Is a REIT a good idea?

Real estate investment trusts: Formation, structure, and operation

REIT benefits

Is a REIT an appropriate structure for you? What is a REIT? > A way investors can “pool” money to buy real estate> Sanctioned by Congress in 1960> Decline in 1970s and recent resurgence

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REIT benefits

Tax-favored status > Big tax benefit: the “dividends paid deduction”> Subject to special tax rules to make sure just investing in real estate

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REIT benefits

Why REITs are so popular > Foreign investors can escape US tax > Tax-exempt investors can avoid US tax > Good way to “buy out” founding members > Lower effective tax rates then C-corporations > Investors like to own stock > Can provide estate planning benefits – particularly if shares are liquid

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REIT benefits

Basic rules for qualification > Minimum of 100 shareholders> Not "closely-held" (5/50% rule)> Satisfy gross income tests (75% and 95% tests)> Satisfy asset tests (75%, 25%, 10%, and 5% tests)

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REIT benefits

Basic rules for qualification > Distribute 90% of taxable income (excluding net capital gain)> Can’t be a “dealer” of property (certain safe harbor rules available)> Can’t provide “impermissible tenant services”> 10-year rule for built-in gain property> Special rule for healthcare and lodging facilities

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REIT benefits

“Good” REIT assets: > Offices> Apartments> Manufactured housing> Malls> Shopping centers> Factory outlet centers> Industrial

> Lodging> Healthcare facilities> Self-storage facilities> Senior housing (assisted and

independent living)> Debt

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REIT benefits

“Bad” REIT assets: > Condos > Land held for investment > Short-hold assets (e.g., single family homes) > Debt with little to no collateral > Assets that generate fee income > Assets that provide a lot of special services

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REIT benefits

Common methods of addressing “bad” assets > Taxable REIT subsidiary (TRS)> Keep property at shareholder level> Foreclosure election> Section 1031 exchanges> Using strategic partnership

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REIT benefits

Methods to REIT formation > Initial determination is state of formation> Many considerations> Form of entity

– Corporation, trust, etc.

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REIT benefits

Contribution of assets to entity > Much depends on current form of ownership and control > Review and compliance with current ownership legal documents > Can be as simple as contribution of entity interests for UPREIT

interests; can be technical process > Financing a key concern

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REIT structure and legal requirements

Pros > Lower taxes = more cash to distribute to investors> Good vehicle for certain investors to “block” US or taxable income> Investors can contribute their properties tax-free> Income not subject to self-employment taxes> Investors can benefit from capital gain rates

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REIT structure and legal requirements

Cons > More expensive: requires quarterly testing> Limit to type of assets and fees> Losses don’t pass to investors> Allocations not flexible like a partnership> Dividends are generally not “qualified”> Dividends subject to net investment income tax> Cannot make inside basis adjustments when stock is purchased> Stock for services is generally taxable

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REIT structure and legal requirements

REIT ownership models > Private REITs

– Not registered with the SEC

> Public, non-traded– File with SEC, shares not traded

> Stock exchange traded REITs– Shares traded on national exchange

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Forming a REIT

Key considerations and procedures > Negotiating and drafting articles and operating partnership documents> Governance considerations/REIT operating procedures

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Advisor and compensation issues

Typical structure Private/non-traded REIT > External manager> Provides asset management and top-side financial reporting> May also provide development and property management, leasing, and

other transactional services> Typically a related party> Has no employeesPublicly traded REITs> Transition to full integration with public offering> Internalization

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Advisor and compensation issues

Typical fees outline Private/non-traded REIT > Percent of gross asset cost under management> Other fees

– Development, property management, etc.

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Advisor and compensation issues

Carried interest > Not common and a significant difference from typical real estate fund

structure> Can be done/NASAA REIT considerations

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Advisor and compensation issues

Non-traded REITs Special considerations > Control by sponsor/advisor> Perception> Limited redemption programs> Valuation> Suitability concerns> Current regulatory scrutiny by FINRA and states> Access to capital

– Technical capital raising rules/compliance

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Significant “collateral” issues

Conflict of interest—private and non-traded REITs Insider issues/self-dealing > Allocation/determination of investment opportunities> Limited purpose REIT vs. diversified> Director/trustee duties to stakeholders

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Significant “collateral” issues

Required reporting and disclosure Private REITs/institutional investors > Audited financial statements

– Historic cost or fair value of assets

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Significant “collateral” issues

Non-traded REITs SEC requirements > 2000 accredited/500 non-accredited investors> $10M in assets> Quarterly reporting> SEC guidelines> Sarbanes-Oxley compliance> Jobs Act exemption> Public float considerations

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Significant “collateral” issues

Non-traded REITs Public offering > S-11

– Investment policies– Character of properties– Operational data– Management arrangements– Guide 5 – past performance requirements

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Significant “collateral” issues

Measuring REIT performance > Funds From Operations (FFO)> Modified Funds From Operations (MFFO)> Net Asset Value (NAV)

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Significant “collateral” issues

Brokerage firm considerations > Significant regulatory scrutiny> Annual valuation> Due diligence reports> Market trading

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Significant “collateral” issues

NASAA REIT guidelines > Often-used guide for state security registration process> Very “paternalistic” / “merit” standards> Very broad topics covered

– Fee standard– Investor standards– Governing document requirements– Governance requirements

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Significant “collateral” issues

Securities law compliance SEC reporting > Periodic reporting> 10-K, 10-Q> Current report - 8-Ks

– Public disclosure of material events within 4 business days

> Proxy statements> Annual meetings

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Significant “collateral” issues

Securities law compliance Offering issues > Federal securities law issues

– Comprehensive review process for public offering – Reg A+ – Private offering – limits on investors/offering process

> State securities law issues – Compliance requirements are technical and numerous – Compliance review required of each state’s laws where an investor resides/all

distinct

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UPREITs and DownREITs

UPREIT > Allows property contributors to defer gain while participating in REIT

ownership> Generally, at contribution, the taxpayer receives units in the UPREIT

partnership equal to the FMV of property contributed, less any cashreceived in return

> The value of the unit “tracks” the value of the REIT stock, not the valueof the underlying assets

> At its option, the taxpayer is able to convert to REIT shares or receivecash (both are taxable)

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UPREITs and DownREITs

DownREIT- same as UPREIT, except: > Not all properties held in operating partnership (O.P.) > May result in dividend funding issues > DownREITs may be easier to set up since existing O.P. does not need

to “sign off”

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UPREITs and DownREITs

Benefits and risks Benefits to REIT > Acquire property at discount > Preserve cash > Reduce debt

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UPREITs and DownREITs

Benefits and risks Benefits to contributor > May be able to receive cash immediately with gain deferral> Recognize gain over a negotiated period of time (usually 7-10 years)> Diversified real estate (by converting into units that track REIT stock)

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UPREITs and DownREITs

Benefits and risks Risks to REIT > Lockout period for selling property > Other outside investors > Section 754 election calculations > Section 704(c) tracking calculation > Property value may decrease

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UPREITs and DownREITs

Benefits and risks Risks to contributor > REIT stock may decrease> Lack of control> Lack of cash to fund dividend (in DownREIT)> Section 704(c) “ordinary income” vs. “capital gain” over time> Lockout period for selling units> Need to monitor debt allocation levels

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Disclaimer

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Winthrop & Weinstine This information should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general information purposes only, and you are urged to consult your legal counsel concerning your situation and any specific legal questions you may have.

Baker Tilly The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments. Baker Tilly refers to Baker Tilly Virchow Krause, LLP, an independently owned and managed member of Baker Tilly International.. © 2015 Baker Tilly Virchow Krause, LLP