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 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:
- The property held to produce rental income must remain in the REIT for at least two years.
- Any accumulated expenditures made through the REIT, during the two-year duration, may not exceed 30% percent of the property’s net sale price.
- 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.
- 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.
- 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.
To qualify as a REIT, an entity must meet two annual income tests (among other requirements). The REIT must:
- Invest at least 75% of the assets in real estate related income.
- Derive at least 75% of taxable income from rents or mortgage interest.
- Disperse a minimum of 90% of gross taxable income to shareholders each year in the form of dividends.
- Maintain a minimum of 100% of its shareholders after the first year of existence.
- Ensure no more than 50% of its shares may be held by five or fewer individuals during the last half of each taxable year.
- 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.
Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.