ABA Section of Taxation
Investment Management Committee
May 12, 2017
Primer on Structuring Real Estate Funds
Moderator: Ameek Ashok Ponda, Sullivan & Worcester LLP, Boston, MA
Panelists:
Cameron N. Cosby, Hogan Lovells US LLP, Washington, DC
Peter J. Genz, King & Spalding LLP, Atlanta, GA
Primer on Structuring Real Estate Funds
Topics
• Life cycle, PE-Style RE Fund
• REIT Feeder into LP
• Open End Fund
• Master Limited Partnership
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Life cycle, PE-Style RE Fund
LPs
GP
Fund
REIT 1
REIT 2
C Corp 1
Foreign
Corp 1
Foreign
Corp 2
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Life cycle, PE-Style RE Fund
Types of Foreign Investors Encountered in Real Estate Funds
• Assume that limited partners are a mix of the usual suspects: U.S. private and state pension
plans, family offices, insurance companies, and foreigners
• Foreign investors fall into three primary categories:
– Taxable non-U.S. investors: fully or partly subject to U.S. withholding tax on dividends and fully
subject to FIRPTA tax on sales of USRPIs and stock of USRPHCs as well as FIRPTA distributions from
REITs
– Foreign sovereigns exempt under section 892 from U.S. withholding tax on dividends and exempt
from FIRPTA tax on sales of shares of blocker C corporations and REITs, but subject to U.S. tax on
FIRPTA distributions from REITs
– “Qualified foreign pension funds” (“QFPFs”) under section 892(l) are completely exempt from
FIRPTA tax. Unlike section 892 investors, QFPFs can own (on a look-through basis) more than 50% of
a subsidiary REIT and can receive distributions from REIT asset sales without any U.S. tax exposure
(provided such asset sale distributions are designated by the REIT as capital gain dividends)
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Life cycle, PE-Style RE Fund
Using One-Off Subsidiary REITs to Hold Fund’s Properties
• Use of one-off REITs to hold a single project
– Allows an exit to be structured as a REIT share sale rather than an asset sale
– Asset sale by REIT, while transactionally simple and efficient, triggers U.S. FIRPTA tax to
all foreign investors except QFPFs
– U.S. investors may object if a share sale potentially impacts the deal pricing because
buyer extracts a haircut
– GP must use reasonable best efforts to ensure that foreign sovereign will not own 50% or
more of any subsidiary REIT or C corporation
– Historic REIT compliance will be scrutinized carefully by the would-be buyer of the REIT
shares – this is when the REIT skeletons come out of the closet
– Tax due diligence, tax indemnities, REIT opinions by seller’s counsel, and tax insurance
are different ways this risk is mitigated
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Life cycle, PE-Style RE Fund
Covenants by Fund Sponsor to Exit by REIT Share Sale
• Variations in commercial practice on covenant by Fund sponsors to structure
REIT share sale instead of asset sale:
– Ironclad commitment – no outs
– this covenant may be extracted by a heavy hitter foreign sovereign with lots of leverage
– Good faith efforts
– Commercially reasonable good faith efforts
– GP may reserve right to test the market and determine whether an asset sale will bring about
materially better pricing relative to stock sale
– Provisions that attempt to measure a haircut and put the burden of the haircut on the investors
for whom the share sale provides a tax benefit
– very difficult to define the haircut, because deals rarely get negotiated with a neat and tidy
“share sale price” and alternative “asset sale price”
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Life cycle, PE-Style RE Fund
One REIT v. Multiple REITs
• One-off REITs can be expensive to own and maintain from a tax
compliance and corporate administrative standpoint
• Accommodation preferred shareholders for each REIT
• One-off REITs (as opposed to one large REIT) put added pressure on
compliance with REIT tests
• Can’t offset losses against gains, which would happen organically if one
used a single holding company REIT subsidiary to hold all the properties
• Using a single REIT at the outset, with the intention of later forming baby
REITs underneath as asset sales are contemplated, presents a host of tax
issues and careful advance tax planning is required
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Life cycle, PE-Style RE Fund
One REIT v. Multiple REITs (cont.)
• If multiple REITs are to be used, the proliferation of these entities can be
controlled by grouping properties (e.g., an assemblage) that stand a
reasonable likelihood of being sold in a single portfolio transaction that
can be effected through a sale of the REIT itself, as opposed to asset sales
• Care must be taken to avoid potential “preferential dividend” REIT tax
issues if asset management fees vary among the investors depending on
the size of their investment
–
The desired economic arrangement can often be achieved, without implicating a REIT
tax issue, through appropriate structuring of the allocations of tax items of the Fund
partnership above the REIT
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Life cycle, PE-Style RE Fund
Not All Property Types Are Compatible With REITs
• Gain on sale of dealer property, such as lots or condominiums held for
resale, is subject to a 100% tax if held by a REIT
• Certain types of properties cannot be held by a REIT if they do not meet
the REIT requirements, e.g., operating farms (as opposed to simply
leasing to farmers)
• Hotels and assisted living facilities can be owned by a REIT if they are
leased to a subsidiary taxable entity (“TRS”) that in turn hires a third
party property manager
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Life cycle, PE-Style RE Fund
Other Tax Benefits of REITs
• REITs can block potential sources of UBTI for U.S. tax-exempt investors,
such as debt-financed UBTI
– However, if the REIT is a pension-held REIT, then a special UBTI rule can cause part of
the REIT dividends to become taxable UBTI to pension trust investors with a significant
interest in the Fund
– The Fund documents may contain protective covenants to avoid pension-held REIT
status
• REITs can also avoid state income taxes that would otherwise be incurred
if the property were held directly by the Fund or through a C corporation
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Life cycle, PE-Style RE Fund
C Corporation Blockers
• A C corporation blocker in general will be used for investments that cannot be
put into a REIT and will be used in conjunction with some type of parallel
fund or AIV structure through which only certain types of investors (those
who need the blocker tax protection) will invest
• The C corporation is subject to corporate level tax as well as state income tax
• Funds may implement an internal leverage structure to reduce the taxable
income of the C corporation and convert it to interest income that is eligible
for the portfolio interest exemption from 30% U.S. withholding tax
– The section 163(j) earnings stripping rules may limit the amount of internal
leverage or reduce the tax efficiency of the interest deductions
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Life cycle, PE-Style RE Fund
C Corporation Blockers (cont.)
• May want to use a single C corporation blocker for each investment so that when
the blocker sells its assets (and recognizes gain subject to corporate income tax),
the C corporation can distribute the proceeds to the Fund without a second
FIRPTA tax being imposed on the non-U.S. investors on the distribution of the
liquidation proceeds
• Tax cost of blocker will typically be borne by the investors who benefit from it and
not by the sponsor or the tax-indifferent investors
• Ordinary dividends from a C corporation are subject to 30% withholding tax
except to the extent reduced by an applicable tax treaty or as to a foreign
sovereign eligible for section 892 exemption. Funds may therefore seek to avoid
non-liquidating distributions from the blocker
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Life cycle, PE-Style RE Fund
Structure for Non-U.S. Assets
• For real estate investments outside the United States, it is commonplace
to structure those through foreign entities treated as corporations for U.S.
tax purposes
• This is acceptable to U.S. tax-exempts because it blocks UBTI, and
dividends from the foreign entity to the Fund are also exempt from UBTI
– foreign investors typically will want to invest the same way to avoid
commercial activity income (for a sovereign) or ECI (for other foreign
investors)
• Foreign and U.S. investors may insist on covenants from the sponsor that
they won’t have to file returns in other countries or bear taxes not directly
attributable to the Fund’s investment in any such country
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Life cycle, PE-Style RE Fund
Structure for Non-U.S. Assets (cont.)
• Considerable attention must be paid to the local country tax structure and
consequences, including tax treaty network
• U.S. taxable investors may invest in the foreign properties through a
parallel U.S. or foreign partnership that is a pass-through entity for U.S.
tax purposes and that invests directly in those properties (i.e., avoiding
the foreign blocker entity). This avoids issues under the PFIC rules and
also the problem of potentially trapping tax losses inside a corporation
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REIT Feeder into LP
LPs
GP
LPs (who desire blocker)
REIT
Fund
Parcel 1
Parcel 2
Parcel 3
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REIT Feeder into LP
What Tax Considerations Drive the Structure?
• Most of the underlying assets must be REIT compliant
• Certain investors want to invest through a REIT:
– Tax-exempts
– Non-U.S. investors
• Certain investors may or may not want to invest through a REIT:
– High net worth U.S. individuals
• The sponsor may form a fund partnership above the REIT, which brings
into question some of the issues discussed in conjunction with Life cycle,
PE-Style RE Fund
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REIT Feeder into LP
Advantages of REIT to Tax-Exempts and Non-U.S. Investors
• No UBTI for tax-exempts, unless:
– The REIT is a “pension held REIT” and the tax-exempt investor owns more than 10% (by
value) of the REIT, or
– The tax-exempt investor leverages its investment in the REIT
• Non-U.S. investors enjoy fewer tax advantages
– Ordinary dividends subject to withholding (may be reduced by applicable treaty)
– Capital gain dividends subject to FIRPTA – withholding and tax return filing obligation
– Sale of REIT shares subject to FIRPTA, unless REIT is “domestically controlled”
– Qualified foreign pension funds (“QFPFs”) and certain qualified collective investment
vehicles (“CIVs”) are exempt from FIRPTA
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REIT Feeder into LP
Advantages of a Partnership to High Net Worth U.S. Individuals
• Tax losses, created by depreciation deductions, flow through
• Tax credits (if any) flow through
• Partnership may be a section 469 “passive income” generator
• But, K-1 compliance (including in states) is far more cumbersome than a
REIT 1099
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REIT Feeder into LP
What Tax Issues Arise?
• Conflicts created by REIT requirements
– Dealer sales and the possibility of the prohibited transaction tax
– REIT requirements (asset and income tests) may cause the Fund to forego and/or
liquidate otherwise attractive opportunities and limit the Fund’s expansion opportunities
– Certain activities may need to be conducted through a C corporation subsidiary of the
Fund (which subsidiary would be a taxable REIT subsidiary of the REIT)
• Conflicts created by IRS audits
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Open End Fund
LPs
GP
Fund
Redemption
Facility
REIT
C Corp
Foreign
Corp
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Open End Fund
Complying with Securities Laws
• 1933 Act (Regulation D; Rule 10b-5)
– Requires quarterly and annual PPM supplements, including interim quarterly unaudited
and annual audited financial statements, and other updates to disclose material
developments and information
• 1934 Act
– Requires maintaining the number of partners below the 1934 Act threshold for
mandatory public company registration (currently 2,000 partners or 500 nonaccredited
partners)
• 1940 Act
– Best handled through 3(c)(7) exemption for qualified purchasers, though 3(c)(1) and
3(c)(5) exemptions may also be possible
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Open End Fund
Clearing Publicly Traded Partnership Status
• Limit the number of partners
• Limit the types and magnitudes of redemptions and secondary transfers
(including section 707 disguised sales between partners)
• Meet the passive income test of section 7704(d) (fairly easy to do), while
steering clear of the “could-have-been-a-RIC” exception
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Open End Fund
Clearing UBTI Standard
• To satisfy section 514, minimize or eliminate debt at the Fund level, other
than ordinary course payables
• Redemption revolver to Fund redemptions should be inside a “blocker”,
with money moving up and down between the Fund and the blocker, taxfree under sections 301(c)(2) and 351
• In most cases, redemptions are financed out of newly issued Fund units,
lest there be a shrinking Fund; section 707 disguised sales between
partners is viewed as not self-executing (“whether” vs. “how” legal
standard for self-executing, see “Disguised Sales of Partnership InterestsWhere are we Now?” ABA 2016 May Meeting)
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Open End Fund
Restricting the Time, Volume and Manner of Redemptions
• Without an active secondary market and without a fixed liquidation date,
redemptions are the principal form of liquidity
• Must prohibit a “run on the bank” if there are too many redemption
requests; but too many unmet redemption requests may mean that the
redemption price is too high, or that the Fund should sell all assets and
return capital to partners in a liquidation
• Lockout periods; blackout periods; redemption loads; volume limits and
allocation policy
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Master Limited Partnership
RICs and Public Investors
GP
MLP
REIT deals
Energy deals
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Master Limited Partnership
Section 7704(c)-(d) and the 90% “Good” Gross Income Requirement
• Section 7704(c)(3) exception so that RICs are the exclusive vehicle for mutual
funds
• Section 7704(d)(1)(D) for real property, including dealer property
– e.g., cemetery plots (Stonemor Partners)
• Section 7704(d)(1)(E) for natural resource deals
– e.g., pipelines
• Sections 7704(d)(1)(A), (C), (D) and 7704(d)(3)-(4) mean that MLPs can
overlap with REITs
– But can an MLP have a section 856(l) “taxable REIT subsidiary”?
– Where both a REIT and an MLP are possible vehicles, REITs tend to dominate, although there
are exceptions (e.g., Landmark Infrastructure Partners)
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Master Limited Partnership
K-1s Can be a Nuisance
• Many investors prefer to receive 1099s
• Investing in a tax partnership and receiving K-1s can come with attendant
state income tax filing obligations, potentially in multiple jurisdictions
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Master Limited Partnership
Investor Considerations
• Separate passive activity loss limitations for MLPs under section 469(k)
• Due to section 514 and UBTI, generally MLPs are not appropriate
investments for 401(k) and individual retirement accounts (e.g., IRS
Form 990-T exposure)
• However, MLPs are suitable investments for RICs on account of sections
469(k)(4), 851(b)(2)(B), 851(b)(3)(B)(iii), and 851(h) and RICs in turn
drive investor demand for MLPs
– K-1s are delivered to the RIC from the MLPs, but the RIC sends 1099s to the RIC
shareholders
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