Raising funds when doing a Regulation A offering can be challenging. Organizers can market to people directly, particularly lower-net-worth investors. However, getting the cash flow required is not as simple as many might believe.
The good news is that there are tools to help accelerate results. REITs are perhaps the most powerful options out there. They’re also the least understood by those new to this process. In this post, we’ll introduce REITs and then explain what issuers need to know to use them effectively.
What’s a REIT?
REIT is an acronym for “real estate investment trust”. However, don’t confuse this with a tax election trust. It’s very different.
REITs are very popular today. Blackstone is famous for using a REIT to raise billions of dollars. And, while you might not see billions from these efforts, a REIT could be just what’s necessary to accelerate results. However, there’s one catch:
You must invest in real estate.
There is no way around that part. Of course, numerous options exist that fall under the “invest in real estate heading”, including the following:
- Collecting rent
- Secured mortgages
- Collecting interest
- Renting out spaces, even if those are short-term rentals or special events
- Getting benefits from the upside on a sale
Another catch is that the organization must be a corporation or at least taxed as a C Corporation. Why subject yourself to these restrictions and limitations, though? It’s all about double taxation.
Eliminating Double Taxation with a REIT
With a C Corporation, income is taxed twice. Here’s an example. You buy shares in a company. In turn, they send you a dividend periodically. However, the company pays taxes on its profits before distributing them. You then pay taxes on the dividends you earn (it’s the same money, taxed at the beginning and end of the distribution process).
With a REIT, that does not happen. The corporation doesn’t pay any taxes because the REIT is required by law to distribute 90% of its earnings to shareholders. Shareholders pay taxes on the money they receive, so it’s only taxed once.
So, if the company earned $1 million, it would need to distribute $900,000 to shareholders, leaving just 10% for use as operating expenses. This flies in the face of how most organizations work. For instance, Berkshire Hathaway has never issued a dividend in its history because they feel the company can do a better job reinvesting the money than by sending a dividend to shareholders to decide where to reallocate their investment dollars.
With a better understanding of this process, let’s consider the qualifications for using a REIT in your Regulation A offering.
REIT Qualifications
REITs can be powerful tools, but they come with many qualifications. Issuers will also need to go through periodic testing to ensure that they continue to meet those qualifications on an ongoing basis.
The 75% Rule
First, understand that 75% of everything invested in must be real estate related. If you are a mortgage pool and are originating, acquiring, or wholesaling real estate mortgages, those debts qualify if you have at least 75% of those assets.
Your Income
Another qualification is that more than 75% of the income must be from mortgage interest or refinancing sales of real estate or from rent.
The 90% Rule
We’ve already covered this one, but let’s touch on it once more: at least 90% of all earnings must be distributed to shareholders.
Company Structure
REITs must be used by organizations taxable as corporations. However, that doesn’t mean that the organization must be a corporation. Many structures qualify here. For instance, organizers might go the route of an irrevocable trust and elect to be taxed as a C Corp. It’s very similar to Delaware Statutory Trusts.
Management of the REIT
Management of a REIT is an interesting thing. Organizers are limited in their ability to directly manage the properties or the actions of the organization, although they certainly have influence. The biggest issue is whether to use a board of directors or a board of trustees. If the deal is going public, you must have a board to steer and guide the organization. If the deal remains private, that’s not the case. There is a lot to gain from having a board, including:
- Help with the decision-making process
- Limit liability from decisions
- Limit the potential for angry investors
Shareholders and Investments
Another requirement with REITs is that deals must have at least 100 shareholders and 100 investments. What does that mean when one is set up? Initially, organizers don’t have 100 investors or any investments, which is fine. However, the organization must bring in 100 shareholders within the first year. If not, it will lose your REIT election, which means you’ll be stuck dealing with double taxation and the investors you did get will be angry that they did not receive what they expected.
This is one reason why REITs are so well-suited to Regulation A offerings. With a Reg A offering, organizers can market a deal to many, many people, particularly smaller investors. It’s easier to reach that magic 100 shareholders when it’s possible to sell the investment, stock, membership interest, or trust interest to just about anyone.
Share Allocation
In a REIT, at least 50% of the shares should be owned by more than five shareholders. Organizations should never end up in a situation where the top five investors own 75% of the company and only 25% is sold to shareholders.
The Benefits of REITs
Why bother with REITs if organizers must jump through so many hoops? It’s because of the benefits offered. We’ll outline those below.
1. No Double Taxation – We’ve mentioned this one before, but it bears repeating. With a REIT, there is no double taxation. Shareholders pay taxes on dividends once, and the company does not pay at all, so long as it is structured correctly. In operation, it’s more like a partnership.
2. Investors Receive 1099DIV – REIT investors receive a 1099 for whatever money they lose. This is in direct contrast to how things work with an LLC or a partnership, where profits and losses flow down. All losses/depreciation stay with the company. This affects the amount of taxable income there actually is. Depreciation reduces the taxable income, and because the company is required to distribute 90% of its taxable income, the business doesn’t have to distribute as much. Depreciation comes off the top, before shareholder distribution.
3. No K-1 – One of the biggest investor pet peeves is dealing with the K-1 every year. If the K-1 isn’t delivered within what the investor feels is a reasonable time, they will hound the organizer for it. That’s understandable because they cannot file their taxes without it, so any delay affects their financial situation. The good news is that with a REIT, there’s no need for a K-1 at all. Instead, there’s the 1099, which is much simpler for investors and leads to a smoother process for management.
4. Easy to Acquire Multi-Asset Funds – With a REIT, you’re “playing with the big boys”. It becomes much easier to acquire multi-asset funds. It’s not as simple as it would be with a Reg D offering, but a Reg A offering provides advantages not found with other options. Because these are much larger deals, acquiring multiple assets and having a more diversified portfolio is much simpler.
UPREIT as a 1031 Alternative
Let’s discuss 1031 rules and UPREITs. Not sure what a UPREIT is? It’s a variation of the REIT and stands for umbrella partnership real estate investment trust. It takes advantage of Section 721 of the Internal Revenue Code and ties in with those 1031 rules. If you’ve ever dealt with 1031 exchange investments, you know how challenging they can be. A UPREIT simplifies things.
If a 1031 exchange goes into a property, that property can be contributed to the REIT without recognizing a capital gain. It’s still a property transfer, not a 1031 exchange, but a 721 contribution. The property is contributed to the REIT and becomes a REIT-issued unit. The REIT then issues shares to shareholders and its tax-free contribution, meaning you maintain the same tax base.
Section 721 is the way to have temporary investors and give them units within a fund. Suppose the REIT is set to allow these contributions to be made with actual real property. In this case, investors contribute property to the REIT, the REIT issues the shares, and investors become shareholders.
However, there is a downside here, which is the 1031 exchange from company interest to company interest. The final investment to do the 1031 exchange property ends as soon as the election or 721 contributions occur. However, the REITs still do 1031 exchanges but they don’t flow back to the investor. Because it destroys the ongoing 1031 exchange, property owners shouldn’t be within the exchange text period to contribute it back at risk of the IRS ultimately saying that the 1031 exchange, the original one, is not problematic. It’s not a REIT issue, but it would be an investor issue, and it’s essential to watch out for their best interests.
In Conclusion
REITs can be powerful tools that accelerate growth and success. They come with numerous advantages, including the ability to avoid double taxation and limit risk exposure. However, they do come with very strict qualifications that are ongoing. UPREITs can also be useful, particularly for use with 1031 exchanges. However, REITs and UPREITs must be carefully structured with the help of an experienced professional.