Ready to Tackle REITs? Let’s Break Down the Playbook!

Real Estate Investment Trusts (REITs) have surged in popularity, especially in the private lending arena for debt funds. If you are thinking of starting a debt fund in order to benefit from using leverage in the form of other people’s capital, then understanding the in’s and out’s of REITs is a must. Since 2017, they’ve become a game-changer, offering tempting perks like 20% tax savings, UBTI blocking, and state withholding blocking. But here’s the deal: just like in football, you can’t ignore the rules and expect to win. REITs come with their own set of challenges, and if you’re not careful, you could fumble the ball. So, let’s huddle up and dive into the top issues you need to watch out for when playing the REIT game.

Loan Sales: Know When to NOT to Pass the Ball

The first challenge in the REIT playbook is managing loan sales. Imagine you’re the quarterback—pass the ball too soon, and you risk an interception. REITs are designed to be a passive investment (a benchwarmer or a ball boy if you will), not an active player who is making passes (i.e. selling loans). If a REIT funds a loan with the intent to sell, it could trigger what’s known as “dealer income,” a big no-no in the REIT world.

So, how do you avoid this penalty? The best strategy is to close and sell the loan through the parent fund, not the REIT. If the REIT already holds the loan, you can still pass it off to the parent fund, but be strategic. Only in limited situations—where you can prove the original intent wasn’t to sell—should you make that move. Remember, it’s all about staying within the boundaries while executing a smart play.

Closely Held Violations: Don’t Get Sacked by the IRS

Next up, let’s talk about closely held violations. The IRS is like the defensive line—if you’re not careful, they’ll bring the blitz. The rules say that no five individuals should own 50% or more of the REIT, fully diluted. This is crucial, and it’s not just a one-time thing. You need to meet this requirement every second half of the tax year after the first year of being a REIT.

Here’s the kicker: the IRS has a broad definition of “individual.” It includes not just one person, but their lineal ancestors, descendants, and siblings too. To avoid getting sacked, make sure your offering documents give you the flexibility to force redemption if needed. It’s like having a strong offensive line—protect yourself from any surprise blitzes.

Inadequate Distribution of Taxable Income: Don’t Drop the Ball

Finally, let’s tackle the issue of inadequate distribution of taxable income. REITs are required to distribute at least 90% of their taxable income to investors. Sounds simple, right? But here’s where it gets tricky—if you don’t account for defaulted loans, valuation allowances, or loss reserves, you could find yourself in a bind.

Think of it as managing the clock in the fourth quarter. You need to work with an experienced CPA to ensure your accounting is airtight. If your REIT is structured as a subsidiary under a mortgage fund, you’ve got a bit more flexibility. The parent fund can act as the loan selling party, while the SUBREIT ensures it dividends 100% of its taxable income to the parent fund. But don’t get complacent—the closely held test still applies to the parent fund, so keep an eye on the cap table every quarter.

Pros and Cons of Investing in REITs: The Playbook

Before you hit the field, let’s weigh the pros and cons of investing in REITs as an individual:

Pros:

• Tax Advantages: Enjoy significant tax savings, including 20% tax deductions.
• Diversification: REITs allow you to diversify your real estate portfolio without directly owning properties.
• Liquidity: Unlike direct real estate investments, REITs are typically more liquid, allowing you to buy and sell shares easily.

Cons:

• Compliance Headaches: As we’ve discussed, REITs come with stringent compliance requirements. This shouldn’t affect you much as an individual investor but is important to know so you can due you due diligence before investing in a REIT and know what red flags to look for in any annual or quarterly reports.
• Interest Rate Sensitivity: REITs can be sensitive to interest rate changes, affecting returns.
• Limited Control: As a shareholder, you have little say in the day-to-day operations of the properties or the REIT.

Conclusion: Execute the Game Plan

REITs can be a powerful tool in your investment arsenal, just like a well-executed game plan on the football field. But remember, success requires discipline, strategy, and attention to detail. By staying aware of the challenges—like loan sales, closely held violations, and taxable income distribution—you can navigate the complexities of REITs and come out on top. So, get out there, play smart, and turn these potential pitfalls into opportunities for success!