A mortgage REIT is a real estate investment trust with a portfolio comprised of primarily real-estate secured loans. REITs, REMICs (real estate mortgage investment conduit) and similar vehicles were a mainstay in private lending during the last cycle prior to Dodd Frank. Recently REITs have returned. But why?
Thanks to the Tax Cuts and Jobs Act of 2017, REITs investors were granted the fabled 20% qualified business income deduction regardless of their tax bracket. Further, REITs are exempt from unrelated business taxable income (UBTI), which can be significant for funds with IRA investors.
Since 2018, mortgage fund managers have been pursuing this strategy aggressively.
Let’s look at the core qualifications to become a REIT and whether the time is right for your fund.
A REIT is a company that owns real estate or real-estate related assets, including mortgages, and is able to qualify for pass-through taxation by meeting certain key requirements set forth in the tax code. Most REITs are designed as pooled funds with real estate assets. The key requirements to qualify as a REIT:
- It must be an entity taxed as a corporation.
- 90% of its taxable income must be distributed to shareholders in the form of dividends each year.
- 75% of its assets must be in real estate, cash or U.S. Treasurys.
- 75% of its gross income must come from real-estate related assets.
- It must not be “closely held,” meaning no five investors may own more than 50% of the REIT.
- It must have a minimum of 100 shareholders.
REITs can be publicly traded or privately held, including exempt under Regulation D. Since REIT dividends are taxed at the individual shareholder’s rate, and REITS always qualify for the new pass-through deduction, REIT shareholders are able to reduce their dividends from 39.6% to 29.6% at the highest tax bracket. Another added benefit of REITs are they are not subject to UBTI. So, for those funds that have IRAs or other qualified plans, this is an additional added benefit to pursue a REIT structure. However, REITs are not for everyone.
Is Adding a REIT Right for My Fund?
Converting or adding a REIT component to a mortgage fund is a very sensible decision when a fund reaches approximately $40 million in assets under management. Any less than that, it cannot sustain the initial and ongoing maintenance expenses.
For those funds that exceed $40 million in assets under management, it can be a significant windfall for investors.
How Do I Add a REIT to My Business Model?
There are two options for adding a REIT to your business model:
- Convert your existing fund to a REIT.
- Add a subsidiary REIT or “SUBREIT” as a majority-owned subsidiary to the fund.
Although Option 1 may seem like the most logical choice, it is not as popular for two reasons. First, it requires the fund to elect a change to a tax election. This typically requires a vote or written consent from the majority of the fund.
Second, converting the fund to a REIT does not give as much flexibility to unwind this should the tax code change in the future or if the SUBREIT were to lose REIT status (which is a permanent). A vast majority of mortgage funds are pursuing a SUBREIT because of this flexibility.
What Pitfalls Should I Avoid?
The primary pitfall we’ve discovered in forming a SUBREIT is that many do not account for the legal issues surrounding transferring the portfolio from the parent fund to the SUBREIT. In states like California, transferring loans from one entity to another can be restricted, depending on the lending license.
Another common concern is losing REIT status due to foreclosures. This is a very real concern. Income associated with foreclosed properties can cause REITS to lose status. There are two solutions to this. If the fund has created a SUBREIT, it can either create a taxable REIT subsidiary to transfer these assets to and be taxed at the normal rate, or it can move the assets to the parent where it would be taxed as part of the fund.
Finally, one additional pitfall is that many believe REIT status grants them the ability to lend nationwide without a license. This is completely false. Some states like Nevada grant REITs the ability to lend without a license, but it is subject to significant qualification for exemption.
Yes, privately held REITs are back in a big way. With the new tax code, funds can introduce a simple, cost-effective way to increase investor yields by saving taxes. This, combined with a UBTI waiver, can be a significant win for many funds in an increasingly competitive marketplace.