Expanding allowable investment opportunities for real estate investment trusts could help revitalize distressed retail businesses and increase private sector infrastructure investments to support President Biden’s Build Back Better plan.
Lawmakers conceived of REITs as mutual funds for real estate investments — a vehicle that allows a large number of small investors to pool their capital and invest in entities that own, operate, and develop income-producing real estate properties such as office buildings, retail centers, healthcare facilities, apartments, hotels and resorts, data centers, telecommunications towers, and other infrastructure properties.
To qualify for REIT tax treatment — earnings distributed are taxed only at the investor level via a dividends paid deduction — an entity must satisfy several requirements, including specified ownership, asset, and income tests, along with distributing at least 90 percent of its income annually.
But the rules restrict a REIT’s ability to assist distressed tenants via a capital infusion, an issue exacerbated by the coronavirus pandemic, Mark Van Deusen of Deloitte Tax LLP told Talk Notes.
Even before the pandemic, with the shift from brick-and-mortar businesses to e-commerce, retail tenants facing liquidity issues often turned to their landlords, who have a vested interest in their survival, Van Deusen said. REITs, however, are generally limited in assisting tenants to ways that won’t help them compete economically, he said, noting that retailers’ distress has intensified amid the pandemic.
Section 856(c) provides that at least 75 percent of a REIT’s assets must be real estate assets, cash, and government securities (and no more than 25 percent of its assets can be represented by securities); at least 75 percent of the REIT’s gross income must be from items involving real estate, such as rents from real property; and at least 95 percent of its gross income must be from items involving real estate and specific enumerated passive investments.
For purposes of the income tests, rents from real property — the most significant type of qualifying REIT income — exclude payments from entities for which the REIT owns 10 percent or more of their equity, other than from a taxable REIT subsidiary (TRS).
Along with restricting a REIT’s ability to invest in its tenants, the related-party rent rule under section 856(d) is also problematic regarding a tenant’s bankruptcy proceedings, in which the REIT is one of its major creditors and therefore entitled to the debtor’s equity, Van Deusen said.
The Retail Revitalization Act of 2021 (H.R. 840) — a recently introduced bipartisan bill — would provide relief from the related-party rent restrictions. House Ways and Means Committee members Bradley Scott Schneider, D-Ill., and Darin LaHood, R-Ill., first introduced the legislation in 2020.
The legislation would increase a REIT’s permissible stock ownership of a related-party tenant from 10 percent to 50 percent, increase the threshold for the constructive ownership rules to 50 percent, and increase the limit on space that a REIT can lease to its TRS from 10 percent to 50 percent if the rents are substantially comparable to rents paid by the REIT’s other tenants for equivalent space.
While those rules would allow REITs to make strategic investments in tenants when necessary, Van Deusen pointed out that other restrictions purposefully remain intact — a REIT can’t own more than 10 percent of the equity of a C corporation unless the REIT and the corporation make a TRS election.
That means REITs seeking to own 50 percent of a corporate tenant under the Retail Revitalization Act must make a TRS election regarding that tenant or put that investment into a TRS, Van Deusen said. Further, he noted that REITs would still be limited to having no more than 20 percent of their assets invested in TRSs.
Similarly, if the REIT owns 50 percent of a tenant that’s a partnership with nonqualified income, that entity would need to be put in a TRS if the income tests would be jeopardized, Van Deusen added.
Troubling ‘Double Downward’ Attribution
Under the section 856(d) related-party rent rules, REITs must consider complex constructive ownership rules, which have caused consternation in the industry.
In a July 2020 letter to the IRS, Nareit, an industry group, argued that the 10 percent rule “is often impossible to apply or enforce because of ‘double downward’ constructive ownership rules in section 318.”
The group noted that those rules can disqualify rent from a tenant that “the REIT is not only completely unaware [of] but also completely unable to determine” constructive ownership for. The group urged Treasury and the IRS to exercise regulatory authority under section 856(c)(5)(J), reg. section 1.318-1, or other applicable provisions “to eliminate the inadvertent constructive ownership in tenants . . . from disqualifying otherwise qualifying rental income.”
In the Retail Revitalization Act, lawmakers propose removing the double downward attribution requirement from the related-party rent rules.
Stimulating Infrastructure Investment
Additional amendments to REIT statutes could aid private sector investment in infrastructure if Congress is willing to expand the rules for qualifying assets and income under the statutory regime.
Mark Kirshenbaum of EY, who spoke during a February 18 webcast sponsored by his firm, pointed out that the 2016 final regulations (T.D. 9784) — defining real property as including inherently permanent structures and their structural components — significantly expanded the types of infrastructure assets qualifying as real property under the REIT tax regime.
After the IRS clarified the definition of real property, the focus shifted to whether payments received constituted “good rents” from real property. Kirshenbaum noted that in recent letter rulings, the IRS has been accepting of income from alternative leasing arrangements for infrastructure assets such as cell towers, pipelines, and storage structures.
“In some people’s view, [further] expanding REITs and the basic definitions . . . to permit more types of infrastructure assets” could stimulate private sector infrastructure investment and reduce the need to rely on government funds, Kirshenbaum said.
“Although the Biden campaign didn’t mention anything on infrastructure in terms of the role REITs might play,” the issues that the industry has raised with Congress that would make REITs relevant to infrastructure plans could sneak into a significant legislative package, said Ray Beeman of EY, who joined Kirshenbaum on the webcast.
Stephen Butler of Kirkland & Ellis LLP told Tax Notes that if legislators are willing to consider a broad approach in the coming infrastructure bill — looking beyond public funding options to incentives that would encourage private investment in critical infrastructure — an expansion of the REIT income and asset tests could prove to be “a more efficient and cost-effective path than federal cash grants or subsidized financing.”
IRS Has Paved the Way
Congress might only need to look to IRS guidance regarding infrastructure property to draft REIT rules that would have “little cost to the public treasury,” according to Butler.
In a 2019 Tax Notes article, Butler and coauthor Ryan Phelps, also of Kirkland & Ellis, proposed a legislative alternative to expand the universe of eligible infrastructure investments that would qualify under the REIT rules and enable increased investment in America’s crumbling infrastructure.
The authors’ approach is modeled after IRS guidance in Rev. Proc. 2018-59, 2018-50 IRB 1018, which provides a safe harbor for infrastructure trades or businesses to qualify as an electing real property trade or business that can opt out of the section 163(j) business interest deduction limitation rules.
By building off that revenue procedure, in which the IRS defines qualifying public infrastructure assets to include airports, bridges, water treatment facilities, electric utilities, and high-speed rail, Congress could “enable private REIT investments in a wider spectrum of public and private infrastructure assets,” Butler said.
Butler also pointed to a 2019 letter ruling (LTR 201907001) — which facilitated the use of REITS for some midstream energy investments — as additional “illustrative guidance” for REIT infrastructure rules. In that ruling, the IRS stated that amounts that a REIT received from the lease of an offshore oil and gas platform, storage tank facility fees, and oil and gas pipeline user fees qualified as rents from real property for purposes of section 856(c)(2) and (3).
Butler suggested, however, that Congress consider other types of assets beyond those enumerated in the revenue procedure and the letter ruling, such as energy generation, transient, and storage facilities.
REIT investment incentives could also be expanded to cover green objectives by enabling investments in renewable energy, energy efficiency, and carbon capture equipment, according to Butler.
Butler noted that along with attracting private capital from investors that wouldn’t otherwise have a viable way to invest in many U.S. infrastructure projects, modifying the REIT rules could “also provide an attractive investment opportunity to pension plans and retail investors, who would like to participate in additional infrastructure investment opportunities but who have limited opportunities to do so.”
And to attract additional non-U.S. capital into the REIT area, Congress could consider extending the exemption under the 1980 Foreign Investment in Real Property Tax Act’s withholding requirements on dispositions of U.S. real property interests that apply to less-than-10-percent shareholders of public REITs to also cover private REITs, Butler suggested. He said that could foster increased investment in infrastructure and in other asset classes in sectors like retail that are experiencing distress.
Addressing REITs’ role in infrastructure efforts and the related-party rent rules is “certainly on the table” as a more detailed proposal gets underway on the different items in the Build Back Better plan, Beeman said.
Beeman suggested that more information on the administration’s agenda, and in particular its tax agenda, may be available by April or May. Congress might get started on proposed legislation before the August recess, but specifics aren’t expected “until perhaps even after Labor Day, when Congress starts moving this plan through the committees,” he said.