REITs: Advantages, Challenges, Tax Considerations, and Trends

Also involved with your typical private equity real estate structures and compliance of those structures with JVs, funds, etc. As well as a variety of international tax issues such as tax withholding, came into blockers in all of the compliance related issues with such matters. Before I hand it off to Josh, I also wanted to note that we will have a guest speaker today, Michael Hoffenberg, founder and managing director of Trevian Capital, who will be joining us at some point of the presentation. I'll now hand it off to Josh.

Joshua Milgrom: Thanks, Arthur. So my name is Joshua Milgrom. I am a counsel in the New York office of Hunton Andrews Kurth. Prior to my joining Hunton Andrews Kurth, I was at Paul Hastings for about seven years. My practice primarily consists of real estate tax, in particular the private equity space both with and without real estate investment trusts in the structure as well as merchant acquisitions in the real estate space and selling and acquiring REITs and real estate generally and basically anything else that you can think of, 1031s, and a bunch of different types of real estate transactions. And I'm happy to be here today and I will pass it off to Ryan.

Ryan Sievers: Everyone, Ryan Sievers, partner with EisnerAmper. I'm in the Dallas office, partner in the National Real Estate Group. I've got about 18 years of experience, about five of that with the big four, about 10 of that with other, let's say national firms. And I've been with Eisner for about the past three years. I focus on tax consulting and compliance services related to real estate investments, including real estate investment funds, REITs and private equity funds. I have significant partnership taxation issues including income allocations, distribution waterfalls, carried interest considerations and structuring and transactional analysis. I also have experience with REITs including acquisition diligence regarding suitability of target assets and so forth. So experiences is focused on real estate private equity funds utilizing REIT structures. And with that Allison, over to you.

Allison Stelter: Hi, my name is Allison Stelter. I'm also counsel with Hunton Andrews Kurth. I've been with Hunting off and on for 14 years. I spent my first 10 years of my career in the Richmond office and then I spent four years at Honigman LLP, which is a regional firm here in Michigan and then went back to Hunton. And my practice focuses primarily on the taxation, real estate investment trusts and also tax structuring and issues related to forms of asset backed securitization, mortgage loans primarily, but also other asset classes. Okay, I will start us off then. First we're going to start with just a few basics about REITs.

At a very high level, a REIT is a corporation that owns or finances real estate related or real estate assets. These were added to the code in 1960. The idea was to provide a way for your average small investor to invest in real estate in a diversified way, even though they might not otherwise be able to afford the capital outlay that would be required to do so. A major benefit of a REIT versus a C corporation is that the REIT is able to take what's called a dividends paid deduction. This reduces the REIT's taxable income and if they distribute enough to their shareholders and have a big enough deduction, they can avoid federal income tax entirely. Most states piggyback off federal income tax rules, although not all.

In order to be eligible to be treated as a REIT and take advantage of the dividends paid deduction, a REIT is required to satisfy certain tests including asset tests, income tests, distribution tests, and some organizational requirements. So we're just going to touch on these briefly and then we'll go into them more in depth later in the presentation. So the first test we're going to talk about is the asset test. Generally speaking, a REIT's assets must consist of at least 75% real estate related assets, so actual real estate, mortgage loans, government securities, and cash and cash items. There are also two income tests that apply to REITs. Both must be satisfied and these apply on a gross income basis. So the 75% gross income tests requires that at least 75% of a REIT's gross receipts be real estate related. And then the 95% gross income test requires that the REIT is a passive investor and thus includes the items that are eligible for the 75% income test, but also things like dividends, non-mortgage interest and gain from the sale of securities. There's also a distribution test that REITs are required to comply with each year.

A REIT, to satisfy this test, needs to distribute 90% of its taxable income to its shareholders, at least 90%. Most REITs typically distribute a hundred percent of their taxable income and thus have no entity level taxation. I also mentioned there are some ownership requirements involved. So one of those is that a REIT must have a hundred or more shareholders for 335 days of each of its taxable years. Most REITs satisfy this requirement by issuing preferred shares to holders through a exchange partner that provides this service to REITs.

There are a couple of different different outfits out there that do this. They have lists of shareholders that are willing to invest unless the REIT is able to get its hundred shareholders, which must be done by January 30th of its second taxable year. Another ownership requirement is that a REIT cannot be more than 50% owned by five or fewer individuals. This is referred to as the 5/50 test. There are some complicated attribution rules and look-through rules that apply to this test. And most REITs have provisions in their charter that are designed... Ownership limits that are designed to help them satisfy this test. And both of these tests apply starting with the REIT's second taxable year.

So here we have a typical REIT structure. You'll see the REIT here in the middle. You see the hundred investors off to the side, those are likely the preferred shareholders I referenced. And then there may be a fund above it. There could also be a partnership below it depending on what type of REIT and what asset class it's investing in Above the fund you see these are your common shareholders, generally speaking. You can have US investors, foreign investors, tax-exempt investors. And then below you see we have a TRS. This is a taxable REIT subsidiary. It is an entity that a REIT can jointly elect to treat as a TRS with the entity itself, and that allows the REIT to do certain activities like disposing of assets or own certain things that might not be qualifying for a REIT and earn certain types of income that might not be qualifying for a REIT.

Turn it over to Arthur.

Arthur Khaimov: Thank you, Allison. One second here. Right. So as Allison just mentioned, an entity has to assess a variety of income and asset test to qualify as a REIT. The income and asset tests are really designed to limit the REIT's activities to holding real estate rather than acting as an operating company. And just note that this is not an all-inclusive list, rather a brief overview. As a matter of fact, I will be adding in some things that are not listed here just to add some color, but it's going to the asset test. They have a 75% asset test. At the end of each calendar quarter, at least 75% of the value of REIT's assets must consist of the following types of assets. So we have real estate assets which include real property, obviously you have your land building, etc. And in parentheses, there is also some incidental personal properties are included.

So for instance, if you have a rental property that's generating some income. From the rental of personal property to the extent of the personal property's value is below 15% of the total value of the building, that income and those assets will still qualify as good assets because it's considered to be incidental to the real property. So something good to look at and watch out for. A mortgage loan. So mortgages, investments in loans, originating loans fully secured by real property will be treated as good assets.

So typically, what you'd want to do is when you're considering investment in these loans or purchasing originating loans, you want to review the appraisal reports to ensure the value of the property, that there's enough equity in the property to cover the loans. Essentially, your LTV value should be below a hundred percent. And the test is done at the date of commitment and maybe it was something we'll get into later on in the webinar, but if something happens later on where the value of real property depreciates for whatever reason, that does not necessarily mean you now have...

And your LTV value is let's say over a hundred percent, it doesn't necessarily mean you now have a bad asset. Unless there's a trigger event, this still will qualify as a good asset. We'll talk a little bit more about that. Allison will discuss some of the modifications, et cetera. But essentially the date of commitment is important and as long as there's enough equity in the property at the date of commitment, you will have a good asset which will generate good interest income as well. When I say good, it means good for the 75% test and 75% income test as well.

Another thing is in the mortgage REIT world, you typically see also perhaps purchases of tranches of mortgage-backed securities. And in those types of instances, you want to look at the PPM or offering circulars. And typically those documents are pretty large and after looking at many of them, we have pretty good experience where to look at. But essentially there's language in those PPMs and offering circulars that tell you how to treat this for purposes of REITs, etc. So that's something to look at. An option to acquire real property is also a good asset. Then we have Mezz, certain Mezz loans, typically Mezz that is secured by LLC's interest that holds the real property. So essentially the collateral there is ownership, potential ownership in that LLC that owns the property. And the question is Mezz that a good asset? And if it's treated as actual debt, the IRS provides a revenue procedure as mentioned here, 2003-65 Safe Harbor.

Essentially, there's an eight step process, eight questions that you have to go through, and if you essentially meet those, that criteria, it'll be treated as a good asset. Now we know what happens. Being that this is a safe harbor, you may not always meet all the eight criteria, all those items. The question is what happens if you meet six out of eight or whatever the case may be. Typically, being that it's a safe harbor, price could auto-protection but facts and circumstances come into play. So at that point in time you want to look at the facts and circumstances and see if you're comfortable that although you outside of the safe harbor, you may still in fact be... This may still be in fact be a good asset.

And also to allow REITs flexibility, their cash management real estate assets also include certain assets that are attributable to REIT's temporary investment of new capital and that's the last bullet point there. Essentially, the rule is limited to only stock or debt instruments in which a REIT reinvests its new capital. Assets that satisfy the requirement for temporary investment of new capital qualify as a real estate assets for purposes of the 75% test and the income test as well. Typically, we honestly try to avoid this. Essentially, it may even be... It's very easy to just buy REIT stock. In the initial years of having setting up a REIT, you may want to generate some good income, some good assets, and although there is a PLR out there now, but before we get into that, prior to that PLR, typically we advise our clients to purchase REIT stock that pays a dividend so that it generates some good income and... Or perhaps invest in some GSTs, government-sponsored entities like Fannie Mae, et cetera.

Another item is cash and cash items. For REIT holding cash and cash items is a good asset. Also, money market funds. Government securities is another good asset. Just one thing to note is it's important to be careful because sometimes you could have a good asset for the 75% test, but the income it generates will not be good income for the 95% test. I'm sorry, for the 75% test. So essentially, let's say cash, especially now with the rise of interest rates, a REIT could hold, we've seen this happen, REIT holds a lot of cash in a bank account, it's generating interest. That interest is only good for the 95% test. Government securities are paying some dividends or interest, those are also only good for the 95% test. So it's important to note to keep track of these buckets throughout the year and note that some good 75% assets may not generate good 75% income.

Last bullet point here talks about, as Allison mentioned about TRSs, and we'll get into it a little bit later, but essentially, now more than 20% of the value of the REIT's total assets cannot... Well, essentially not more than 20% of the value of the REIT's total assets may not consist of securities of TRS. So you may want to keep track of your TRS and the value of the TRS and compare it to the total assets because there's a 20% threshold. It used to be 25, it was then reduced to 20. Now, just one other thing I wanted to mention is that what happens if you own an interest in a partnership. If you own an interest in a partnership, the REIT is deemed to own a proportioned share of the partnership's assets. So essentially you have to look through the partnership and you have to use your capital interest in the partnership to then take your proportion share of assets, gross assets, and include them in your REIT test.

Going on to the next slide. Excuse me. So wanted to get into a little bit of on the security side. There's also securities testing for the five and 10% in the asset as part of the asset testing. Now, before we discuss the actual testing, why don't we review some background. Securities testing could be tricky as you may... It's something that's also not always something that you may not have been seen for a while because if you're dealing with equity REITs, you could potentially not ever be exposed to doing any securities testing. A more typical on the mortgage REIT side that have a large variety of financial instruments in their portfolio. Excuse me.

I've seen these issues more with either very large private REITs or publicly traded REITs. It is common to be testing a financial instrument under the security sets for mortgage REITs due to the high percentage of debt-like investments and related hedging derivatives that either do not qualify as a good REIT asset or there's insufficient information to determine qualification. One example of such instruments are interest rate swaps. To the extent that you're hedging and you're identifying an interest rate swap as a hedge, you may eliminate it from your income testing, your gross income testing, but you may still have to test the asset on the securities testing.

Now another thing to mention before we get into an actual test is to determine whether a REIT complies with the various asset tests related to the securities. One must first determine what constitutes security. If a loan does not, let's say if a loan or an asset does not meet the criteria to be treated as a qualifying asset, you may need to consider whether it meets the definition of a security under the 1940 act. The Investment Act of 1940. As the code doesn't really define it for purposes of asset tests and terms that are not specifically defined in the REIT provisions of the code have meanings identical to those in the 1940 Act.

So essentially, starting off testing whether it's a good asset, it's a good asset then you don't have to do any of this. If it's not a qualifying asset for the 75% test, your next step is to determine whether it will be treated as a security. So let's just get into the actual testing. At the end of each calendar quarter, a REIT's ownership of the securities of an issuer must comply with the following test. The value of the securities of one issuer owned by the REIT may not exceed 5% of the aggregate valve the REIT's assets. So essentially, this is an easier test meet. Well, to test and watch out for.

Essentially, you're taking your total assets and multiplying by 5% and that number cannot be larger than your investment, one issuers. The 10% test is a little bit more difficult. That's where REIT has to essentially ensure it does not own by value or voting rights of 10% or more of the issuer's outstanding stock. So essentially, if you're buying publicly traded stocks, that's easy to check as that information is available. To the extent that it's not investments in securities of a publicly traded company, that may be a little bit more challenging.

Now another thing to note, if let's say you do fall into the securities definition, there is another out where you can potentially not test it for the 10% test. It's something called the straight debt exclusion, a loan that does not otherwise meet the criteria of being a real estate asset. Like I just mentioned, will be excluded from securities testing. I'm sorry, if you do meet the criteria of real estate asset, once again, you don't have to test anything for the securities testing. To the extent you do not, the next step is to see, well, okay, I may test it for the 5% test. The 10% you may have a now, as I mentioned, the straight debt safe harbor. The basic requirement is that the debt must consist of a written unconditional promise to pay certain sum in cash. Interest on the debt must be non-contain-

Arthur Khaimov: ... cash. Interest on the debt must be non-contingent upon profits or the like, and the debt must be non-convertible. So essentially, if you have a loan of some type or a debt instrument that you can meet the straight debt safe harbor. You do not have to test for the 10% test. Let's go onto the next slide. Excuse me. So now, we're onto the income test. It really is required to satisfy 75% gross income test and this test is intended to ensure that at least 75% of the REIT's gross income is real estate related. Restrictions on type of income of a REIT is to be sure that the bulk of its income are from passive income sources and not from an active conduct of a trader business. So essentially, that's the goal here. So what's included in the 75% income test? You have rents from real estate, leases of real estate property, et cetera, building land.

Some of the items mentioned here is that it can be based off on net income, profits or cash, gross receipts are okay, can have any related party rents. Non-customary services, we'll talk a little bit more, have to be provided by an independent contractor or a TRS as Allison mentioned. And the 15% personal property as I mentioned before, to the extent that you have rental income that's allocated or to a personal property, as long as it's below 15% of the value of the total property, it'll be considered as good 75% income and a good asset. So just a couple of other items wanted to mention. Gains from a sale of real property will also be part of the 75% test, as long as it's not dealer property. Dividends from other REITs is good income. Committing fees to make loans or purchase or lease property are also items of good income and obviously, interest on mortgage loans.

As I mentioned before, as long as it's properly secured by real estate, they will be treated as good qualifying income for the 75% test. Let's move on to the next slide. 95% gross income test. At least 95% REITs gross income for each taxable must consider the following types of income. So as Allison mentioned before, 95% test includes whatever's in the 75% bucket. So in addition to that, you have dividends including dividends from TRSs interest that are not qualifying mortgage interest. Let's say interest from bank accounts as I mentioned earlier, gains from the sale of disposition of stock or securities are also part of the 95% test.

All right, so part of the income test, just wanted to note a couple of items. Frequent sources of bad income. So you have fee income, any management fees, et cetera, that will be treated as bad income. So as I mentioned, we have the 75% as we have the 95% percent. So technically, REIT does have 5% available to absorb any bad income. So let's say if you have some fee income or anything otherwise, any other bad income, you may still be able to leave it at the REIT as long as the REIT can absorb it in the 5% bucket. So related party rents, we're not going to get too much into it, but essentially, there's the ownership of 10% or more and there's some nuances there to look into.

One other thing I wanted to note that's not written here is something called impermissible tenant service income. So it's referred to as ITSI. So with respect to a property, so typically, when we do REIT testing, at least annually, we try to have the property manager who is someone who is very familiar with the activities of the property, fill out a property service questionnaire, excuse me. In that service questionnaire, we list basically a lot of questions and if the answers are no, you move on to the next one. If the answer is yes, they may need to have some more information. We're basically trying to dive in, to hone in on any potential rent income that will not satisfy the 75% test and there may be some services provided to tenants that may be impermissible. So that's part of impermissible tenant service income. Now, why is that important? Because at any given year, if any income from the ITSI portion exceeds 1% of your total gross income from that property, then none of the income from that property qualifies as good rental income.

And so, I actually wanted to quickly say an example I found in Checkpoint where it drives this point. Let's say for REIT, owns a property that has $13 million of gross revenues and REIT has ITSI income from the property of $150. So since 150,000 is more than 1% of that $13 million, then the full $13 million will be excluded from your 75% test. So obviously, it shows the importance of tracking this and being vigilant. Now, let's say you only had $100,000 of ISTI income, in that case, only that 100,000 will be excluded and treated as impermissible income.

Now, although the name implies impermissible service income, it's a little bit misleading because there is another rule. Essentially, it says that if the total cost is equal to 150... Let me just drive this with an example, just the wording of it is a little bit confusing. So let me just actually share another example from Checkpoint. So let's say once again to the same example, we have $13 million of gross revenues. A REIT earns income of let's say only $20,000, which is way below 1%, but the REIT bears direct expenses of $100,000 to provide that service. So then what happens is you take the 100,000, you multiply 150% of the cost. So you take the cost, you multiply 150%, which equates to $150,000, which exceeds 1% of gross income. Then essentially, once again, the full $13 million is excluded. So you have to watch out, even if you're not generating so much income from that ITSI service, you have to be careful how much cost you're incurring to provide that service.

Now, onto some of the excluded income items, hedging in from qualified liability hedges, as I mentioned previously, if you have a hedge that's a qualifying hedge, essentially, what that means is you're hedging a liability, for interest rate hedge we've seen a lot of those now. When you have an interest rate cap agreement and you're identifying it for tax purposes as a qualifying hedge, then per REIT rules, that interest income that you're generating or that income that you're generating will be excluded from the gross income testing. COD income gains from sale of dealer property because those are subject to 100% tax. We're not going to talk too much today about prohibited transactions and dealer property, but just note that dealer property has a heavy penalty of 100% tax on any gain. Certain foreign exchange gain. Now, another item that's important to note... I'm sorry, someone?

Michael Hoffenburg: Yeah, you got Michael here. Sorry.

Arthur Khaimov: Oh, Michael. Hi, how are you? Thanks for joining us. Let me just briefly finish this and then we'll get to you. I know you have limited time and thanks for joining us. So there was new guidance. There was a PLR that recently came out, which was great news because this is a subject matter that's caused a lot of discussions and gray area for both taxpayers, taxpayers practitioners. What happens if you have a new read that has zero income in year one? Does it pass the gross income test is zero over zero, 100%? Or zero over zero does not qualify? And there's always been a gray area about this. Recently, there was a PLR request and the IRS came out with a ruling that said it was specifically to a situation where a read in year one thought it would have assets, but something happened essentially and they didn't generate any income.

So they essentially filed a return with zero income. The auditors came in and then they said, "Well wait a second, this may be a problem." So they went to request a ruling and they were happy to amend the return for year one to treat it as a C-Corp. The IRS came back and said, "You do not need to do that." And I actually want to read just the language that they specific what they wrote. The IRS wrote, "The gross income test as being concerned with the sources of a REIT's gross income and not with whether the REIT has gross income in the first instance."

So they were focusing on the fact that it's not that you don't have any gross income, it's when you do generate income, what is that income? So it says that the code does not prevent qualification as a REIT on account of having zero gross income. And that was a big ruling, although you cannot take a PLR and apply it to your circumstance. But obviously, this helps see how the IRS is viewing these issues and which way they're going. And the same for the asset actually, they mentioned that zero assets are okay and they even told the taxpayer, we do not need to amend your return. All right, as I mentioned before, we have a guest speaker today and I do want to pause a little bit on the slides because Michael just joined us. He has limited time this morning. Hi Michael, thanks for joining us.

Michael Hoffenburg: Thank you so much for having me and I apologize I wasn't able to get video on here, but hopefully you guys can hear me all right?

Arthur Khaimov: Yeah. Hear you fine and perfectly. Thank you. And we know your time is limited. Just why don't we just jump right into it. Before I ask you a couple of questions, why don't you take a few minutes to introduce yourself?

Michael Hoffenburg: Yeah, sure. Hi everyone. Michael Hoffenburg, I'm the founder and managing principal of Trevian Capital. We're a real estate credit platform. We focus on providing senior secured shorter duration bridge loans, think two to three years, predominantly in the middle market. So sub $50 million around the country, although we could do deals as large as $200 million. We have a bias towards the multifamily space where we've owned and operated and successfully implemented business plans on the equity side. But we've lent on effectively every asset type around the country. We're currently in 24 states, average loan size is 12 and a half million dollars. So that's the backdrop. We have both a discretionary fund that we invest out of as well as a separate account with a US-domiciled insurance company that we insure, originate and service on behalf of.

Arthur Khaimov: Thanks, Michael. So just wanted to start off by asking, could you tell us a little bit more about the current state of the lending atmosphere now?

Michael Hoffenburg: It's interesting, if you would have asked me that question about three days after the Fed lowered interest rates, 50 basis points. I would say, cautiously optimistic with the most rosy outlook that we've seen over the past 24 months. Since then, the tenure has increased approximately 55 basis points back up to today. I think it was at 425 or 427, something like that. And we've seen a lot of folks put their foot on the brakes trying to figure out valuations. Real estate's a private asset class and it lags the overall public markets. And what we're seeing and what we thought would start happening right now, which I think will end up happening post-election and certainly, after the first of the year, I'd say after the inauguration, is really the markets will normalize and most importantly, it'll allow real estate and interest rates to settle and start clearing. Trades will clear.

To contextualize the real estate lending market, it's $5.8 trillion. There's approximately $2.8 trillion of commercial real estate that's maturing between now and 2008. That's about 50%. That includes all the loans that were extended this year that didn't get figured out. That's coming due over the next, call it three, three and a half years. And so a lot of folks just need to figure out what to do and that's going to spawn transactions, which will allow real estate to finally ,I'd say, clear and establish new valuations.

With interest rates going up 500 basis points and real estate being a function of cap rates, which is obviously a function of interest rates, it's been so opaque. So there's been billions of dollars raised in the private credit space to deploy capital where banks have pulled back and on the equity side to take advantage of opportunistic acquisitions. So everyone is foaming at the mouth to transact. There really hasn't been that many transactions. So I'd say today, it's still a wait and see approach, whereas 45 days ago, I would've said the market's going to start clearing and everyone's super, super excited about the opportunity set today.

Arthur Khaimov: Thank you for that. No, that's some very good points. And so being that you've experienced these fluctuations and interest rates, how has this changed your lending practices?

Michael Hoffenburg: From the onset, I guess we got very lucky in the sense that we were never a loan to value lender, right? We take more of a conventional approach. We underwrite to the same underwriting metrics that a Fannie Mae, Freddie Mac insurance company bank will underwrite, which is really focused on cash flow. It's lesser of loan to value steps, which is a function of appraised value or valuations, which is function of cap rates. And all of us on this webinar could look at the same class A multifamily deal in suburban New York, and I bet every single one of us has a different cap rate, which will create a different value and ultimately, a different loan to value. So for us, what we've been hyper focused on is cash flow, especially lending in the multifamily sector, retail sector, industrial sector, self storage and student housing.

Cash flows are relatively predictable and so if you wanted to write to the lesser of loan to value debt service coverage ratio and debt yield tests and in particular, be hyper focused on where the Ford interest rate curve is going and create a buffer against that Ford curve, anywhere from 25 to 100 basis points on a forward-looking basis, 18 to 24 months out, you can underwrite conservatively, still deploy capital and deals, still do pencil.

So for us, we've effectively stayed out of any trouble. We've had 100% performing portfolio in our discretionary fund, zero principal markdowns, zero defaults and foreclosures. And that's a function of underwriting the cash flow versus a loan to value. And so underwriting at a 125 debt service coverage ratio on where we think conservative interest rates will be on a forward-looking basis. And also, underwriting conservative analyze. Look, my rental revenue assumptions are going to be very different looking at a class A multifamily deal that's delivering in Austin, Texas versus a B+, A- deal that sits in Cincinnati, Ohio where there's been limited new supply or even Chicago. So we're really cognizant of cash flow versus I'd say, a cap rate exercise.

Arthur Khaimov: Very interesting points. Thanks, Michael. What are your expectations on interest rates for the near future and just the future outlook of the industry?

Michael Hoffenburg: Over the past couple of weeks since the market's really moved in the 10 years started to take up, we've had a very defined view. If you look at SOFR, which most short-term loans are pegged to, one month term SOFR in particular, you're looking at that curve with a steep downward decline. Used to be leveling off around 300 basis points. Today, it's more like three and a half to three and three quarters. Yet, if you look at long-term fixed rate debt, which is priced to treasuries or swaps, those are going up. So as you think about 12 months out, 24 months out, 36 months out, and even the nearer term again, end of Q-1, I think spread's actually wide, right? Over the past couple of months, spreads have drastically come in, right? People were excited, interest rates had leveled off. The Fed embarked on their cutting campaign. The ten-year was three and three quarters or even 3.65%. The market was looking very rosy and spreads just warred tighter. I'd say about 150 to 200 basis points.

What we're seeing and what we're anticipating actually is those spreads, come end of Q-1, beginning of Q-2, as a function of where long-term fixed rate debt will price, is going to have to widen, right? You could still park money in treasuries and earn close to 4.5% Today. So how are you going to do a 275 overdeal on a 75% loan to cost three-year bridge loan? So I think it's going to be a really interesting market dynamic with spreads low leveling off over the next couple of months. And then ultimately, widening as people are looking to deploy capital.

And look, in the industry as a whole, the market's going to clear next year. I don't want to call the bottom at this point, but we're awfully close to it. Transaction volume year over year from its peak in 2021 and the beginning of '22, was down 75% in '23 and pretty much static at a 75% decrease compared to 2021 and 2022. So just the market's been anemic, only those that have had to transact are transacting. So for us, we're waiting in the wings ready for the market to clear. And look, transaction volume picking up is great for everyone and we see that absolutely returning to the market.

Arthur Khaimov: Yeah. That sounds good, Michael. Thank you again. I know you have limited time. Just wanted to ask you one final question is tell us why you chose, just to your business structure. Tell us why you chose a REIT as your business structure and why it was important for yourself, and also for your investors.

Michael Hoffenburg: Yeah. Sure. I think that's a good question. Thank you. When I learned about the REIT structure, we were launching our fund, which is an open-ended evergreen vehicle. And underneath the fund, 100% of all of our loans are lent out of our REIT, the Tribune Capital Debt Fund REIT. And we chose to do a REIT for a number of different reasons. Not only do we solve for current income for our investors, but when we looked at marketability of our fund and of the platform and ultimately, gaining investors, it became a no-brainer to put a REIT structure in place. The first reason is you don't have to pay entity-level taxes. The second reason, it serves as a UBTI blocker. So that allows us to get qualified money pension fund 401k IRA money. It just makes our fund with the REIT underneath more marketable.

The third reason is it serves as a blocker for business or trade issues for foreign investors. While we don't currently have foreign investors, we have several foreign investors with onshore US domiciled feeder funds or feeder entities. So that was super attractive for them. And then I'd say the biggest reason is simply, it saves 20% to your investor on an after-tax basis on both federal and state taxes. So if you look at those savings on an after-tax basis, if you're delivering roughly a 10% net return, just on federal taxes, it's delivering 75 basis points or 74 basis points of a higher net after-tax return just on federal tax savings alone. If you layer on tax savings in New York State, for example, from a state level, on 20% on state, we're talking 100 basis points net higher after-tax return, if you're delivering a 10% return. We happen to be doing a little bit better than that. We're delivering 12%. So that's about 115 basis point net positive after-tax return just by having the REIT structure in place.

Sure, there's admin that goes along with it and quarterly reporting and quarterly REIT testing, but eyes are amped but once we engage them to, one, educate us on the REIT product and then two, talk through the admin side of it, they effectively take care of everything. Very easy to work with, very proactive to get the test done ahead of time and just simplify the entire process. So Arthur you, your team, your firm, have been a pleasure to work with and one, getting everything in place. But I think more importantly, the compliance aspect of it is a piece of cake, having you guys as an extension of our team. So if you guys are considering putting the REIT in place and are out there raising capital, I would highly encourage you, from a marketability standpoint to investors. And certainly, if it's a cash flow and current income strategy, you're distributing the capital anyway. So it really becomes a no-brainer.

Arthur Khaimov: I appreciate that, Michael. And we're actually going to cover some of those topics you mentioned. But yes, I appreciate that. Thank you so much. We do have a question for you, Michael.

Michael Hoffenburg: Sure.

Arthur Khaimov: Sorry. Are you seeing preferred equity commitments into multifamily deals?

Michael Hoffenburg: We do not deploy press into that space. All that being said, of course, with values resetting, there's a gap that needs to be filled by either MEZ. There's a huge opportunity set that exists in the preferred equity space. That's just not really an area that we focus on. But yeah, we're seeing it everywhere and we're always in need of folks to come in because we can't get to the last dollar that maybe the borrower needs, and that requires either MEZ, but we also get a pledge in the membership interest of the entity that owns the assets. So that turns into.

Arthur Khaimov: Well, Michael, once again, we thank you so much for your time and all the information provided. You're welcome to stay on, and I know you have limited time.

Arthur Khaimov: You're welcome to stay on and I know you have limited time, so there's nothing else. I don't think there's any other questions. You are free to go.

Michael Hoffenburg: All right. Well, thank you so much for having me on. I do have to jump into another meeting, but appreciate it, and you guys are in great hands with Eisenman. All the best, everyone. Thank you so much.

Arthur Khaimov: Thanks, again, Michael. Bye-bye.

All right, let's just go back to our slides. I'm trying to see where we're up to. Just one second. Bear with me.

Okay. Just wanted to mention, preferred equity just came up as a topic. We have seen an uptick in preferred equity investments. Now, just one thing is to be cautious as far as using a REIT or REIT-owned entity in preferred equity deals. If the preferred equity is treated as debt for tax purposes, you may want to consider discussing it with your accountants or counsel. Language matters. Nuances of those papers and documentations that are put together can make a difference. So, it's just something to be mindful of.

So now onto the distribution test. This is always a fun topic. So distribution, as Allison mentioned at the beginning of the webinar, distribution test, there's a 90% distribution requirement. Each taxable year, a REIT is required to distribute 90% of its taxable income to remain as a REIT. Now, typically, to avoid any taxes, typically REITs want to distribute 100% of their taxable income. Now, just also wanted to note that a REIT is allowed to have multiple classes of stock. Now, as far as distributions are concerned, in order to get the dividend paid deduction, you just have to be cautious about preferential dividends. Now, if you do have a preferential dividend, that will not count towards your dividend pay deduction. It'll be completely excluded. Now, essentially, that's a topic of its own. So, we can't get into all the nuances, but just simply put, a distribution will be preferential if there's the preference as to any share of stock as compared to any other shares of the same class of stock.

So, just be mindful in an ordinary distributions, if you have 10 shareholders in class A, you have to be careful when you're distributing shares, when you're making distributions of cash, that they each have to get a provider share, equal provider share of that distribution. There's a lot of nuances in this topic. So beyond the scope of this discussion, just wanted to mention to be mindful of. Now, what are some of the types of distributions that can be utilized for dividend paid deduction purposes? So we listed out here in four bullets. One is cash. Let's say you have cash distributed in tax year 2024. That actual cash can obviously be used as a DPD deduction against taxable income. Another option, a very common option is 857(b)(9). Under the code section, a REIT is allowed to declare a dividend in the last quarter of the year and pay that cash in, let's say in our case, let's say we're making declaration now, we can pay that cash in January of 2025.

In that case, you are allowed to pull back that distribution to tax your 2024. The REIT can use it as a DPD deduction, and it'll also be taxed to the shareholder and their 1099 as a dividend they received in 2024. Excuse me. So this is a good option for especially in the beginning years of a REIT for cash management purposes if you don't want to over distribute. You don't want to have any return of capital. Typically, let's say you have a hundred dollars of taxable income that you're expecting to have, and you currently distribute, let's say $85. So you have $15 to cover taxable income. You can elect to make that distribution on the 857(b)(9) in the last quarter, and pay that out, pay the actual $15 in 2025, in January of 2025.

Now there's flexibility there, and the reason why this is very common is because let's say at that point in time you realize you really only needed $10, not $15. For tax purposes, although you're making the full distribution out on January of 2025, $15 for tax purposes, you're allowed to pull back only $10 that you need, and leave the other $5 for 2025. So it's a good strategy and something to be mindful of. There's also 858(a) distributions. Those are essentially distributions where let's say for whatever reason you were lacking distributions, you realized it too late, you're allowed to make an election to pull back any, let's say in our case, 2025 distributions. You pull it back to tax year 2024 to cover tax year 2024. Now there may be excise taxes involved, and the reason being is because it's almost like an interest charge by the IRS. A 4% excise tax.

Now, because in that scenario, although the REIT will be using that distribution to offset taxable income in 2024 and get the deduction in 2024, the shareholder will realize that income and recognize it for their taxes in 2025. So because of that year difference, there is an excise tax penalty essentially. Now, the excise tax may not apply. There's a test. If you're below a threshold, you may use the 858(a) without paying any excise taxes. Now there's also consent dividends are quite common in the private REIT space.

Essentially, it's a deemed transaction. It's a deemed distribution. Essentially, when you're filing, let's say you don't want to make the 858(a) for whatever reason, you realize you need more distributions to cover taxable income, with the filing of your REIT return, there are forms 972, 973 forms, essentially that you include with your tax return where the shareholder signs and agrees to pick up that deemed distribution in their taxes in 2024 as well, in the same year as the REIT deduction. So there's no excise tax penalties there. A couple of nuances there, one being that it's a deemed distribution, but also deemed contribution by the shareholder. So the shareholder's basis in stock goes up. Something to be mindful of when keeping track of cost basis. So because it's a paperless, a cashless transaction, it's a deemed distribution, deemed contribution, by the shareholder back into the REIT.

Now, be careful because some states may not recognize consent dividends. And there was at one point an issue with California where they did not. It was I believe somewhat of a gray area too, but the consensus was that they don't recognize a consent evidence. So therefore, in the case where we had consent dividends, we actually had to do a consent dividend for federal purposes, but an 8 58 for state purposes. That's one issue with consent dividends. Be careful with states if they don't recognize it, you may have to track them separately, have two different tracking for federal and for state purposes.

The next bullet is just corporate. I won't read it, but essentially talks about the excise tax. Let's say to the extent that you are only distributing 90% to maintain your REIT status, like I said, you may have to pay income taxes. There may also be an excise tax. There's a way to test kind of like your prior years, et cetera, your future years, and I mean your current year, and to ensure that if there's some sort of a shortfall, you may have to pay an excise tax. But once again, typically, people avoid it by distributing a hundred percent.

Dividend pay deductions. I will probably have to go through it a little bit fast now. I apologize, but I think we're running short on time. Dividend pay deductions. So as we've just discussed, dividend paid deduction, DPD is generally, it's DPD against earnings and profits. So it's available for ordinary dividends, cash, property, et cetera. I will probably skip some of this because I just talked about it. When you have a DPD that succeeds REIT's taxable income, let's say you have more distributions, you cannot create a federal loss for federal income tax purposes. But be mindful that for states because of state addbacks, you may benefit from some of those deductions and can have additional deductions for DPD for state purposes. Let me just skip to the next slide. I apologize, just going a little faster here. E&P. E&P, it's an enormous topic. It requires a lot of tracking. I think it has become a more complex when essentially now what happens is in the REIT world, you technically have to keep two different tracking systems for E&P purposes.

What is E&P? E&P is essentially corporation's economic ability to pay dividends to its shareholders. And there are addbacks. Your starting point is taxable income, but then there are addbacks for E&P purposes. One quick example is let's say you paid a penalty. A penalty is not deductible for income tax purposes, but being that you don't have that cash to pay out to your shareholders, you do reduce your E&P for that penalty. However, there are other nuances with REIT. So you kind of have to keep track of E&P for DPD purposes and E&P for 1099 reporting purposes. They will not, if there are E&P differences, they may often not align with each other.

So yes, I guess just be cautious. Dividends and distributions are not the same. And the taxable dividends are against the E&P and distributions could be just by return of capital. So I'm sorry if I had to go through that rather quickly. I will now... Oh, I think there's one more slide for me is the taxable REIT subsidiary, TRSs, as mentioned before. TRSs are very important in the REIT world. Essentially, a REIT owns the TRS, and the TRS is an ordinary C corporation. It'll pay income taxes, but it's often used in conjunction with the REIT to provide services, or to collect income that a REIT may not otherwise be able to, because it's not part of good asset and qualifying asset and qualifying income buckets. I will now hand it off to Ryan, I believe.

Joshua Milgrom: No, I got these.

Arthur Khaimov: Sorry, Josh. Josh, go ahead.

Joshua Milgrom: So now that we've gone through some of the basic REIT qualification requirements, we want to talk through some of the other considerations and benefits of using a REIT for your investment structure. So the first item we're going to talk about is the Section 199A Qualified Business Income Deduction that provides non-corporate taxpayers with a deduction of 20% of their qualified business income, the income that's earned from a qualified trader business. Plus a deduction of 20% of its qualified REIT dividends. So we'll start with a quick description of what qualified business income is. And just as a starting point, qualified business income will generally come from a flow-through entity. So a partnership, an S corporation, and basically consists of income gain, loss or deduction, to the extent it is produced by a qualified trader business. A qualified trader business is actually defined by what it isn't.

So it is not the business of being an employee. It is not certain service industries such as law firms or accounting firms, architecture firms, but anything that's not included in what it isn't is considered a qualified trader business. There are certain types of income that could be generated by a qualified trader business that do not qualify as qualified business income, and those would include capital gains and losses, dividends and interest, just to name a few. That's a non-exhaustive list. And the availability of the deduction is also limited to the greater of either 50% of the qualified trader businesses W-II wages for the year, or 25% of its W-II wages for the year plus 2.5% of the unadjusted basis of certain of the assets owned by the qualified trader business immediately after they were acquired.

Importantly for this discussion, and as mentioned before, in addition to qualified business income, qualified REIT dividends are also eligible for this 20% deduction. Qualified REIT dividends generally include ordinary REIT dividends, but not REIT dividends that are designated as capital gain dividends. And an important note here is that qualified REIT dividends will automatically qualify for the 20% deduction. It doesn't matter what sort of income, as long as it doesn't make the REIT not qualify as a REIT anymore. The type of income that's generated gets cleansed and becomes a REIT dividend when it is distributed out by the REIT. And it doesn't matter what sort of trade or business it comes from as long as, again, it doesn't make the REIT not qualify.

So this availability of the 20% QBI deduction and deduction for qualified REIT dividends can provide a significant benefit for non-corporate REIT shareholders in that it reduces the highest marginal effective rate, tax rate, on qualified REIT dividends from 37% down to 29.6%. So now we're starting to see all the different potential benefits of a REIT sort of stack up. You have avoiding anti-level tax, and now you also have the benefit of reduced tax burden at the shareholder level when we stack 199A on top of that. So now to add an additional benefit...

Arthur Khaimov: Josh, if I just may add... I'm sorry, I just want to add one thing. I think it's important to highlight also that the distinction between a REIT and a partnership, in a partnership comes as a high net worth individual may not benefit from that deduction because they may have phase-outs, et cetera, whereas in a REIT context, the high net worth individual will automatically benefit by that 20% deduction.

Joshua Milgrom: Right.

Arthur Khaimov: Go ahead, sorry.

Joshua Milgrom: No problem. So moving on to the next slide. Sorry if I'm moving a little quick. We are going to add an additional benefit, and that is the deduction of miscellaneous itemized deductions by a REIT. So historically, taxpayers have been allowed to deduct certain expenses in excess of 2% of their adjusted gross income. Those miscellaneous itemized deductions included items such as portfolio expenses, investment expenses, tax preparation fees, and the list goes on and on. However, the Tax Cuts and Jobs Act which was passed in 2017, suspended the availability of miscellaneous itemized deductions from 2018 through the end of next year, 2025. That suspension does not apply to corporations however. And as discussed earlier by Allison, a REIT is a corporation for US federal income tax purposes. It's just subject to a special taxing regime so long as it continues to meet the REIT qualification requirements.

So the REIT as a corporate entity may deduct what would've otherwise been a miscellaneous itemized deduction if it wasn't within the corporate, the REIT structure. So a REIT could be a superior structure to a partnership if a business is expecting to generate what would have been miscellaneous itemized deductions. The REIT is able to take those deductions to offset its other REIT taxable income. Whereas if you were to set up your structure in a partnership, those deductions would not be available to its partners so long as if they were, say high net worth individuals who would not be eligible to deduct their miscellaneous itemized deductions at this time. So let's look at an example of how this could work. So let's say a sponsor forms a debt fund in the form of a partnership. And let's assume that the debt fund generates a hundred dollars of interest income and $20 of portfolio expenses that would've been eligible as a miscellaneous itemized deduction, but given the current suspension, they're no longer available.

The $100 of income if you're using just a partnership structure would pass through to the fund's limited partners, as would the $20 in portfolio expenses. The LPs would end up paying tax on $100 of income that's generated, but they would not get any benefit of the portfolio expenses because they're currently not deductible. So as a result, the LPs will just pay tax on $100 of income. Now let's look at the exact same set of facts, except the fund either is a fund that invests through a REIT, or although this is not common, the fund does away with the partnership altogether and just has a REIT. So it's just you invest directly through a REIT. In that situation, the REIT again generates $100 of taxable income, and it has $20 of portfolio expenses, but the REIT as a corporation is eligible to deduct those $20 of portfolio expenses from it's $100 of taxable income.

As a result, the REIT ends up with just $80 of taxable income that it would distribute to its shareholders, which would in turn give them the dividends pay deduction and avoid tax at the REIT level. The $80 of REIT ordinary dividends would be taxable to the shareholders of the REIT. But if we go back to what we were talking about earlier in 199A, that REIT dividend would generally be considered an ordinary dividend, and as a result, is also eligible for the 199A deduction. So that $100 of income that we had in the partnership example, and don't forget a partnership... Sorry, 199A does not apply to interest income in that idea. When we're using a partnership, you end up with $100 of taxable income to your limited partners when you use a partnership. And after the 20% deduction for qualified REIT dividends, if you use a REIT instead of a partnership, you end up with just $64 of taxable income that's distributed out to your partners that they must include in their tax returns for the year.

So as you can see, there's a significant benefit when you start adding up all these different benefits over time that can greatly reduce the tax leakage and the tax burden of a structure when you use a REIT instead of a partnership. I'm now going to turn over to Ryan to speak about a few additional benefits of using a REIT.

Ryan Sievers: All right, thank you. So the benefits that Joshua just walked through really came about because of TCJA. So 20% deduction as well as the netting of portfolio deductions really exploded the use of REITs after TCJA, particularly with mortgage REITs. The next couple topics here are really REIT benefits that existed prior to TCJA and still continue to exist today. And so one of those is simplified reporting. So in a typical real estate fund organized as a partnership, you can have countless categories of income, ordinary rental, interest dividends, capital gains 1231 and recapture 1250, the list goes on. And you generally will have states in every location in which, or state filings and state K-1s in every location in which the fund owns property. So you can end up with dozens of state filings. And as an investor in one of those funds, you receive a K-1 federally and you have to incorporate all of those items into your return.

And then you'll also receive a state K-1 for each state, and you would need to file or make a determination of filing in each of those states as well. You also have withholding issues and all sorts of complexities that go along with state filings and partnerships. A REIT structure, whether that REIT is owned directly by the shareholders or more commonly in the private space where the old fund or the fund set up from the outset owns the REIT, all of the reporting is simplified. In other words, the fund picks up a dividend from the REIT. A dividend is either ordinary or capital, and the fund would simply allocate out that item to its partners at its level. So all of those line items and all of those items on that federal K-1 are really simplified down into just a few items. And then from a state standpoint, really the fund would not pass out state K-1s, and really the partners in the fund would have federal income and then the state impact would be eliminated, and it really would be sourced to their state of domicile or residency.

So the REIT serves as an state income tax blocker, which is a tremendous benefit for simplification and for burden. As pointed out earlier, I believe by Arthur, there are potential state captive REIT issues. Depends on your structure. I wouldn't say that they're common, but they need to be mindful of. And effectively what that means is the state would disallow the dividends pay deduction for its state purposes. And so while you would not have federal income at the REIT, you can end up with state taxable income and pay state taxes. So that is one issue to be mindful of. Next slide. All right, so UBTI, Michael mentioned this. REITs can serve as a blocker for most UBTI. And for those that aren't familiar, UBTI is unrelated business taxable income, and it is a tax for tax-exempt investors that generally would not be taxable income they receive...

Ryan Sievers: Investors that generally would not be taxable income they receive. However, to the extent that income is from an unrelated trade or business or in the real estate context is derived from debt financed property, although the fact they are tax-exempt, they can still have taxable income on their UBTI. So a REIT as a corporate entity will generally block that. There is an exception for a pension-held REIT where UBTI can still part of the dividend can still be true as UBTI. That's beyond the scope of this conversation, but just pointing that out there.

And comparing the REIT structure versus the fund structure, funds have, for certain qualified organizations, there's fractions rule which will allow specific types of tax exempts to still avoid UBTI on debt financed income. Basically the fund and all of its subsidiaries would need to be compliant with that fractions rule and so it can create restrictions on allocations and so forth. Generally those considerations are irrelevant with a REIT and the REIT simply blocks the UBTI and is a very nice tool in the toolbox for that purpose.

Same goes for effectively connected income. So we had our slide earlier with the typical REIT structure. You had a REIT owned by a fund and then fund was owned by US taxables, tax exempts and foreigns. And so you'll notice a theme here that a REIT is a nice little tool for those last two boxes. It's a structuring tool for both UBTI tax exempts as well as ECI for foreign. So a REIT acts as a blocker for ECI for non-US investors.

There are exceptions to that. So an operating dividend that comes out of a REIT, which is a dividend other than a dividend related to disposition of US real property interest. Operating dividend comes out as what's called FDAP income, which is subject to withholding at 30%. However, that withholding can be reduced or eliminated by treaty and the FDAP dividend if adequately withheld doesn't create a filing requirement for the recipient. So no ECI, no necessary filing requirement.

There are a couple of exceptions to that. So a FERPTA gain which will present as ECI is if the REIT disposes of a real property interest and makes a distribution of that gain, that gain will be a FERPTA ECI. And one major exception to that FERTA taint is if you're disposing of a REIT, if you sell REIT shares that are domestically controlled, the REIT is not a US real property holding corporation and the gain on that sale will not be treated as ECI FERTA. So it's a nice way for planning of exit from a REIT for foreign investors. And with that we will talk a little bit more about domestically controlled REITs.

Joshua Milgrom: Thanks Ryan. So as Ryan just mentioned, if a REIT is owned 50% or more by US persons, it will generally be considered a domestically controlled REIT and the sale of the stock of a domestic controlled REIT is not subject to FERTA. Therefore, investing into a domestic controlled REIT can help non-US investors avoid FERTA taint and it's a very favorable tax-efficient way for a non-US investor to invest into US real property. As a result, maintaining domestic controlled REIT status or DC REIT status is very important for non-US investors. In fact, in the private equity space, you'll very often see a sider of provision or even sometimes in the operating agreement of the fund say that they will maintain domestic controlled status and exit investments through sale of REIT shares to ensure that non-US investors are actually comfortable that they will get the benefit of investing in the domestically controlled REIT upon exit.

As you can tell, this is an important issue for non-US investors and historically, in order to avoid running afoul of the domestic controlled REIT rules and causing any issues for your non-US investors, sponsors would often try to aggregate some of their non-US investors into a US corporation that would in turn own REIT stock. So the idea was that when you look at the owners of the REIT, the US corporation would be respected as a US holder and you wouldn't look through that corporation to determine whether or not the REIT would qualify as domestically controlled. The IRS actually looked at this in a private letter ruling, I believe back in 2009, and decided not to question the structure and not to look through the US corporation. And as a result it became a pretty common structure for privately held REITs to avoid or to make sure that the REIT continued to be qualified as domestically controlled.

However, in December 2022, the treasury signify that it changes view on the issue when it issued proposed regulations that would require REIT to look through a domestic corporation in certain circumstances. Then earlier this year in April, the Treasury released final regulations on the same issue. The final regulations differentiate between non-look-through persons and look-through persons. And non-look-through persons include individuals, it includes foreign corporations which are just treated as foreign in the calculation and it does include non-foreign controlled US corporations. Non-look-through persons includes non-foreign controlled US corporations. So everything that isn't a non-look-through person is a look-through person for these purposes.

So a corporation that is owned 50, a domestic corporation has owned 50% or more by non-US individuals. non-US holders, will be treated as a look-through person. So as a result they would have to look through that domestic corporation when determining whether or not it will be treated as a domestic controlled REIT or not. However, given the prevalence of the structure that I mentioned of using a domestic C corporation to maintain domestic controlled status, the Treasury included a ten-year transition rule that was not included in the initial proposed regulations. And the transition rule allows the REIT to continue to use its historic structure for the next 10 years from the date that the final regulations were adopted.

However, the Treasury wanted to put in guardrails so that these sponsors cannot just continuously roll over their existing REITs and continue to have the benefit of the transition rule. As a result, they put two tests in place and if either of them is violated, the REIT will no longer be eligible for the transition rule and it will be tested as if ... The domestic corporation will no longer give them the benefit of continuing to qualify as domestic controlled.

The first test is called the ownership test and that test provides that ownership of the REIT by non-look-through persons cannot increase by more than 50% in the aggregate. So again, they don't want just to be able to turn over ownership of a REIT to new investors and allow those new investors to continue to get the benefit that was originally put in place for the old investors. Note that for publicly traded REITs, however, transfers by holders of less than 5% of the REIT are disregarded for this purposes. So you don't have to track smaller, minor transfers when you're a publicly traded REIT.

The second test is called the asset test, which provides that a REIT cannot acquire a significant amount of new US property interests from the date that the regulations were published and a significant amount of US real property interests is defined as 20% of the fair market value of the US RPIs held by the REIT as of the date the REITs were public.

Again, they don't want to just reuse the same structure and allow you to completely swap out your old investments. Note that this could potentially be a trap for the unwary, at least initially when the REITs were first finalized. There was some question whether something like a 10 31 exchange would count towards the 20% limit of turning over your US RPI. But the regulations are drafted broadly enough that I think the general consensus at this point is that yes, even if it's not a taxable exchange, a like kind exchange can still give rise to new US RPIs coming into the REIT and therefore counting towards the significant amount of assets that would need to be turned over to fail to qualify as a DC REIT under the asset test. So taxpayers who have historically used this structure must consider the asset and ownership test moving forward to ensure that they can continue to maintain their domestic controlled REIT status.

And just one final note because there was some question over how to notify purchasers of domestic controlled REIT stock, whether or not they need to withhold when purchasing the REIT stock. And the final regulations do provide that the domestic controlled REIT can issue a form of FERPTA certificate that can tell the non-US ... Sorry, the purchaser of the domestic controlled REIT stock that the REIT is a domestic controlled REIT and therefore no it's not subject, the sale of the shares is not subject to FERPTA and no withholding is required. I'm now going to turn this over to Allison who's going to walk through some debt modification issues.

Allison Stelter: Yeah, so as promised, I'm just going to talk briefly about debt modifications. So under the code, this is a general rule that applies to all taxpayers. If the terms of a mortgage letter modified in a way that's considered a "significant modification", that modification triggers a deemed exchange of the old unmodified dead instrument for the new modified dead instrument. And some examples of modifications that are considered to be significant under these rules are things like change in the yield by more than a de minimis specified amount, changes in the timing of payments. There is a safe harbor there, but if you're outside that safe harbor, then that is considered a significant modification. A change in the nature of the loan from recourse to non-recourse or vice versa. A changes changes to who the allegor is or the security for the loan.

All of these things can be considered a significant modification and if you don't fall into one of the very specific rules, there is a general facts and circumstances test under which a modification needs to be evaluated to determine whether or not it is significant. So as I mentioned, this rule is a general rule. It applies to all taxpayers, but it is particularly important for REITs because as I believe Arthur mentioned earlier, mortgage loans need to be fully secured by real property for them to be considered a fully good asset for a REIT and to produce fully good income. So if a mortgage loan is modified, it needs to be retested for purposes of the asset test to determine whether or not it is still fully secured by real property.

In times when there's a lot of distress in the debt market, this issue comes up for REITs. They want to modify the loans, they want to try to make the loans perform, but they run up against this issue where they could be, by modifying the loan, they could end up with an asset that's no longer fully good for REITs. So the service came out with a revenue procedure 20-14-51 that provides a safe harbor for REITs under which a REIT is not considered, or I'm sorry, not required to redetermine ... Let me switch slides here ... To redetermine the fair market value of the real property securing its mortgage loan for purposes of the gross income and asset tests.

If the modification is as a result of a borrower default or made at a time when the REIT reasonably believes that the modification is going to substantially reduce the likelihood or the significant risk of a default on the original loan. So this guidance when it came out was super helpful. Note the timing, 2014. We were coming out of the credit crisis. There were a lot of debt modifications, a lot of defaults, and this safe harbor gave the REITs comfort that as long as they were modifying within the safe harbor, they wouldn't have to redetermine the fair market value of the loan and thus wouldn't risk having their asset be deemed partially non-qualifying. If there is a modification outside of the safe harbor, the REIT is required to redetermine the value of the real property and if it turns out that the loan itself is no longer fully secured, the REIT has to apportion the asset and the income for purposes of the qualification tests. So this was a super helpful piece of guidance and came out at a really critical time.

Arthur Khaimov: Allison, just to make a distinction, if there is a modification that does not fall under the significant modification definition, in that case you would not need to revalue the asset and treat it as a deemed exchange. Is that correct?

Allison Stelter: That is correct. However, any change is going to be considered a modification and whether or not the modification is significant, there are specific rules set out that I mentioned a couple of them change in yield, change in allegor, change in timing of payments. If you don't come under one of those specific tests, you're under this general facts and circumstances test and there isn't a lot of guidance out there under that test as to what it would be considered just a modification or a significant modification triggering the deemed exchange. So you're correct, a modification that is not significant would not trigger the requirement to retest, but what is a modification that is not significant isn't entirely clear if you can't fall squarely into one of the safe harbors or the exceptions under the more specific tests.

And then, sorry, we are going just a few minutes over, but what we wrapping up here very quickly. We did also want to touch on a special topic with respect to EV charging. Obviously electric vehicles are coming and they're here and they're going to continue to be increasing, I would say in the market and for REITs, there was a question about if you provide the ability to charge an electric vehicle, what kind of service is that? Is it a service that's more like parking and thus has a lot of very complicated rules for REITs or is it a service that's more like a utility? And earlier this year the IRS came out in private guidance with a PLR that confirmed that in their view the service provided by an EV charging station is electricity. So it's like a utility and thus the ruling, the service ruled that the amounts charged for the electricity consumed at the REITs EV charging stations including increased rents for properties that had this feature would be qualifying rents from real property for purposes of both the 75% gross income test and the 95% gross income test.

Now the taxpayer represented a few things. So if you were outside of this specific fact pattern, it's not entirely clear how the service would come out. So it's important to keep in mind that in this ruling the taxpayer represented that EV charging stations were customary at similar properties in the relevant geographic area, that the number of EV charging stations available and installed on the property would be appropriate for the number of tenants and their guests and customers. They were not going to charge any access fee or markup on the electricity and that any use by the general public was expected to be de minimis. So we now have guidance finally out there that says that at least within this set of facts, the IRS is going to say this is a utility. Utilities are generally common in most areas to provide and thus the REIT can go ahead and do so without worrying about potentially having an impermissible tenant service income issue. And I will turn it back to Ryan.

Ryan Sievers: All right, we are in the home stretch. Sorry if we're going over a few minutes. Last few thoughts. So Inflation Reduction Act, this is with respect to solar, allows eligible taxpayers to transfer certain credits from solar panels, EV charging stations to unrelated taxpayers rather than using those credits themselves. There was proposed regulations by the treasury in June of 2023 that clarified that tax credit transfers to a related party for cash would not result in gross income to the REIT. And also clarified that the transfer of those credits would not result in prohibited transactions, which we skipped over, but a prohibited transaction would generally result in a hundred percent tax on any sort of gain from that transaction. So both useful guidance with respect to the solar credits.

Really quick, a few asset classes that can be held by REITs. It's a really broad list here. I will point out hotels and healthcare require unique structures to be set up to hold them through REITs. While the asset is really dependent upon whether it qualifies under the asset income testing requirements we discussed earlier for both hotels and healthcare, there are unique structures that are required. So if you're in one of those spaces, make sure you're aware of that. Alternatively, if you're lending on hotels and you might ever foreclose on a hotel, be very aware of that as well.

Finally, we've discussed a few benefits to REITs here that are related to TCGA, which is the 2017 Tax Act. So the 20% QBI deduction under that code section REITs are given what I call super status. They immediately qualify for the 20% deduction. That will expire in 2025 unless when A is extended bonus depreciation is not really REIT specific, but it is phasing out for 2024. It's currently at 60% and will be declining 20% each year after that. We noted portfolio expense deduction that was suspended by TCGA that made REITs extra beneficial. That suspension will be lifting and they will once again be deductible after 2025. However, I would point out that portfolio deductions generally may be of limited benefit to taxpayers anyway, and so a REIT structure where those are fully deducted at the REIT and netted against dividend income effectively could still continue to have value. So these items obviously are pending any sort of congressional action and obviously are somewhat highly dependent upon outcomes of elections and new administrations and so forth, which is obviously beyond the topic of this conversation. And with that, I believe we are done.

Arthur Khaimov: Ryan, just to clarify, these expire at the end of 2025, right?

Ryan Sievers: Correct. So they'd be relevant going into '26.

Arthur Khaimov: Correct. And just one last thing. There has been already proposals on Congress to extend the 20% QBI and we're hopeful that it will be extended given Congress's history of being somewhat favorable to the real estate world. All right, well thanks for that Ryan. If I may just add one last thing. I think there was a lot that were said on this and we kind of went over obviously this non all-inclusive list and reads our uber sensitive entities that require some handholding, but although may seem overwhelming, but the proper guidance from tax consultants, advisors, it's fairly seamless once you set it up and we are typically, between the attorneys and the accountants involved, that's another I think highlight here is to, it's good to be proactive with REITs and have your attorneys and accountants work together proactively to tackle any of these issues. Thank you so much for joining us and hopefully this was useful for everyone.

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