real estate investment can mitigate these
adverse tax consequences and the administrative requirements associated with the
imposition of certain taxes.
To address tax issues for non-U.S. and
U.S. tax-exempt investors, many funds
choose to include a privately-held REIT at
some level in the fund structure. By converting the character of income and gains
from U.S. real estate, REITs can effectively
solve a host of tax and regulatory issues
that affect a broad range of potential investors, such as those sensitive to UBTI, those
not wanting to bear the burden of filing
separate state tax returns, and those non-U.S. investors concerned about effectively-connected income. In addition, the use of
REITs, when coupled with certain non-US
investors’ status, treaties, or dispositions by
selling REIT stock as opposed to real property may address FIRPTA tax concerns.
While one or more REITs in a fund may
solve a number of investor issues, specific
tailoring is required for a fund to acquire
many types of real estate assets that offer
attractive investment opportunities while
still complying with the regulatory requirements that govern REITs. These requirements include (i) limitations on types of assets held and the character of REIT income,
(ii) holding periods for investments, and (iii)
consideration of exit strategies.
Taxable REIT Subsidiaries
While the REIT rules present a minefield for acquisition specialists at real estate
funds and the damage caused by tripping
one of the mines can be economically severe, a number of structuring solutions are
available for investments that might otherwise not be eligible to be held in a REIT.
Examples include investments in assets that
are primarily real estate but that also constitute operating businesses, such as hotels.
While the underlying asset is real estate,
the income that is derived from the asset
is not considered rental income but rather
operating income from a trade or business.
To convert this income into good rental income, a separate taxable subsidiary, often
wholly owned by the REIT (a “TRS”), can
be created to lease the asset from the REIT.
Because the REIT rules do not allow the
TRS to operate the business itself, the TRS
must enter into a third-party management
or franchise agreement. The TRS collects
operating revenue and pays the operating
expenses and capital improvement costs of
the asset and then pays rent to the REIT,
which is an expense against the income of
the TRS. Rental payments cannot be per-formance-based and careful consideration
must be paid to valuation of real and personal property of the asset and the income
forecasts of the asset. Because the TRS is a
taxable entity, the income it earns from the
operation of the asset is subject to applicable income taxes, which results in tax “
leakage” in the structure. Additional documentation, administrative costs associated with
multiple entities, and structuring that may
be required to satisfy a mortgage lender
along with negotiating difficulties that may
arise with a joint venture partner, not to
mention the income tax leakage, make in-
)(
vesting in income-producing assets such as
hotels through a REIT more complex and
expensive. In the current market, however,
it is a price that fund sponsors seem willing
to pay.
Dealer Income
Avoidance of so-called “dealer income”
is another issue that confronts REITs. As a
general rule, REITs are supposed to receive
income from the ownership of real estate
held for investment rather than from acting as “dealers in property,” and the IRS
imposes significant penalties on REITs that
receive dealer income. Typical examples of
transactions that can trigger dealer income
are the sale of individual condominium units
in a development deal, the sale of outpar-cels or pads in a retail investment, or the
triggering of an early forced sale in a joint
venture. While there are a number of rules
relating to the “dealer” issue, one safe harbor that has been established is for REITs to
hold investments for a period of four years
after they are “put in service” before disposition. Another possible solution may be to
structure such a transaction as a debt investment rather than as an equity
investment.
Wanted: Creative
Problem-Solving
It does not appear at present that allocations of capital to real estate funds are being
curtailed, and fund sponsors do not appear
to have slowed down their fund-raising efforts. In fact, it is possible that even more
diverse sources of capital may flow into
commingled real estate funds as a wider
range of overseas investors seek to take advantage of the currently weak U.S. currency
and relatively stable U.S. commercial real
estate market. Couple this with fund sponsors having to consider a wider range of investment opportunities in order to achieve
their targeted return (including investing in
jurisdictions outside the U.S.), and the prognosis appears to be for greater complexity
in deal structuring and the need for creative
problem-solving.
REsource Spring2008
