Navigating REIT Risk

Sarah Beth Rizzo:Thanks Arthur. Yes, I'm Sarah Beth Russo. I'm a tax partner at Skadden in Chicago. I do a lot of REIT and partnership work and general M&A and excited to join you all today.

John Rayis:Hi, I'm John Rayis. I'm a senior strategic advisor at Lockton. We do tax insurance and rep and warranty insurance. And before then, I was a corporate tax partner at SCAD and ARPS for about 28 years. Don?

Donald Zief:Sorry, I was on mute. Thanks, John. I'm a senior consultant with EisnerAmper and I spent over 40 years practicing in the real estate arena with a subspecialty in REITs. I'm both an attorney and a CPA. And I've practiced with both large New York City law firms and big four accounting firms. I'm a co-author of the Real Estate Investments Trust Handbook, which is updated and published annually. And I've got extensive experience with both private and public REITs, as well as taxable tax exempt and non-US investors. So with that very, very brief introduction, I'd like to dive right in today. You can see from our agenda we have a very, very full agenda. We have a lot of topics we want to cover. And so we won't be able to spend too much time on each one, but we hope to leave enough time at the end for some questions.

Let me start by talking about two REIT areas where we can counter frequently and yet there are fraught with risk. First, domestically controlled REIT structures. Just by way of background, as a general rule, foreigners, which are non-resident alien individuals and foreign corporations are not taxed on capital gains that are not connected with the conduct of a US trade or business. There's one important exception, capital gain from the sale of real property interest, a US RPI, is deemed to be derived from the conduct of a US trader business and is taxed at the graduator rates of tax imposed on US residents. US RPI includes both a direct interest in real property as well as an interest in any domestic corporation that held more than 50% of its assets in real property within five years of the date of sale. So a REIT is clearly a US RPI.

What this means is that if a REIT sells real property and distributes the proceeds to shareholders, foreign shareholders are treated as if they engaged in the sale of real property and are subject to US tax even though it's a capital gain. There's one important exception is if a foreign shareholder sells stock in a REIT that is a domestically controlled REIT. And we have the definition right up here, a REIT's domestically controlled when a foreign persons hold less than 50% of the stock directly or indirectly across a testing period of five years. As I said, the foreign holders can then dispose of the restock without triggering US tax under the Foreign Investment Real Property Tax Act of 1980, otherwise known as FERPDA. Now in fact, foreigners look to invest in REITs for just this very reason that upon exit versus via a sale of shares, there will be no US tax.

Further, the IRS has ruled that a permissible restriction on transfer of REIT shares can be a provision in the REIT articles of incorporation that prohibits a transfer if the result would be that the REIT is no longer domestically controlled. You can see how important it is that a REIT be invested control for foreigners. And we've listed under the key tax issues, some of the due diligence that we performed and that should be performed to make sure that this characterization is valid. You have to trace ownership up through various entities, liquid entities. The watchword here is indirectly owned. There are no formal statutory attribution rules here, such as in other areas of the code where lineal descendants sons and daughters on stock going by their parents and things like that. Here the word is indirectly and that means it requires a look through of a lot of entities to get through the ultimate owner.

John will talk about this a little bit later where tax insurance can help mitigate the risk that such entity is not domestically controlled. Next, I want to talk to prohibited transactions. Now prohibited transaction is slightly counterintuitive. By that I mean that upon the sale of REIT property, the REIT has done everything it's supposed to do. It's been organized correctly. It's got over a hundred shareholders. It's not closely held. It's operated correctly. It's satisfied the annual income test and quarterly asset test. It's meant to 90% distribution test and it's distributed all of its taxable income as it's supposed to. So now it's at the end of a normal real estate cycle. It's selling its properties like any real estate investor would. However, the REIT's supposed to be a passive investor. And if it sells property too quickly or too frequently or hasn't held the property for any required length of time, it can be viewed as a dealer, an entity whose business is the buying and selling of real property instead of just investing.

That happens. Then there's an onerous 100% tax on the gain from any such sale. As an example, REIT buys property for $100,000 and sells it for a million dollars. The gain on sale is $900,000. $900,000 has to go to the IRS. That wipes out all the economic gain and even more when he considers state taxes. So prohibited transaction status avoided, tried to be avoided at all costs. But thankfully, as we've shown here, there's a safe harbor, which if all the criteria are met, will save the rate from the imposition of the 100% tax. So the elements we've listed here, the real property sold must be a real estate asset held for at least two years for the production of income. Capitalized expenditures within the last two years before sale can't be more than 30% of the sale price. There cannot be more than seven sales per year, but for this purpose, many, many properties sold to one buyer in one transaction is one sale.

If that limit's not met, there are some alternative tests. One is if the adjusted basis of all the properties sold by the REIT is less than 10% of the adjusted basis of all the aggregate properties owned by the REIT at the beginning of the year, that test is met. Similarly, it's a fair market value of the property.

I'm sorry, at the REIT, beginning of the year, that test is met. It's also another three-year average test that makes it easier to comply with this. And finding if the seven sale limit is exceeded, but you meet one of the other alternative tests, substantially all the marketing and development expenditures are made through an independent contractor or a TRS. Now, if that safe harbor is not met... I'm sorry, let me go back. If that safe harbor is met, what it means is there's protection against 100% tax, but it does not mean REIT is not a dealer. It can still be a dealer of property, which means that upon sale, gain capital gain, it's ordinary income. Also, depreciation can't be claimed on property held for sale or inventory items. Now, if the safe harbor is not met, then we're thrown into what's called the facts and circumstances analysis.

There are accountants court cases in this area that consider whether a selling entity is a dealer. And on the same set of facts, courts can actually hold opposite ways. But the main factors that are looked at are here, and they're from court cases, number of frequency and continuity of sales, the extent of improvements and promoting selling activity, the length of the holding period, and the purpose for acquiring and selling the property and proportion of income from real estate activities. Now under key takeaways, I just wanted to spend a little minute on the third. One of the ways to avoid the 100% tax at the REIT level is to transfer properties down to a TRS, a taxable subsidiary, which is a corporation in which the REIT typically owns 100% and which has elected jointly with the REIT to be treated as a tax-free subsidiary. It's a C corporation, so it pays corporate tax.

If the properties are transferred to the TRS and it sells, the 100% tax is avoided. However, it's replaced by a 21% corporate income tax rate on its income, which sometimes can be mitigated a little bit if some of the assets sold have capital losses in them. The thing to really, really be careful about is that the properties are transferred to TRS early enough in the process. So the TRS negotiates the sale and not the REIT itself. If the property is sold too quickly, the IRS has a terrific argument that the REIT actually sold the properties and the 100% tax is imposed at the REIT level. Once again, John's going to talk about this a little bit later in the presentation about tax insurance. And now I'll hand it off to Sarah Beth who'll talk about -

Arthur Khaimov:Don, just to... If you don't mind, just have a wanted to point something out for a second. Yeah.

Just one thing as far as the prohibited transactions, obviously another good key takeaway here is to try to have practice discussions with your council, accountants, et cetera, to make sure that you're meeting all these standards and avoid possibly 100% tax. The other thing I just wanted to point out, Don, for our viewers is that as far as the domestically controlled REIT issues that you just discussed in the previous slide, I just wanted to point out because there's a lot of information out there and there may be some confusion because there were some proposals back in 2024. I think there was Treasury Department came out with new regs and then they took them away. So it's really important to also ensure whoever's doing some research on this is that you're reading the most updated rules and regulations because there was a lot of confusion back and forth with proposed regs coming out that looked scary and then they got a lot of pushback.

So they reverted back to the old rules, et cetera. And we're actually going to come out with an article kind of demystifying all that soon enough. And I just wanted to make that point to everyone that when you're looking at these rules, ensure that you don't get confused with everything that's out there and talk to your advisors.

Donald Zief:Thanks Arthur. Yes, Arthur, I completely agree with what you said. Thank you for pointing it out. Arthur, I'll turn it over to Sarah Beth who talk about REIT acquisitions.

Sarah Beth Rizzo:Yeah. No, Arthur, I was going to ask you on prohibited transactions, how often do you see folks relying on the safe harbor and really trying to fit in the safe harbor versus relying on a more facts and circumstances analysis just in your practice?

Arthur Khaimov:That's interesting. Well, yeah, I'll tell you that with mortgage REITs, a lot of times it's facts and circumstances given the timeframe of those loans being below two years. And I would say it's probably like fifty-fifty. I don't know about you, Don. What do you see?

Donald Zief:Oh yeah. I mean, everybody can try and tries hard to comply with the safe harbor. The one thing that's the most prevalent that people have a problem is a two-year hold. And a lot of times because of that, we're throwing the facts and circumstances.

John Rayis:Yeah, Arthur, I was also going to add that tax insurance for prohibited transaction risk where you're not able to meet the safe harbor is one of the most common areas where REITs are getting tax insurance. We've done more of those policies than I've had hot dinners.

Sarah Beth Rizzo:It's a deep hole for sure. I liked Don that you explained and by 100% I mean 900,000 because I think when you say 100% tax, often people can't even conceptualize that's actually what you mean. So definitely a good area for tax insurance. All right. Should we jump to acquisitions for a few minutes? Okay, great. Thank you. So acquiring REIT stock can come up in a number of contexts. So obviously there are public REIT acquisitions, general REIT M&A, but also often in the context that Don was speaking about with the private REIT where an investor is foreign and requires that instead of the REIT selling the asset that the REIT stock actually be sold to the buyer. And also just a target that's maybe not a REIT that has REIT investments. All of these are issues where we're looking at the REIT status as a buyer and determining whether this is I guess evaluating the risk.

So as we've touched on but not gone into detail as Arthur previewed, there are a number of technical REIT requirements and it's really easy to foot-fault some of those. So these deals usually require an opinion from REIT council that it's a good REIT, but also it's really necessary to do your own due diligence as to REIT status and where the risks are. And then obviously as is the theme of much of this presentation to consider tax insurance. So where do you start if you are the buyer? So I generally start with the test, the income and asset test looking back often through the life of the REIT as how close they've been to the line, but also how things have moved over time and what are they treating as good versus bad? Are there issues to focus on either the income or the asset test?

I also like to request property service questionnaires to look at the substance of the services, but it also can give you a clue as to how they're doing this. How seriously are they taking compliance and how often are they looking at what's going on on the ground? You can have a great tax director, but if the folks at the properties aren't educated, on the REIT rules, they can go off and do things that they see as creative and enterprising. We saw a number of those during COVID. No, actually we can't provide those services. So I look at that. And then before I get too deep in the weeds, I generally try to have a conversation with whoever it is who's been closest to the REIT compliance. So whether that's the person providing the opinion or if it's the tax director or someone even in operations at the company to try to zero in on what are the major issues to focus on before we really dig into the weeds.

So those issues can be the size of the TRS, the transfer pricing with the TRS. Have they gotten their hundred preferred shareholders and how have they been doing distributions? All kind of the technical issues with the asset and income and ownership test. And then thinking about from the buyer's perspective, whether the buyer can actually acquire a REIT. Can it meet the ownership test on its end? Does it have five or fewer individuals who would own 50% of the stock? And does it practically have someone who can manage REIT compliance? If there were distributions in the year of closing, often you're required to keep the REIT around for the full taxable year. So making sure that you're able to maintain the compliance of the REIT after closing. Also, if there's a 1374 issue, that can also drive the need for the seller to sell REIT stock.

And then that could mean that the buyer is buying into that issue and would need to keep the REIT around for even longer potentially. And then also looking at the Safe Harbor as Don was describing for prohibited transactions looks back over multiple years. So if this is a REIT that you're going to keep around longer term, looking at that compliance and how that might affect your plans for the assets as well. And lastly, I would just mention that there are these tricky successor REIT issues. So if you're bringing this REIT into a new REIT structure, making sure that something wrong with this REIT wouldn't taint the larger REIT. There are a bunch of technical rules in that area as well. And then to touch on tax insurance, I've been doing this for many years now, but I'd say this is one of the biggest changes I've seen over the course of my career.

These REIT deals used to always be based on indemnities and tax insurance was something that was very few and far between in deal work. And now when we do these REIT stock sales, it's pretty rare to do one without tax insurance. So it's amazing how much the industry has grown and then just the insurer's knowledge about the issues. I've been surprised too at how relatively straightforward it is to go through the process with really sophisticated folks on the insurer side.

So we can flip to John, I think you were touching on the state and local issues.

John Rayis:Yeah. So one of the issues that's driving a lot of business people crazy lately is some of the recent increases in state and local transfer and other kinds of taxes that have been going on throughout the country. While the New York UBT, the unincorporated business tax has been around for a long time some of these issues have become more and more important. Like California Prop 13, that's the property tax that reassesses property whenever there's a change of ownership. So trying to structure a transaction to not trip against those rules are quite important. There's a California transfer tax, which is different than Prop 13. It's a separate tax that is imposed upon the transfer of property or the termination of a partnership, which is why it becomes very important. Then there's the new LA and San Francisco million dollar transfer taxes that are imposed in addition to that.

And the transfer tax that is particularly onerous, it's 4%, which is quite high for a transfer tax. And that's a Philadelphia transfer taxes. So trying to structure around all these transfer taxes is something where we've been very involved in the tax insurance space. Why don't we go to the next slide on...

Donald Zief:Thank you, John. Yeah. So whereas John talked about transfer taxes, we're going to talk about for a minute about transfer pricing. And that comes into effect basically where a TRS, which we talked about earlier, interacts with its REIT. Both of these entities are very, very much related in that the REIT owns 100% of the TRS. You can see on the left where the statutory issues are redetermined rents, redetermined deductions, excess interest and redetermined terrorist tax service income. What we see most of the time are transactions where a REIT owns either a healthcare facility or a hotel where REITs can own their real estate, but the income from them is not really rent. A hotel room, a renter for a night is not REIT in the... I'm sorry, it's not rent in the REIT context. There's too much services provided. Same thing with healthcare facilities. So the REIT leases the hotel or the congregate care facility to its TRS.

The TRS then hires what's called an ineligible independent contractor to manage the property. What the issue is, is that that lease between two related entities, the REIT and the TRS, has to be reasonable and fair and for the IRS to respect it. And that's where transfer pricing reports come in.

I'm sorry, if the rent is not fair or it flunks one of the tests, there's 100% tax, not just a tax rate on the amount by which it fails. So not only is transfer pricing reports typically done, but tax insurance as well is frequently asked for to make sure that the risk is much more mitigated than that is supplied just by transfer pricing report. Arthur, is there something that you'd like to add here?

Arthur Khaimov:Yeah. I just wanted to just, I guess, put this simply. You read in a TRS they're related companies. So when you have such a relationship, there's temptation there to manipulate pricing. The prices you charge each other in order to save on taxes, whether it's rents, shared services, loans, et cetera. So if the IRS catches that the pricing isn't fair, essentially, you have an issue there. And a transfer pricing study is basically proof done in advance that the prices were fair. So the REIT has something to point to the IRS if it's ever asked, something substantiated per the intercompany charges, et cetera. And obviously skipping this step is the risky one as the penalties are harsh. Yeah. So I just wanted to kind of add that basic overview of what we're trying to accomplish with this slide here.

Sarah Beth Rizzo:How often do you all recommend folks refreshing their transfer pricing studies in this area?

Arthur Khaimov:So that's interesting. When we have hotel REITs, et cetera, we've had some people I believe view it should say at least three years. I think what I found, it depends on circumstance. When COVID came and left, there was some repricing there because of the state of the economy, et cetera. So I think when there's really legitimate reasons to reprice something due to something that came up, whether it was unforeseen, et cetera, I believe it to be a good thing to do. But if to the extent nothing has changed, I believe people try to keep it for three years or so. And reevaluating these things are good on an annual basis when we review some of these TRSs and read returns we pay attention to those rents to see whether one is running a huge loss, for instance, if the TRS is paying too much rents in order to have those deductions and you have the REIT picking up good income, et cetera.

So these are the things that we do look at year to year, but I would say rule of thumb, probably three years is a good amount of time.

Sarah Beth Rizzo:Right. I agree. I think it also kind of depends on how much of this you have going on in the structure. How sensitive is it for the retest as to how often you refresh?

Donald Zief:Yeah.

John Rayis:Arthur, we've gotten one question where someone asked, have you seen cases where the IRS ruled sales fell outside of the safe harbor as dealer property?

Arthur Khaimov:You got cut off a little. Say that again.

John Rayis:Have you seen cases where the IRS has ruled like a private letter ruling that a transaction which didn't meet the safe harbor was not a prohibited transaction? I though the IRS really won't deal with factually heavy circumstances. That's why people come to advisors and ask for advice in those cases.

Donald Zief:There are some rulings where the IRS actually has... Yeah. There are some rulings where IRS has looked at liquidation. Even though you don't meet the safe harbor or all the criteria, the taxpayer said, "I'm liquidating. I'm getting out of the business or I'm going to a different market or whatever." And there are a few where the IRS has said, "Okay, that's not a prohibited transaction." But I think that's the only other error, the only other fact where I've seen that.

John Rayis:Yeah. I think Sarah Beth and I got one of those rulings where the IRS ruled it was a partial liquidation, not a prohibited transaction. But generally speaking, I think that's why we've been so busy in the tax insurance space on prohibited transaction risk.

Donald Zief:I guess Sarah Beth, you want to discuss data centers?

Sarah Beth Rizzo:Sure. Hopefully the audio is a little better. I apologize. So data centers are everywhere we look, right? They're in the news and in the REIT space, it's a quickly growing asset class. Data centers are specifically addressed in the dash 10 asset test regs. There's an example, Example Six, that makes it clear these are qualifying fleet assets. The HVAC, the security system talks about humidity control. All of these components are treated as structural components even though they're customized to have a lot more functionality than in your typical office building. And the regs say that that's fine. And then other components like the electrical, the regs talk about it meaning the inherently permanent structure factors in the dash 10 regs. But we still see a number of issues come up in both the asset test and the income test area with data centers. So a lot of it hinges on the fact that the data centers are just very, very valuable, which is why they're getting so much attention and so much interest from investors.

So if a data center is in a private single asset REIT or even a REIT with a small pool of assets, the value of the data center can dwarf all of the other assets. So a lot of the issues come up when the data center is still under development. So there are a number of very expensive components in a data center. They all have these massive backup generators and because there is so much investment, these things have a long lead time when you order them. So they get pre-ordered when what you may only have as far as the data center is the land. You don't really have a lot of construction. Also, tenants can have a lot of leverage on when things are getting installed, when development is happening, and they are obviously not REIT sensitive. So before something like a generator is installed, it's not a qualifying asset for purposes of the asset test.

And before you have a lease in place, you can't even take advantage of the 15% personal property rule, which says that personal property can be treated as a qualifying real estate asset if it's leased with a real estate asset and it's less than 15% of the value. So this can be a big issue when data centers are under development. When companies struggle with that, sometimes they even consider doing a separate procurement company to hold the assets in that interim period. So it's something to pay attention to when you're advising a data center client on the asset test issue. Another one when we're looking at leases with the tenants is who owns the assets that the tenant may be paying to have certain assets installed. And there's sometimes a negotiation about who will be the tax owner, who will get the depreciation from these assets. And just making sure that the position that you're taking consistent within that region, just across your portfolio when you're looking at can the thing be removed?

Is that an asset they could really hold separately? How does that align with your analysis of whether these things are personal property under the regs or real property?

We can go to the next slide. So the lease value is also something that we talk about a lot in this area. A data center is just land in a shell initially, but the value goes up exponentially sometimes when it's actually leased to a tenant. And the regs are also helpful here. And there's an example towards the end of the asset test regs that as long as the value of the lease is attributable to rent from real property or it's inseparable from real property, that's still an interest in real property for the purposes of the asset test. There's also helpful authority in section 167 that a buyer of an asset can't bifurcate their basis between the lease and the building tickets as comfortable that even the lease, that if you argue that it's an intangible, that it would be a good real estate asset. Power arrangements similarly are something to look at as to whether those are a separable asset.

Obviously data centers need a lot of power and these arrangements to get it can be very, very valuable. So we look, we get very into the weeds on the contract for the power or multiple contracts for the power to see could that right be sold to a third party or is it something that really runs with the land and should be part of the real estate asset? We have similar issues that come up in the income test area. So again, going back to the development stage, despite the PLR that we have now, I think most of us are still advising that REITs always have some qualifying assets and some qualifying income. So during development when you don't have a lease with income coming in, making sure that you buy some REIT stock or have some qualified temporary investment income to meet the income test advisable and especially not wanting to wait, I think as John may have been touched on, having to wait to go get a ruling on those issues.

Another point for the income test is just when there are big upfront payments from a tenant for one REIT and or another to fund the build out. The timing of when that gets taken into income and whether you want to or have to be in a 467 lease treatment comes up with a fair amount. Also payments from tenants for power, looking at is this really a customary electricity service or is the rate starting to act like a utility? It's very easy when the power is just on site, but when it's farther away and maybe powering multiple data centers, it's something that we look at. So it's really just a very fact intensive area. And as it continues to grow, some of these issues are things that people haven't thought about for as long as the other issues in the REIT area that we've been touching on.

One final one that I'll mention before we go to the next topic briefly is just to go back to Don's part of the presentation related to FERPTA. The regs on structural components are a little bit different in the FERPTA area. The statement I wrote down is that a US RPI doesn't include machinery where the sole justification for the installation is the fact that the machinery is required to meet temperature humidity requirements, which are essential for the operation of other machinery. So it's interesting if you can have an asset that is a good real estate asset because the Dash 10regs are a little bit different, but not a USRPI. And it's a position that folks sometimes consider where you have foreign investors and what the withholding obligations are. So I think now we're kicking it. Arthur, are you taking mortgage rates?

Arthur Khaimov:Yes. So thank you Sarah Beth. Really some great points there. So just wanted to discuss a couple of issues that are more prevalent with mortgage REITs. This is not meant to be a deep discussion on mortgage REITs themselves. But anyway, unlike the equity side of the business, mortgagers typically don't own or manage the building themselves. They finance it to the owners and operators who do. And typically interest income related to a mortgage is good income for purposes of the income test and a good asset for purposes of income test to the extent it's properly secured by real property. And once again, we're not going to go into all the weeds here, but there could be circumstances where interest, let's say a loan could be secured partly by personal property and the majority could be real property. In those cases an apportionment may be necessary to bifurcate between good income versus bad income.

Typically doesn't happen as much because of the 15% rule Sarah Beth just mentioned. So typically, and we typically don't see any loans being within the REIT world, of course, loans being secured by personal property. There could be some ancillary items, et cetera. But for the most part, these will be good income.

Now the one thing we wanted to discuss were the preferred equity investments. So in a preferred equity investment, really a lot of times what you can have is an investment that may be labeled as a preferred equity in the deal documents, but can be re-characterized as debt for tax purposes. And so there's a few steps to this. So number one is you really have to understand is it debt or equity for tax. And in order for it to be debt, it has to meet certain criteria. For purposes of this webinar, we're not going to outline all that criteria. And typically we and/or the attorneys are involved a lot with kind of assisting the client to ensure that these steps are met and satisfied to be treated as debt. But the crux of it is that the documents need to reflect that it in fact is debt for tax purposes and clearly identify the collateral, define the lender's rights upon default, excuse me, and provide a clear path to enforcing those rights.

For REIT purposes, this is especially important because once you call an investment debt, we must then follow the testing requirements and the guidelines for debt testing. Therefore, the investment you call debt must be properly secured by real property. If the documentations don't support those rights, it can undermine the intended tax treatment and create REIT asset testing issues. And I stress this because when you have a preferred equity investment that is once again treated as debt for tax purposes but may not be for GAAP, for instance, the documents may fail to tackle those important tax REIT nuances that are required to satisfy both the asset and the income test. So you must ask yourself a question really like what is securing the loan here? The document should clearly identify the collateral. Is there a mortgage deed of trust, a pledge of ownership interest in another entity?

And too often the answer is unclear or incomplete. We've had good amount of instances where clients that didn't tackle those issues were missing these key ingredients in their documentation. So the idea here is that particularly for REIT purposes, the lender's rights should provide a clear path, whether direct or indirect to ownership. If your only remedy is a contractual payment obligation with no effective way to reach the property, that can create problems. So excuse me. So a good takeaway... Yes. Sorry, John, did you want to say something?

John Rayis:No, I'm sorry.

Arthur Khaimov:No, that's fine. No. So a good takeaway here is that once you've concluded the investment is debt, you're only halfway there. You really have to make sure that you have supporting documentation that will clearly define the collateral and security for the loan in order for it to be treated as a good asset for tax purposes. Now related to that discussion is if I go to the next slide is mezz debt. So mezzanine debt is generally the layer that sits between the senior mortgage and equity, but it's secured by the ownership interest in real estate ownership entity rather than the actual real estate itself. So essentially you can have first mortgage lien against the property, second mortgage, and then you have Mazda, which the collateral for that is essentially an ownership in an LLC or a partnership that owns the real property. So like I said before, there must be some pathway to ownership, whether direct or indirect.

So for mezzanine loans to qualify as a real estate asset for the 75% test, they must meet specific requirements as prescribed by a revenue proc 2003-65. These requirements, there's eight requirements here. I'll just quickly go over them. 85% of the pledged entities assets must contain real property.

And the reason why it could be difficult sometimes to kind of follow all these steps is because you don't always have the transparency. You don't always know you would really have to request documentation, perhaps trial balances, financial statements from the underlying entity to ensure that they have 85% of real estate assets. The other requirements are that the borrower is either a partner in or sole member of a pledged entity. The loan is non-recourse secured only by the borrower's interest and pledged interest. The lender is granted a first priority security interest and pledged interest. Upon default and foreclosure, the lender will replace the borrower as a partner and the member in that pledged entity. And upon doing so, you now have a direct ownership line to the property. On the date of commitment to make the loan, the pledge entity holds real property. The loan value of the real property owned by the pledge entity equals or exceeds the amount of the loan.

And so just it's important to note that this ref prog provides a safe harbor with specific requirements that we just mentioned. So if you meet all those eight steps, I skipped the last one, but yeah, it's fine. You can read it. You have it on there. But the point here is that you meet these eight steps, you meet the safe harbor to be a good asset and highly advisable to meet those steps.

Now sometimes there's a misconception as we just discussed with prohibited transactions, safe harbor. Failing a safe harbor automatically does not mean you fail an asset test. Does not automatically mean you fail an asset test. It simply means you lose that certainty of the safe harbor. Outside of the safe harbor, the REIT must rely on facts and circumstances analysis, which may introduce more uncertainty, more complexity. I'm sorry, potential scrutiny if asked. So one of the key takeaways here is to really involve tax counsel early when structuring MESDET so that the documents align with the safe harbor requirements whenever possible. It's always good to meet a safe harbor to sleep better at night. And if not, well, that's why we have John of course, and he'll walk through some of those benefits of having tax insurance. But really proactiveness here is key. And just anything with REITs in the REIT world, proactiveness is key.

Best way to avoid potential issues is to really tackle them before you finalize the structures in the paperwork. It's much easier to fix issues to tackle them before they're finalized. And as far as these eight steps that I just mentioned, meeting those safe harbors, we've had instances where you meet seven out of eight. We've had instances where some loans weren't exactly non-recourse or were partly non-recourse, perhaps some issues with admitting a new partner and et cetera. We've seen a lot of different issues. And once again, the best way to avoid coming into and failing a test potentially and dealing with issues and potentially failing tests is to really try to proactively approach these steps and ensure to meet these steps. Once again, a lot of times those preferred equity deals are structured in a way that they're akin to mezz debt. So therefore the intention is to treat it as mezz debt, you really should try to see if you can meet all these eight steps.

And if there are no other comments or questions on this, I will hand it off to John.

Sarah Beth Rizzo:I would say on the safe harbor, like you mentioned, I think the non-recourse being perfectly non-recourse is often very hard to get where it's a true third party deal. And just generally falling fully within all of these difficult. But agree when you're involving counsel, being able to get as close as you can and making tweaks that maybe won't really disturb the business agreement that gets you close enough that someone can opine that even though you're a little bit outside the safe harbor, really this should be a good real estate asset. Because ultimately what you're trying to get to here is that it looks like a mortgage. That it really is equivalent economically to a mortgage and even if you don't meet all of these very technical requirements.

Arthur Khaimov:Yep, absolutely.

John Rayis:Sarah Beth, we've gotten one question here, Arthur and Don as well. Have you seen cases where the IRS went after a REIT on a prohibited transaction? Back when I was practicing law, we saw a number of those, but do you guys want to comment on that?

Donald Zief:Yeah. Normally, what will happen if the IRS generally there's a conversation with the IRS between the taxpayer asking for the ruling and the IRS. And if it seems like the IRS is going to rule that it is a prohibited transaction, typically the taxes given the option of withdrawing the ruling. But in recent years, John, I haven't seen any negative rulings on that issue. Arthur, I don't know if you have that.

John Rayis:I was talking, Don, about audits where the IRS comes in and actually assesses 100% tax.

Donald Zief:Oh, I see. Actually, I have not.

Arthur Khaimov:I have not either, thankfully. But typically I would say for the most part, our support for the prohibited transactions, whether it's the safe harbor or outside of safe harbors, usually there's a good amount of support on our end where we try to get there, but I haven't seen an order where they kind of rule against it or anything like that.

John Rayis:Well, other firms are not as careful as you guys, Arthur.

Arthur Khaimov:There's an interesting question I'd like to address here. They're asking about bad boy carve-outs and that's a great question. And I believe the bad boy carve-outs actually standard and are not and don't negatively impact the non-recourse aspect of the loan. What do you think, Sarah Beth?

Sarah Beth Rizzo:Yeah. Well, at least I guess I would say yes, because I think that's the one that makes that prong very difficult. At least I would say people regularly get comfortable that Mes loans with bad boy carve outs are good. Real estate assets, even if arguably they fall outside the same harbor. Should we talk tax insurance, John?

John Rayis:Sure. So tax insurance is basically a process by which you shift the risk of uncertainty to a large insurance company. These are generally A rated insurance companies. And as we always tell people, you don't need tax insurance unless the issue is important and you need certainty. If you don't need certainty or the issue is not important, you don't need tax insurance. Tax insurance covers five things. It covers the tax, interests, penalties, defense costs, that is attorneys and accountant's fees for the audit as well as gross up because the insurance proceeds are generally considered to be taxable. It can be obtained without an formal opinion. It can be obtained with a more likely than not memo. And it can go for seven or 10 years depending on what the client wants. Here's the current pricing range. For REITs, it's on the lower end of the spectrum, generally two, three, 4% depending on the issue and specifically the type of risk.

As I mentioned, what you need from your advisor is a more likely than not memo.

It generally can be obtained within about two weeks. There is usually a deductible for attorney's fees and audit fees, but those are pretty minimal. These are the types of typical tax risks that REITs come to us for insurance. It's everything from re-qualifications. It can be combined with rep and warranty insurance, which I will speak to in a second. It's preferential dividend issues, the domestically controlled FERP day issues, debt equity issues, partnership issues, including 704C layering issues. So it's all kinds of issues that can be insured. This is what the market is very familiar with. The issue of rep and warranty insurance versus tax insurance, rep and warranty insurance is for unknown risks. That is where someone gives a representation in a agreement. That's what you can get insured. Tax insurance is for something different. Tax insurance for a known risk. That is you know that there is a risk out there.

It's not 100% certain. And so that's what you would get tax insurance for.

Recently in the REIT area in particular, we've been combining tax insurance with REP and warranty insurance in an M&A context. And the advantage of this is that you can, while REP and warranty insurance is generally not more than 10% of the acquisition price where you combine it with REIT insurance with tax insurance, the REIT is protected because you can get a higher number on rep and warranty insurance. And depending on what issue comes up, you have the flexibility to go and say, I'd like to put in a claim for this much tax insurance or this much rep and warranty insurance. So it's much more flexible. These are the various cast of insurance companies. These are all A rated. It's everything from AIG to Berkshire Hathaway, Warren Buffet's company. For those of you who watch ESPN, it's the Liberty, Bibbity, Yellow EMU, as well as all these other companies that are typical in providing tax insurance.

The general limit is about a billion dollars is the size largest policy you can get. And these are the A - rated companies that do this kind of work.

Arthur Khaimov:John, if I may just ask you a question. Tax insurance should compliment good analysis and not replace it essentially. You still have to go through all the proper channels in order to get comfortable with a position. Is that typically... I mean, I believe you look for that as well, right?

John Rayis:Absolutely. So it's difficult, for example, while your advisor may tell you that a conservation easement should qualify, we won't do conservation easement policies because those are just too risky. In the REIT area in particular, the heavy areas are prohibited transaction partnership issues and REIT qualification oftentimes combined with a rep and warranty insurance policy in an acquisition context. Those are the three most popular, most common tax insurance type policies.

Donald Zief:John, just curious. So do you do your own deep dive going into documents or looking at that, behind the opinion, things like that? Or is it enough to have a more likely than not opinion?

John Rayis:So I would say both. You're going to need a more likely than not memo or opinion, but the insurers will still go through the transaction documents to make sure that everything's on the up and up.

Donald Zief:Right. Thanks.

John Rayis:So we've gotten one question. Have you seen lenders require this insurance as part of their loan commitment to mitigate other issues related to M&A or other portfolio acquisitions? Absolutely. So a lot of times the lenders are telling the client to get tax insurance because of what they see as a perceived risk.

Arthur Khaimov:All right. Thanks so much, John. I just quickly wanted to thank everyone for joining us. There's a lot said here and one hour is certainly not enough to go through all of these items. This is just meant to be a high level welcome to take on any questions after if you can reach out to any one of us. Sorry we couldn't address all the questions, but thank you all for joining us. I don't know if anybody else had some remarks they wanted to mention before we handed off to Astrid.

John Rayis:Well, thank you all. And you have our email addresses there if you have any follow up questions that you'd like to ask.

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