There are many ways to structure a real estate investment, but the most attractive real estate investments are the ones that are structured in a way that provides potential investors with the opportunity to qualify for one or more tax benefits. Over the years, the federal tax code (the Code) and the regulations promulgated by the US Department of Treasury (the Treasury Regulations) have become voluminous and more complicated. In the last decade, in particular, they have also been a topic of political debate and oscillation. For the most part, the tax benefits that are most important and appealing to real estate investors have remained intact (and, in some cases, have been expanded). Moreover, real estate investment sponsors and their advisors have become creative and sophisticated in structuring their investment vehicles to qualify for tax benefits. This article provides a primer on real estate capital raising and some of the important investment structures that sponsors have adopted to offer investors a tax-advantaged real estate investment: real estate investment trusts (REITs), Delaware statutory trusts (DSTs), and qualified opportunity funds (QOFs). These three vehicles can be complementary, and many real estate sponsors offer all three vehicles to their investors.
Sponsors can raise capital for a real estate investment by incurring debt, issuing equity, or a combination of the two. Debt financing can consist of a standard loan from a lender, which can be secured or unsecured, or can involve a debt instrument issued to an investor, such as a convertible note or bond. If the debt financing is secured, it is typically secured by a mortgage on the real property itself (mortgage loan), a pledge of equity interests in an entity in the chain of ownership (mezzanine loan), or a combination of the two. Equity financing generally involves raising capital by selling ownership interests to third-party investors in entities that directly or indirectly own real estate. The investors that typically buy such ownership interests can be either: (i) institutional investors, such as hedge funds, mutual funds, private equity funds, endowment funds, pension funds, and insurance companies, or (ii) retail investors, such as individuals.
When a real estate sponsor offers an ownership interest in a real estate vehicle, the offering may be an offering of “securities,” which requires consideration of several federal and state statutes, including the Securities Act of 1933 (Securities Act) and the Securities Exchange Act of 1934 (Exchange Act). An offering of securities can be conducted publicly or privately. The Securities Act requires that any offer or sale of securities be registered under the Securities Act with the US Securities and Exchange Commission or qualify for an exemption from registration. The Exchange Act requires the issuer of a publicly traded security to file periodic disclosure reports, such as a Form 10-K Annual Report, a Form 10-Q Quarterly Report, and a Form 8-K Current Report, providing information concerning the issuer’s business activities.
Because of less onerous requirements on the issuer of private securities, a significant amount of real estate capital raising is conducted through private offerings. Section 4(a)(2) of the Securities Act allows for a registration exemption for transactions by an issuer not involving any public offering. Most private real estate offering sponsors rely on either Rule 506(b) or Rule 506(c) of Regulation D, which are considered “safe harbors” under Code section 4(a)(2). Historically, sponsors generally have relied on Rule 506(b). That rule permits the sponsor to sell to an unlimited number of accredited investors (i.e., investors meeting certain financial or professional criteria) and up to 35 nonaccredited investors, but it does not permit the sponsor to conduct a general solicitation (i.e., broad solicitation and general advertising). Recently, however, more sponsors have shifted to relying on Rule 506(c) because it permits general solicitation. Even so, a Rule 506(c) offering can be made only to accredited investors, and the sponsor has a greater due diligence burden because it must take “reasonable steps” to confirm that each purchaser is an accredited investor.
Simply put, a REIT is merely a type of entity that is formed to either (i) own, lease, and eventually sell real property; or (ii) issue debt that is secured by real property and receive interest from the borrower. There are many reasons why investors like to invest in REITs, but those most commonly cited are that REITs (1) allow for the “democratization of real estate”; and (2) offer tax advantages over certain other real estate investment vehicles.
Most investors cannot afford to purchase a real estate investment or do not have the time to manage the investments properly. Moreover, foreign investors generally do not have access to US real estate for various tax reasons. REITs help solve those issues by permitting investors to pay a modest amount to acquire shares in a REIT that owns institutional-quality assets and handles all of the property management responsibilities. Moreover, a properly structured REIT (or set of REITs) can be used as vehicles for foreign investment in US real estate.
REITs are one of the types of entities that are often referred to as “creatures of the Code” because they owe their existence (and certainly their popularity) to the Code. A REIT resembles a corporation in its governance and operating structure, but, if the REIT meets the various requirements in the Code, then the Code treats the REIT as a pass-through entity and, accordingly, avoids double taxation. “Double taxation” is a term that refers to two levels of taxation on the same revenue stream. For example, if a corporation is a landlord and receives rent from its tenant, then the corporation would pay taxes on the rent. If the corporation then distributes the rental income to its shareholders, then the shareholders are taxed on that dividend. By contrast, if a landlord is a REIT (or a partnership) that meets all of the requirements of the Code, then the REIT itself would not pay taxes on the rental income, and the rental income “flows through” the REIT to the shareholders, who would then subsequently pay taxes on the income.
The most common REIT structure is an Umbrella Partnership Real Estate Trust (UPREIT). An UPREIT structure is one in which the REIT is the general partner of a limited partnership (often referred to as an “operating partnership”) that owns all or substantially all of the REIT’s assets. The limited partners of the operating partnership typically are owners of large real estate portfolios or investors in a DST that want to either dispose of the portfolio in a tax-efficient manner or pool their portfolio with other portfolios to create a larger, more diverse investment. The limited partners can contribute their portfolios of real estate to the operating partnership in exchange for interests in the operating partnership (often referred to as operating partnership, or OP, units) on a tax-deferred basis under Code section 721. These limited partners will generally negotiate tax protection provisions or agreements that limit the operating partnership’s ability to engage in certain transactions that would cause the limited partners to recognize the gain that they deferred when they contributed their portfolios. Moreover, after a certain amount of time, the limited partners generally have the right to convert their OP units to potentially more liquid REIT shares. Although the conversion transaction may be taxable, limited partners typically convert only when they otherwise already plan to liquidate their investments in a taxable transaction.
All benefits (including tax benefits) come with a cost and, in the case of REITs, the cost is regular and ongoing compliance and due diligence efforts. As noted above, a REIT must meet several tests and requirements. At the outset, there are various “organizational” requirements that a REIT must meet, but the most important and time-consuming requirements are the asset, income, and distribution requirements. The paragraphs that follow summarize only some of these requirements.
The Asset Test. A REIT must ensure that at least 75 percent of its assets, by value, are real estate assets, cash and cash items, and government securities (75 Percent Asset Test). “Real estate assets” include interests in real property, interests in mortgages on real property, shares in other REITs, and debt instruments issued by publicly offered REITs. The 75 Percent Asset Test is measured and tested quarterly. Because the 75 Percent Asset Test permits both equity investments and debt investments in real estate, there generally are two types of REITs: equity REITs and mortgage REITs. REITs must also adhere to other asset tests, including limits on the types of securities that they can own.
The Income Tests. A REIT also must ensure that 75 percent of its gross income is derived from rents from real property, interest on obligations secured by mortgages on real property, gains from the disposition of the real property, dividends from other REIT income, income and gains from foreclosure property, and certain other specified real estate sources (75 Percent Income Test). Moreover, a REIT also must ensure that 90 percent of its gross income is derived from one of the types of income that qualify under the 75 Percent Income Test, plus certain types of income from passive investments including stocks and securities, dividends, and treasuries (90 Percent Income Test). An important limitation on a REIT’s gross income is that a REIT’s gross income cannot include any “impermissible tenant service income.” This restriction limits a REIT’s ability to provide to its tenants certain services, often new and innovative services. REITs often still can provide these services to their tenants, but they must either hire an independent contractor to perform the services or assign employees to work for a taxable REIT subsidiary (TRS) of the REIT in order to perform the services. Both solutions come with a cost: If the REIT hires an independent contractor, then it must pay a third party to perform services, and if the REIT has employees of a TRS perform the services, then the income from the services is subject to corporate taxation. Both the 75 Percent Income Test and the 90 Percent Income Test are measured and tested on an annual basis.
The Distribution Test. REITs also must distribute at least 90 percent of their taxable income to their shareholders (90 Percent Distribution Test). As a practical matter, most REITs distribute 100 percent of their taxable income to shareholders because they receive a dividends-paid deduction equal to the amount of their distributions.
A DST is a different type of real estate investment vehicle that focuses on a different tax benefit: deferral of gain under Code section 1031. Under Code section 1031, provided certain requirements are met, a real estate investor can sell real estate and defer recognition of its gain if it reinvests the sales proceeds in other real property (Section 1031 Exchange). Among other things, both the real property that the investor sells (its relinquished property) and the real property that it acquires (its replacement property) must be used in a trade or business or held for investment, the relinquished property must be of a like kind to the replacement property, and the investor must “identify” and acquire the replacement property within a certain time limit following the sale of the relinquished property. Section 1031 Exchanges are a very popular tax-planning tool for real estate investors, and a DST structure is one way for a real estate sponsor to access that capital (i.e., the sales proceeds that a real estate investor has from the sale of its relinquished property). In short, a DST is an entity that can qualify as replacement property if certain requirements and limitations are met and respected.
By contrast to REITs, the DST structure is relatively new. The DST structure owes its genesis to Revenue Ruling 2004-86. 2004-2 C.B. 191. Broadly speaking, Revenue Ruling 2004-86 held that, for federal income tax purposes, the DST described in the ruling was disregarded and investors in the DST were treated as directly holding the real estate assets of the DST because the DST qualified as a “fixed investment trust” under Treasury Regulation § 301.7701-4(c) and a “grantor trust” under Code sections 671 through 679. The IRS reasoned that the DST qualified as these two types of trusts because it was subject to certain restrictions under its trust agreement, which prevented its trustees from taking certain actions that are now referred to as the “seven deadly sins.” The seven deadly sins are as follows: (1) a DST cannot receive new capital after its initial offering has closed; (2) a DST cannot renegotiate or enter into new mortgage debt unless a tenant has become bankrupt or insolvent; (3) a DST cannot renegotiate its property leases or enter into any new leases unless a tenant has become bankrupt or insolvent; (4) a DST cannot develop or redevelop property and generally is limited to performing only normal maintenance and minor nonstructural improvements, unless it is required to do more by law; (5) a DST cannot reinvest, and must instead distribute to its investors, the proceeds from its sale of property; (6) a DST must distribute all cash, other than normal reserves, on a current basis; and (7) a DST must hold any reserves it maintains in short-term debt obligations.
DST sponsors have navigated the seven deadly sins restrictions by focusing on certain types of real estate investments. For instance, sponsors generally (i) acquire new or recently rehabilitated properties that are stabilized or approaching stabilization (i.e., no development projects or properties that require material modifications), (ii) avoid properties with loans or leases that will need to be renegotiated during the term of the offering, (iii) target properties that are subject to a triple-net lease with a creditworthy tenant, (iv) ensure that the term of the debt that is secured by the property is shorter than the term of the property lease(s), and (v) establish reserves up front (out of loan or offering proceeds) or out of cash flow in case of future cash shortages.
There are other structural items that can be adopted to comply with Revenue Ruling 2004-86. First, because a DST cannot enter into new leases, when a sponsor wants to acquire a property that requires continuous leasing activity (such as a multifamily asset), the sponsor enters into a triple net master lease with an affiliated master tenant that engages in the leasing activity. Second, sponsors include a “springing LLC” provision in the DST’s trust agreement because sometimes, despite the best planning, situations arise in which the DST has no option except to engage in one of the deadly sins. The springing LLC provision allows the DST’s trustees to determine that the DST must engage in one of the seven deadly sins to preserve the asset and cause the DST to be converted into a limited liability company (LLC) and for the investors’ DST interests to be converted into LLC interests. Although a spring to a springing LLC means that the investors hold an asset that no longer qualifies as relinquished property in a Section 1031 Exchange (the LLC interests), investors are better off with an asset that can be salvaged than with no asset (e.g., one foreclosed upon by a lender).
Finally, the newest of these three tax-advantaged real estate investments is the QOF. QOFs were added to the Code by the Tax Cuts and Jobs Act of 2017. Congress wanted to spur economic investment in impoverished areas and low-income communities by providing tax incentives to real estate developers and investors. As a result, it added a new Code section charging the governors of the US states with designating certain census tracts within their states as a “qualified opportunity zone” (QOZ). Also, Congress provided rules under which a taxpayer can defer recognition of certain eligible gains, including capital gains, by investing an amount of cash equal to the gain in a QOF within 180 days of the date that the taxpayer realized the gain (e.g., the closing date of a real property sale).
A QOF is an investment vehicle classified as a corporation or a partnership for federal income tax purposes and organized for the purpose of investing in QOZs. A QOF must meet a handful of organizational requirements to qualify as a QOF, but a QOF must ensure that at least 90 percent of its assets are invested in “qualified opportunity zone property,” which includes “qualified opportunity zone partnership interests,” “qualified opportunity zone stock,” and “qualified opportunity zone business property.” Each of these types of qualified opportunity zone property is subject to certain organizational and operational requirements and tests. Generally speaking, the most common and flexible way to structure a QOF investment is to have a QOF create a second-tier partnership that acquires, develops, and operates the asset (QOZB, because the entity, in order for its interests to qualify as qualified opportunity zone partnership interests, must meet the qualified opprtunity zone business requirements). QOF structures are particularly well suited for classic ground-up development deals, particularly where the developer does not seek QOZ benefits and can enter the deal as a partner at the QOZB level. As discussed below, these deals provide significant tax benefits for QOF investors and are generally no less attractive for developers than other development deals.
Initially, there were three tax benefits associated with investments in QOFs: (1) The investor in a QOF enjoys temporary (currently until December 31, 2026) deferral of the gain that gives rise to its investment in a QOF; (2) if the investor holds its QOF interest for (a) at least five years before December 31, 2026, then the investor’s basis in its QOF interest is increased by 10 percent of the amount invested in the QOF, and (b) at least seven years before December 31, 2026, then the investor’s basis in its QOF interest is increased by another 5 percent (for a total of 15 percent) of the amount of gain invested in the QOF; and (3) if the investor holds its QOF interest for at least 10 years, then the investor’s basis in its QOF interest is increased to the fair market value of the QOF interest on the date of sale. At this point, the temporary deferral described in item (1) above is not as material as it was in 2017 and new investors in QOFs can no longer qualify for the step-up in basis described in item (2) above because an investor after 2021 will not have held its QOF interest for five or seven years before December 31, 2026. The most significant QOZ benefit is (and always has been) the one described in item (3) above because it provides for a permanent elimination of tax on the appreciation in value of the QOF interest if the QOF interest is held for at least 10 years.
Higher interest rates in recent years have led to decreased real estate investment activity, and sponsors have had difficulty modeling the types of returns that real estate investors find attractive; however, tax incentives can bridge the gap and provide alternative reasons to invest in real estate. As noted above, there are many ways to structure a real estate investment, but the most attractive structures provide investors with the opportunity to qualify for tax benefits. In this article, we have discussed three important real estate investment structures: REITs, DSTs, and QOFs. Structuring these tax-advantaged real estate investments can be complicated, but sponsors who work with advisors who are well-versed in the rules will find these structures achievable and attractive.
