Reminders for REITs on Prohibited Transactions

Reminders for REITs on Prohibited Transactions was originally published in AAPL’s Summer Edition 2020 Private Lender Magazine.

The passage of the Tax Cuts and Jobs Act led to an increase in the number of private lending funds converting to mortgage REITs over the past two years. Fund managers made the conversion decision by carefully weighing whether the tax benefits of the Section 199A 20% Qualifying Business Income Deduction outweighed the increased compliance costs associated with operating a REIT.

Due to the current pandemic, it is important to be circumspect when administering your REIT.

Loan payment delays or forbearances may be indicative of upcoming loan modifications or foreclosures, which could disqualify the private lending entity’s REIT status. To maintain REIT status, the REIT may need to make investment decisions that might reduce stockholders’ overall return and alter investment objectives but would keep the REIT election safe. Loss of REIT status would lead to the mortgage REIT reverting to a C corporation, resulting in unfavorable tax treatment. The C corporation would pay tax at a 21% tax rate, and the dividend payments issued to investors would be taxed a second time at the investors’ income tax rates, resulting in double taxation.

Loan Modifications
Loan modifications or foreclosures could result in REITs failing to meet the required income or asset tests. If loan modifications or foreclosures within a REIT do not meet safe harbor guidelines, they may result in prohibited transactions. Loss of REIT status may occur if IRS regulations are not met. There are workable solutions around these matters if the manager is proactive and plans to avoid problems.

Prohibited Transactions for REITs and Safe Harbor Rules
REITs are required to pay a 100% tax on net income generated from prohibited transactions. These transactions may arise when a loan is foreclosed on and leads to the sale of a real estate owned asset if that property is considered to be held as inventory or primary sale to customers. Exceptions may be made when the fair market value (FMV) of the property sold in a year does not exceed 10% of the aggregate tax basis or aggregate FMV of REIT assets at the beginning of the year.

Fund managers with mortgage REITS and borrowers in default need to be more diligent during our current economic state. IRS safe harbor rules provide relief in situations where a REIT might engage in a prohibited transaction if REIT compliance is not met.

To ensure these rules are satisfied:

  1. The property held to produce rental income must remain in the REIT for at least two years.
  2. Any accumulated expenditures made through the REIT, during the two-year duration, may not exceed 30% percent of the property’s net sale price.
  3. The REIT: (a) made no more than seven property sales during the year; (b) during the tax year, the aggregated adjusted bases of the property does not exceed 10% of the aggregate adjusted basis of all assets held by the REIT as of the beginning of the year; (c) the FMV of property sold does not exceed 10% of the FVM of the total REIT assets as of the beginning of the year.
  4. If the property consists of land or improvements not acquired through foreclosure or lease termination, the REIT has held the property for at least two years for the production of rental income.
  5. If the seven-sales property rule related to Sec.(b)(C)(iii)(I) (item 3(a) above) is not met, substantially all of the marketing and development expenditures relating to the property sold were met through an independent contractor or taxable REIT subsidiary from whom the REIT receives no income.

Dealer Versus Inventory
To distinguish between inventory and investment property, a REIT may take the position that the property sold was not inventory and the REIT is not a dealer of property assets. If it were determined that a REIT sold dealer property, that would be considered a prohibited transaction. Essentially, property or inventory held primarily for sale as part of its business model is not considered a capital asset.

Income from a Foreclosure Property
If the REIT does not follow IRS guidelines, income from a foreclosure property will be taxed at the highest rate by multiplying the net income from the sale of the foreclosed property by the highest rate specified per tax code. Tax will be imposed for each taxable year on the net income from a REIT liquidating a foreclosure property asset.

Sales of assets of a REIT that do follow a liquidation plan would not be considered prohibited transactions under tax code Section 857(b)(6). The IRS ruled that if the taxpayer previously expressed that he or she intended to hold the assets or properties for a minimum number of years, yet now sees a long decline in asset value and has explored alternatives to hold on to the properties, the REIT may pursue a complete liquidation.

REIT Qualifications
To qualify as a REIT, an entity must meet two annual income tests (among other requirements). The REIT must:

  1. Invest at least 75% of the assets in real estate related income.
  2. Derive at least 75% of taxable income from rents or mortgage interest.
  3. Disperse a minimum of 90% of gross taxable income to shareholders each year in the form of dividends.
  4. Maintain a minimum of 100% of its shareholders after the first year of existence.
  5. Ensure no more than 50% of its shares may be held by five or fewer individuals during the last half of each taxable year.
  6. Have no more than 20% of its assets consist of stocks in taxable REIT subsidiaries.

Make sure to consult your tax adviser, as a REIT may be subject to some federal, state and local taxes on property, even if the REIT qualifies as a REIT under federal tax guidelines. If the mortgage REIT has a loan in default, which the fund manager feels will result in a loan modification or foreclosure, carefully review the REIT qualifications and safe harbor rules to mitigate any risk of loss of REIT status or of engaging in a prohibited transaction.

Designing Nonperforming Notes

Designing Nonperforming Notes was originally published in AAPL’s Spring Edition 2020 Private Lender Magazine.

A nonperforming loan (NPL) is a type of note that is in default, distressed, delinquent or otherwise dilapidated. NPLs are interchangeably used with nonperforming notes, distressed debts or distressed loans. Generally, an NPL holder no longer anticipates repayment from a borrower in accordance with the original terms.

These NPLs are sold in a private market, typically between 50 cents or 80 cents on the unpaid principal balance (UPB), depending on a variety of factors. Those can include length of time the note was in default, collateral value and probability of a successful outcome.

A buyer purchases these NPLs with one or a combination of these strategies: (1) modification or extension (2) reinstatement (3) borrower pay-off or (4) foreclosure. An analysis of these notes, including borrower information and exit plan, is crucial when purchasing these NPLs.

Logically, the same buyer needs money to purchase these notes. If fortunate, the buyer may self-finance the purchase. Alternatively, the buyer may sponsor in a fund structure and gather a pool of investors to raise capital or set up a direct investment model where the investors are noteholders themselves via whole or fractional interests. In a fund model, the buyer will typically act as the fund manager in a general partner/limited partner structure and deliver profit return to these investors.

When setting up the fund, however, the fund manager should consider the following issues.

Securities Exemption

The fund manager must first understand that when accepting money from an investor, the manager is selling securities. Accordingly, the fund manager must either register the fund securities with the Securities and Exchange Commission (SEC) or be exempt under one of the securities laws. One of the most popular exemptions implemented in the private investment arena is Regulation D, Rule 506 or, alternatively, Tier 2 Regulation A offering.

Fund Structure

From a fund structure perspective, there are two prevailing strategies typically implemented in the NPL space: open-ended versus closed-ended. Both have sound reasoning, but there are implications to these strategies.

Closed-Ended versus Open-Ended Fund

closed-ended fund is a structure that has a definite capital raising and closing period. The typical timeframe ranges between one to three years. As soon as the target maximum is raised, the fund closes the offering and begins operation. This way, all the investors have the same admission and accounting period, and the fund is generally easier to administer. On the other hand, the fund manager is restricted from additional capital raise. The typical raise is between $1 million and $5 million in a close-ended fund. If the manager wants to raise additional capital, he or she needs to set up another fund. This results in additional legal and/or tax costs.

A closed-ended fund strategy works in the NPL space because there is an inherent and substantial risk when purchasing notes at a discount. There is an uncertainty of when (or if) the notes will perform and when investors will be paid. Closing the offering limits the exposure of risk of payment to the investors.

Conversely, an open-ended fund is a structure that has an indefinite and ongoing capital raise. The open-ended fund typically has a higher max offering ceiling and a much longer time horizon. Because it is an ongoing raise, the admission and accounting period differs, and the fund is exposed to certain investor payment risks. These concerns can be mitigated by diversifying the portfolio through performing note acquisition or origination, or reperform the NPLs.

Nevertheless, in either model, the fund manager should be aware that NPLs need time to reperform, modify or otherwise produce income. To account for that expectation, a fund manager may provide additional features not seen in traditional mortgage funds: (1) cumulative preferred return (or otherwise deferred return), (2) longer lock-up period, (3) performance-based rates, or (4) elect to form a close-ended fund. To be sure, an open-ended fund can be liquidated when the manager wishes to do so, or simply cease raising capital. Ultimately, investor appetite and risk tolerance matters.

Discount Recognition

NPLs are purchased at a discount, which is the difference between the UPB and the acquisition cost. Implicitly, the fund will need to adopt a tax method of accounting for recognition of the discount into income.

The two available methods for tax purposes are:

  1. The cost recovery method.
  2. The market discount method.

Several factors should be considered in determining which method to use, including whether the fund is closed-ended or open-ended, because there will be an impact on the timing of taxation for the investors.

Neither the cost recovery nor the market discount method is permitted under generally accepted accounting principles (GAAP), further increasing and complicating the accounting. Either approach can be used in a fund environment; however, the preferred method for a fund with investor money is usually the market discount method.

Whether the cost recovery method or the market discount method is selected, the UPB is recorded as an asset with the discount recorded as a contra-asset on the balance sheet. When a payment is received, interest income is always reported as income, and the principal reduces the UPB and cost basis.

The cost recovery method can only be elected if the purchase is considered speculative, where there is a strong possibility that the cost basis and a portion of the discount may not be collected. Under the cost recovery method, income recognition on the discount is deferred until the cost basis of the NPL is recovered. The cost recovery method works in situations where the fund is closed-ended and not admitting new investors during the life of the fund. This method defers taxation of the discount into future years.

A second tax method is the market discount method, which amortizes the discount in tandem with the principal payments as they are received. This method is more appropriate for open-ended funds, which allow new investors into the fund over the fund’s life.

The rate of amortization will correlate to the expected principal payments received over the remaining life of the loan. If the fund manager expects to receive all the payments, then a straight-line method of recognition is practical. The amount of amortization will be a function of the total discount over the expected number of payments to maturity.

Modifications and Foreclosures

Modifications can be an attractive alternative to foreclosing on an NPL. While the fund may not recover all the UPB’s obligated payments, offering new manageable terms can result in a pay-off that produces a favorable yield.

It is critical to understand the accounting implications of modifications as it may lead to an unintended outcome. For tax purposes, if the modification results in a significant modification, then there is a new loan. The new loan will be recorded at fair value, meaning any difference between the old and new value will be a recognized gain or loss. Be sure to consider the amount of the discount that hasn’t been amortized, as it will factor into the gain or loss.

A loan modification is considered “significant” for tax purposes when based on all the facts and circumstances, the legal rights or obligations that are altered along with the degree of alteration are economically significant. This occurs when there is a change in any of these items. A change in:

  • Annual yield of greater than 25 basis points or 5% of the annual yield of the unmodified loan.
  • Timing of payments, deferring the period the greater of five years or 50% of the original note term.
  • Obligor or security.
  • The nature of the loan.
  • Financial or accounting covenants.

If the modification is a significant modification, then the lender must issue a Form 1099-C, Cancellation of Debt to the borrower.

A forbearance would not be considered a significant modification provided:

  • There is no written or oral agreement.
  • It does not exceed two years plus any period of good faith negotiations.
  • The borrower is in bankruptcy.

Foreclosing on NPLs has a similar effect as loan modifications, but with different considerations of the fair value. At the time of foreclosure, there is a new asset with the previous loan considered as noncollectible debt.

Considerations should be given to the valuation method of recording the fair value of the real estate owned asset (“REO). A BPO may not represent the actual long-term value. Foreclosed assets can come with renovations and carrying costs if the intent is to sell. The value of the REO should factor in selling costs such as open house staging or commissions at sale.

REOs in the portfolio are always subject to ongoing impairment testing, but within reason you can quantify the expected differences between the fair value and net gain at disposition.

Phantom Income and Taxes

You may notice that NPLs have more situations where income is reported, even if there aren’t any cash proceeds. This “phantom income” is taxed to the investors as the income is recognized. The timing of recognition of income versus timing of cash distributions may vary widely, resulting in a taxable event without cash to pay the tax. Fund managers may want to time the disposal of some of the fund loans or REOs to have cash reserves on hand for distributions.

While there are asset strategies such as syndications that renovate properties before they generate income, a portfolio of loans can imply cash flow in the minds of investors. When creating the offering, consider how the portfolio supports the waterfall to investors. Will there be a distribution of cash monthly based on payments from reperforming loans? Should the fund incorporate incentive fees or acquisition/disposition fees for loans that will be held for less than six months?

Another surprising factor for fund managers is that foreclosing and holding REO assets may lead to tax implications for the investors in other states. Thirty states consider foreclosing on even only one parcel of real estate located within that state to be a nexus-creating activity resulting in a state tax filing. Within the context of an NPL fund formed as a passthrough entity, investors will receive-multistate K-1s for each year that there is a foreclosure or REO asset held in another state. The fund may need to withhold taxes from the investor’s distributions and pay taxes directly to the state.

Conclusion

Designing an NPL fund can be complicated. Without careful consideration, the design can lead to adverse tax consequences. The considerations described here add another layer of complexity the sponsor must be aware of in addition to the securities compliance. Nevertheless, a well-thought-out offering with a strong team around a fund manager can successfully launch and maintain the fund.

About the Authors:

Beeta Lecha is a principal at Spiegel Accountancy Corp. She leads the Taxation and Fund Accounting practices. Lecha has 13 years of private equity and alternative investments experience, primarily focusing on private lending and real estate funds. In addition to fund accounting and investor reporting, Lecha provides tax strategy, tax planning and tax compliance for fund managers and real estate investors. Lecha is a member of the American Institute of Certified Public Accountants (AICPA) and the California Society of CPAs (CALCPA). She serves on the Education Advisory Committee of the American Association of Private Lenders (AAPL).

Tae Kim is a corporate and securities attorney at Geraci LLP, AAPL’s general counsel, whose practice involves advising clients on securities compliance in private and public offerings, fund designing and preparing offering documents. Kim and the Corporate and Securities team work closely with clients to establish mortgage funds, real estate acquisition funds, syndications, real estate investment trusts (REITs) and Qualified Opportunity Funds.

Nate Ashley is a fund accounting supervisor at Spiegel Accountancy Corp. He provides accounting and consultation services to private lending and nonperforming note funds. Ashley works with distressed debt fund managers on mitigating issues related to non-cash income and the valuation of foreclosed assets.