to the fund and that will push through the waterfall of the fund. And so the investors will still get their K one s, but they'll get a dividend line item instead of line one, which is their regular distribution.

So that's how they get the 20% reduction. Now there are other benefits of being a REIT for your investors, for those of you who have a lot of IRA investors and happen to have leverage and are sensitive about U B T I REIT's block U B T I. And so that's also beneficial for those of you who work with charitable render trusts because charitable render trust and U B T are like oil and water, it will kill a charitable renter trust. There are also a lot of benefits for foreign investors. There are certain reductions when it comes to the offshore investors coming in if you are a REIT. And then lastly it does block state withholding. So for those of you who are lending multiple states and have invested all the country, this is a great benefit to you and just reduces the overhead and rain damage that comes with that comes around tax time.

So let's kind of go into the common misconceptions. The number one misconception that I always get when I'm on a phone call about REITs and fund one managers is do I have to be a really big fund? I have to have 50 million or more? And that was kind of the common thought early on I kind of espoused that thought as well. But the reality, the reasoning behind it, I want to make sure we explain the reasoning behind it. The reasoning behind that was because that at 50 million A U M A fund can manage the larger expense of going rate and can kind of spread the damage a little bit and reduce the pain to the investors where a smaller fund, if you were a 5 million fund or a 10 million fund or less, that expense could be significant and reduce return. Now we've run the numbers and even for a smaller fund it's worth the expense in the first year even then because it does increase returns because think about that, the 20% reduction it factually will reduce your investor's tax bracket I think to around 29%.

So that's a pretty significant reduction. Now granted, if you are larger it's easier to manage. Another thing to consider is starting fresh. And so a lot of new funds have asked about adding the wheat or the sub at the planning stage at the initial launch date. And this is also okay, I think stopping you from doing so if that actually from a legal standpoint, the timing is the same. So for us we we'd actually recommend it because you have enough a cushion to meet those requirements that Tay was talking about, the hundred investor give until the next tax year, the five 50 rule you have until the second half of the following tax year. So you have a lot of time to meet those requirements and frankly it's a lot more cost effective to do it early on when there's nothing to work with as opposed to adding it on to an existing fund because that requires a little bit more due diligence, a little bit more advisory and a little bit more extra labor because we have to move the assets from the fund to the sub.

And so that cost benefit analysis, you can do it yourself. But roughly speaking, our understanding is, and this is all inclusive, not just our legal expense is going fund can cost anywhere between, I'm going, we can cost anywhere between as low as I think around 50, $60,000 as high as about a hundred thousand dollars depending on the fund. And so that's including other service providers. So you have to weigh that with that 20% deduction and U B T I block and then the state withholding can be a nominal benefit. But depending on the lender it may be significant. We've found that as long as clients are able to manage the expense and it is a fund expense manage the expense well perhaps amortizes or so on and so forth, it's still a worthwhile endeavor because that 20% deduction carries directly to your investor. It happens the day you elect and when you and going forward.

And so your investors will be able to increase their return, reduce their tax liability. And this is the only methodology that I'm aware of in our space that gets the tax rate down to anything close to kind of capital gain. There's always the objective. And also it's also an analysis you have to make for yourself. If you're a smaller fund manager, you also should also look at your investor demographic and because there are ways for your investors to get this 20% deduction without going as well. And the only one way that we're aware of for funds is that if the investors themselves are in a certain tax bracket, I believe it's three 17 or below Mary filing, if they're below that, they automatically get the 20%. If they're above that, they do not. And the issue with that is the primary kind of resource of investors in our space has always been high net worth investors and those folks tend to be in that highest tax bracket above three 17.

So at the end of the day, it's worth the analysis and the weighing of the cost and benefits. Another thing is there's a big myth, oh I don't have enough investors. And we talked about this, the use of shareholder accommodation services is pretty prevalent throughout the re industry. Even the larger REITs out there use them. And why is that? Because frankly using that kind of set it and forget its solution is a much more efficient and much more effective means of doing it than having to manage own investors. Having them to offering it up to all of them and say, who wants to sit down below at the subrate level and be meet the hundred investor requirement? And then what happens if these folks want in and out? You have enough to worry about managing your portfolio, your employees, your origination and your capital rates. This kind of outsource service tends to be a little bit more effective in my mind. Now it doesn't prohibit a fund from using their own investors. You absolutely can if you have enough of a robust team. But I can tell you funds with several hundred million dollars and 50 to a hundred employees are still using this service cause it just makes life easier.

Do want to talk about one other myth is this has kind of been out there, this is, I don't know where this started from. Mortgage REITs cannot foreclose. This is a complete and absolute misconception. REITs can absolutely foreclose. There's a actual election that REITs can save for foreclosure, for foreclosure properties to announce them as foreclosure properties. The issue with REITs is actually more along the lines of the definition of IRS dealer and the rules around prohibited transactions. Without getting overly technical, the idea behind a REIT, if you think about the thematic purpose of a REIT, REITs were created to be passive investors. They're not meant to be operators, they're not meant to be dealers, right? I'm sure most of you are familiar with the idea of an IRS dealer if the REIT is buying and selling and buying and selling real estate like a dealer, that is a no-no for a REIT, right?

The idea being we do not want that to happen. And this is also another reason why we promote the sub REIT structure as opposed to a REIT structure because then you have some flexibility. You have the parent, we can move the asset to the parent if we wanted to, but frankly if you were going to foreclose and take back the property, you could still do so. There are issues with selling it right away. So there are safe harbor transactions that have a certain numeric count in how many you can sell within a given tax year and not trigger this issue. And then once, if you're thinking you're going to exceed that threshold, this is why you have vendors on staff. So your cpa, that your CPA team and your legal team need to be able to work together to advise you what to do in that scenario.

And it's always very case by case because in a lot of scenarios for it actually may not even be a typical closure to property the sale may actually qualify and you may not actually have known that it qualifies because of the qualification of the asset class. So we recommend in managing your portfolio and dealing with loss, mitigation, foreclosure and also R E o, that essentially it's important to have your tax team and your legal team at the ready to answer any questions and guide you through. But it is definitely doable. And if you look out there in the marketplace, there are plenty of funds out there that are designed to foreclose. There are reeds that are designed to ask pursue distress assets. It exists, right? And there's a reason for that. So it's a myth, complete myth that REITs cannot foreclose kose, they they're just like any other investor.

They should foreclose if necessary. So one of the things that we want to cover also is some of the kind of commonly asked questions and issues we face in our space. And we're going to get to some of the questions here. We have some really good question in the q and a. Once again, you got questions, use the q and A one. The first one is always about kind of the s e rules. And a lot of folks, they kind of conflate being a REIT and SEC regulations and securities regulations. They're actually very separate. And s A REIT is really just a tax selection to maximize your tax strategy as an investment vehicle. It has nothing to do with your status and how you offer and sell securities. So in other words, you can offer shares or a offer your fund membership interest or LP interests with a sub read without having to change your exemption.

You don't have to go public, you don't have to register, you don't have to go ip, none of that. You can maintain your reg D, you can maintain your reggae and still go read. You can still maintain exemption and go read. And frankly, I don't know if anyone still does this or not, but you can even maintain state exemption if you want. So has nothing to do with the security exemptions. You're going to rely upon a very commonly asked question that oh, I have to go public very much. Not true. I do also want to spend some time on the five and 50 rule. This is a very complex issue if you get down to the nitty gritty ta, let's talk about this. Sure. Publicly speaking, we're facing this issue every day now cause we have elected last year we did over, I think we did about continuum last year. Those are all converting and having to make sure they're complying now this time of year. So let's talk about that. Walk us through the closely held rule.

Tae Kim:

So just REITerating some of the stuff that we did talk about, right? Again, first year is waived but at the second half of the second year and going forwards, typically if it's a calendar year, July one to December 31st, that's when you have to really comply with the five 50 rule. One other thing that we have to just I wanted to note here that there is a related party test to be involved, which means that the family members do come into play when it comes down to the ownership percentage of the five and 50 rule. So that's something that we really have to go through the analysis of. In fact, we actually have one of our clients who actually did come across that issue and we have to adjust couple of the ownership percentage to make sure that the five 50 rule is compliant with again, I stated before, it's really at the personal individual level.

So if there's a big pension fund or a huge fund of funds, who is actually investing into these REITs? It goes all the way to the shareholder level all the way at the end individuals. So that's really one thing that you do not have to worry about too much because the pension fund or any other big investor who's coming in really do not have to be accounted for as part of the five and 50 role. And also just making sure that it's really depends on the do dollar amount that the value of it and whoever contributed more into the fund, whoever contributed more money into that fund, both at the parent or at the REIT level, is one of the component that we do have to watch out for. And so that's the calculation that we have to make when to comply with the five

Kevin Kim:

50 rule. Give us a little more color on the related party issue because that has become one of those sleeper issues that we've found that investors come in with multiple accounts, husband, wife, child, how far does it go?

Tae Kim:

So to my understanding is that the related party has to do with the family members both at the side and the up and down level, including the spouses as well as the parents and the kids

Kevin Kim:

Not brothers and sisters. So not linear, just ascending and descending and then husband and wife, right? Mm-hmm.

Tae Kim:

Right. And so if they do own collectively, then the IRS treats all them as one as opposed to an individual.

Kevin Kim:

And that can be a little tricky folks. Cause you want to make sure you're looking at your, you got to make sure you're looking at your investor pool and see if they're, the only way to really know is to look at common names and ask. And you may have folks who have invested independently of each other and they happen to be parent and child or they happen to be husband and wife. And so these are all rope together. So it's important to do that. Another thing you want to think about when you're doing this, and we install this to everyone, is you have the ability to exit and keep capital. Make sure you qualify for this. So in the event that you have to redeem to maintain status, you have to have the authority to do so. And also if you have to keep money in to keep maintain status it's also important you have that power.

So these are issues that are very common and it's something that a lot of the REITs that went that converted last year are navigating right now. Cause they have until, this is the second half of their tax year calendar tax year to get this done. So it's very important once again fully diluted calculation. And so I want you guys to think about this as Tay mentioned, pension plans and fund of funds and wouldn't it be nice if we all pension plan investors, but also we also have smaller trusts, we also have smaller entities, family entities and stuff like that. You really want to look through them and it's above. So if the REIT, you have the parent fund and then you have your investors, you want to look through that as well to see on a fully diluted basis, do any five investors own half a mortgage fund?

And it's very important you meet this because one of the things that we've seen is if you do not do this and in the following year you could definitely lose REIT status and big no-no, right? We do not want that tax penalty on us. So very bad. The big issue, this is also another issue here, lending issue. So for our industry we've had multiple presentations on licensing. I'm sure those of you who are on the call today are very curious about this. But we're not here to talk about licensing, but it is an issue. And so those of you have funds in California because of our local government, it is very unclear whether it's permissible to just transfer loans freely between parent and sub. And if you are an existing fund and you have a subrate right? And you have a CFL license, California finance lender's license, it has become kind of a standard practice to put a CFL at the SUBRATE level to make sure it can independently originate loans, hold loans, fund loans, and also move loans back and forth without involving the management companies d r E license.

We do not recommend using your D license if you can avoid it getting CFOs much easier to manage. But if you do not want to get a cfl, you can use your D R e. And this issue comes up in other states. Other states like Arizona, Arizona will ask for a license whereas the license, but Arizona does have a lot of friendly laws associated with table funding at the affiliate level. So in a lot of help there in Arizona and Nevada as well and some of the other restorative states. So it's important to analyze when you are going REIT, you also want to evaluate, do you need a license if you're planning on originating at the REIT level, if that's the case, you need to think about that in the states that you are pursuing. Thankfully in private lending there's not a lot of licensure required states.

Basically it's about depending on the situation, probably 10 to 15 states in the unit that require a license for what we do in our space. But it is important. Another thing think about is assignment of the existing loan. If you're an existing fund and you install a sub underneath your fund, anything you're fun. The question becomes how do I move those loans to the subsidiary? And we talked about licensure. For those of you who are listening in from California, you know either have to get a license for the subsidiary or use your DRE license. Affiliate transfer is another way to do it. But there's also a question of this. What about recording? So hey, what do we do with record? What's our advice when it comes to recording?

Tae Kim:

Yeah, sure. So when it comes down to recording in and of itself, once you assign the loans, again, assuming that we're doing the sub restructure, assigning the loan down to the sub and do we do not record this until there is anticipation that there will either be a default or a foreclosure. And so at that point the advice and the recommendation will be to record it at the subrate level. And in the event that you guys decided to back kick it back up to the fund level, that's when you can reassign it and record it there after

Kevin Kim:

Another issue that's come up. For those of you who are in the commercial space who are doing cannabis loans, it has some issues and it's not really a legal issue. More of a practical issue. Hey, you want to give us more call there?

Tae Kim:

Sure cannabis lending still can be done through the in of itself. Of course there is a licensing application licensing implications to be had. For example, in California when you do have a cannabis loans, you know do need to make sure that we do have a certain licensing requirements to comply by. And just when it comes down to cannabis loans due may come into play in terms of the loan in of itself. And also just as a side note, when it comes down to a cannabis mortgage fund electing to be a read, there's also the accommodation and the shareholder accommodation services who actually do not want to accommodate to get these hundred investors in. And so there are other servicers out there and please contact us and let us know if you're having any trouble with this re-election. If you're a cannabis lender.

Kevin Kim:

So the cannabis lenders and in the webinar with anyone who knows those folks, it is an issue. More vendor services issue. Just like with title, not every penguin company wants to work with a cannabis mortgage fund or cannabis mortgage rate. And it is something you have to find the right vendor that makes a bit same with title. But also remember that in a lot of the commercial mortgages that cannabis owners do, the transactions also have to maybe have assets that may not fit under the rules. So some issues associated with taking equity or leasehold, oper, operating leasehold income or warrants and so on and so forth. So you want to think about that as well as whether it qualifies at the rate level. So these are additional analysis you have to make if you have those kinds of assets in your portfolio. So I think we have enough time to the questions got plenty of time actually.

So once again guys, if you are, oh actually one thing before we move on questions. The why, why you should go read, right? So I want to talk about that really quick. So we've been talking with a lot of clients lately. I know with covid things have been stressful and capital raise has been a challenge and funds are kind of in a weird place. But my understanding is things have kind of at least leveled off for most funds out there and investors are liking what we have to offer at the mortgage fund level because they're getting beaten up on Wall Street and by market is basically it is what it is and there's a lot of poor performance out there and this is a very solid, nice performing asset class. Now the reason why REIT right it really seriously consider it if you have a debt fund, if you're thinking about going a debt mortgage fund, the reason why I really strongly recommend it is number one is that deduction, that 20% deduction, right?

It is so significant. Most funds, you're going to see an increase in returns after you kind of stabilize the expenses a little bit, probably around even in the first year after expenses for most funds, you're probably going to see anywhere between a hundred to 150 basis point increase in returns after the tax deduction after all being stabilized upwards of that. And so that's a significant increase in return because you are reducing that investor's tax bracket significantly. You're going from, I think it's like 39.6% to 28.9%, something like that. And it's a pretty big difference. And investors, especially high net worth investors are always tax sensitive. And so it's a very, very powerful way to increase their return organically without adding additional leverage, without adding additional risk to get the rates up. And your investors will love you for it because frankly what else? There are not as many easily qualifiable tax programs out there.

In addition, the U B T I blocker is massive, especially for a lot of our clients who have significant credit lines. I don't know about you, but a lot of my clients have investors in these tax haven states. They're in Texas, Arizona, Nevada for no income tax, but they're in IRA and there's U bti. They're very unhappy with seeing a U B T I bill when they are in a tax-deferred vehicle and B, don't have income tax at their local state level. That makes them unhappy. And so this is kind of balance that, balance that from it and then frankly it'll also reduce your overall, I guess, investor, investor issues when it comes to yield compression as stabilize after the pandemic which will return. I'm already hearing about it because you are able to provide that deduction to the investor. So all things being equal, it is worth it, right?

It is very much worth it, especially considering the urgency. Now I've heard some arguments, oh well you know what if the Democrats take office and take control? No, no, no, I really don't think so. This is a pretty non-controversial tax issue and frankly there's a lot of other issues on the docket. I highly doubt they're going to attack a bill that's going to sunset in 2026 anyway. So that's my opinion but I think is a very valid argument. But frankly 2026 is the sunset year. You have six years to get this 20% deduction. I think it's worth it. And I mean there's a possibility that it may become permanent. There's arguments that there's kind of conjecture that the current administration may submit a bill to make it more permanent, but that is conjecture at best right now with the pandemic. So that's kind of the argument why and to me it really doesn't matter if you're starting a new fund, if you're smaller, if you're larger, you should do this.

The only instance where you shouldn't go read is I've only had this one time is the fund manager has essentially almost all IRA investors, they wouldn't get much and they're not levered, no benefit there. Really very nominal benefit there. So that made sense, don't need to do it. But for most of my clients we strongly recommend it and we can walk you through a process that's relatively easy to manage and not ask complicated to process. So it's going to go through the questions now. So first question here if not a REIT, can trusted investment income qualify for 20% deductions? It's kind of not on topic, but happy to answer it. I'm not a cpa so if you want to get tax advice, I recommend you talk to your cpa. My understanding of the code is it really depends on the trusted investors structure. If they're an IRA investor, no.

If they're coming in via pass through entity and they qualify and if qualifies another program, yes, if the investor has a lower tax bracket below three 17, yes. So I would talk to your CPA to see if those investors will qualify, but my understanding is they can not will but can depending on the situation. Next question here. Oh, from a friend here over there, Jeff Baker. Can fund the fund in your chart be an llc? Absolutely it can. Most of our funds out there are LLCs and they can remain status. The fund doesn't have to change anything. All we have to do is add a supplement and add a small disclosure about having subsidiary. So we try to minimize disruption to your fund as much as possible because the last thing you want to do is go out and talk to your investors and get their approval about something that's going to benefit them ultimately with very nominal risk.

So next question here with a sub-REITs structure. Are you precluded from eventually becoming publicly traded? Absolutely not. It's a matter of going that route in doing your S 11 or S one. You have to, you'll have figure that out for yourself. It's not ideal. These funds are not really meant to go public but stopping you. A lot of folks have thought about going reggae, which is kind of the middle round. It still is considered a public offering in my mind and you can eventually go to OTC if you wanted to. And there are a lot of real estate and mortgage that are not necessarily publicly traded that are reggae comes to mind at first. Those E REITs have, you've heard of those and it's out there so definitely can do it. Next question here. Our friend Mark Kevin is the 65 to a hundred thousand costs to convert one time or annual if one time, what is the expected annual estimated incremental annual cost for penguin reporting, audit, legal, et cetera?

So I will mark, we can talk privately about the cost to convert for legal and we talked to your CPAs about the one-time setup cost to get actual cost for you, but also the incremental annual cost. The majority of the incremental annual cost lands on the CPA side and the penguins. Penguins do have an annual dividend. They need to be paid. It's an expense to the, depending on the company you choose, the dividend is really a percentage on capital. My understanding is the ones that we recommend are 12% on capital. So they're coming in for $125,000 thousand dollars. That's every year. And they also oftentimes will charge you every year for a smaller dollar amount to do the annual compliance examination to make sure you are maintaining compliance. You don't jeopardize their investors. There's also issues with audit. If you're audit, if you audited financials for your fund, a recommendation is you to consolidate financial, consolidated audited financials for your subsidiary.

And then you also have to file taxes for the subsidiary as well. So there's a additional cost there for your fund for legal, there's not any additional ongoing, there's really just your ongoing rights unless you're facing a big significant kind of foreclosure situation where you need legal to step in. Next question from our friend Rocky. Thank you Rocky, for the question regarding licensing questions. Why would anyone originate at the sub level as opposed to the fund level? Well, because primarily if in California, especially if you were going to be originating and directly placing the loan into the subrate, why go through, right? Why go your parent to your and move to the sub, you can go directly to it, right? That's one big reason. And then also to have the freedom to move things back and forth without involving a DRE license right now it requires an additional license below and the reasoning there is because the DRE will not get off its ass and answer our questions. We've been asking them, lobbying them to give us a clear opinion on this issue and they refuse to. So we're trying to push that issue as hard as we can.

Next question here from Jeremy. What part of the reap benefit will sunset in 2026 again? So the, it's not the reap benefit, the tax cut and jobs act 20% Q B I deduction sunsets in 2026, right alongside the Q oz pro, alongside the q oz sunset in 2026 as well. So that's very key. Next question here in your chart. 10 99 from sub to llc then K one s to investor but income is recharacterized and gets 20 <inaudible> state tax issues. Yes. So your investors get a K one and it says, I think it's line five, their income is now stated there as a dividend, right? It's pushed through the fund. Same thing there. Waterfall, waterfall, waterfall listed as line five. So they get the benefit of being a wheat dividend from sub retail l c that transfer, yes, it is a dividend. So it'd be 10 99, but ten nine for dividends.

That's how you do it. The state tax issues it avoids because the dividends are, because it's a re dividend and the nature of being a re dividend allows you to avoid state withholding, right? State by state withholding can be a big pain for companies that have or renderers that have mastered all over the country and loans all over the country. That's why it allows you to avoid that withholding. It's not necessarily the fact that you're transferring or anything like that with the dividend, the nature of the dividend in and of itself. So that allows you to do, avoid the state level with. So that's all the questions we have today. Those of you have additional questions, feel free to contact us. Our contact information is here below. You can email me, you can call me. Same with Tay. We're here to answer any of your questions. For those of you who are fund managers or potential fund managers who are really seriously thinking about this, we really recommend you set up a time to talk with us and we will happily kind of walk you through it. Some housekeeping now. So do want to make sure we do housekeeping? So we have another webinar coming up with, Hey here. Kay, tell us about this webinar.

Tae Kim:

Sure. So this is really just more about the understanding of the security litigation enforcement. We have seen a couple of enforcement actions that would like to make sure that we address all of our private fund managers. And I'm going to be hosting this together with Darlene Hernandez from Senior Litigation Associate.

Kevin Kim:

And guys, this is so important because I distinctly remember last cycle to the tail end securities litigation was kind of the big thing. I think that we settled our last investor dispute in 2015 and that stemmed from an '09 lawsuit. And so guys, it's important to think about this understanding the ramifications of investor disputes, shareholders disputes, partnership disputes, and also what the regulators will do in certain situations with every pandemic and every recession, it's going to happen. So it's good to learn up on. So it's very, very good. Tae's working closely with our litigation team and a lot of these kind of investors right now. So another thing, a little bit of announcement here is I want you guys to join us at our next kind of state of the market, big virtual meeting. It's called Evolve. Want you guys to evolve with us.

And that's going to be on September 29th, 2020. It's going to be a virtual event and I'm really looking forward to it. It's going to be a lot of great features there. So you're going to be able to network, you're going to be able to meet folks, listen in, and we are making sure that we're getting all the best features we can to make your experience the best it can be. And once again, it's going to be on September 29th, next month and we hope you can join us there for Evolve. And that's all for us today here at Geraci for this webinar. Thank you very much for listening in. Once again, if you have any questions about a REIT, adding a REIT about your existing REIT, feel free to give us a shout. Happy to walk you through it, happy to explain some things and if you are a fund manager or thinking about going fund, please give us a call as well. It is definitely a good time to start thinking about it. Capital is not what it used to be out there, so raising the money yourself, controlling it yourself. Strong argument for that. Once again, I'm Kevin Kim. Hey Kim from Geraci LLP. Thank you everyone. Signing off now. Looking forward to seeing you all at Evolve.

Tae Kim:

Thank you.

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