Investment Analysis

REIT Due Diligence

Buyers and sellers alike must look beyond operational functions to ensure compliance.

The complex rules governing real estate investment trusts add a challenging aspect to any entity- or property-level due diligence. Buyers of REITs or property to be held by a REIT must navigate ambiguous rules governing tenant services, make determinations regarding the customary nature of how the properties are operated, and consider all business relationships with tenants and contractors. Looking past the operational aspects of the properties, the administrative function of ensuring compliance is essential to REIT buyers and sellers.

Income Test

Defining “rents from real property,” which include, in part, charges for services customarily furnished or rendered in connection with the rental of real property, is central to the REIT income test requirements. Whether services are “customary” is subjective in nature, and little guidance is given. In fact, private letter rulings issued by the IRS are the most common sources of information; however, such rulings may be relied on only with respect to the taxpayer for which the ruling was issued. Ultimately, buyers and sellers may disagree on the treatment, and as such, all determinations of “customary services” should be well documented, specifically citing what the norm is for the asset class in that geographical area.

REIT rules allow for an independent contractor exception, whereas non-customary services can be provided by the independent contractor to the tenants. In addition to REIT ownership thresholds of the independent contractor that cannot be crossed, a REIT generally cannot receive income (such as rent or dividend income) from the independent contractor; all costs for non-customary services must be borne by the independent contractor, and a separate charge must be made for the service.

REIT buyers must dig deep to avoid foot faults that would terminate the target's REIT status at some point along the way.

Relationships with independent contractors and tenants can exist without others' knowledge. The attribution rules provided by the Internal Revenue Code may result in a REIT being treated as owning a portion of a tenant or independent contractor if a shareholder owns a portion of the REIT and also owns a tenant or independent contractor. For this purpose, a REIT could run afoul of the 35 percent independent contractor threshold or 10 percent related party rent threshold.  Any potential buyer should examine all relationships. The determination that one small contractor does not qualify as an independent contractor could result in all the rent from that property being treated as non-qualified income.

REIT Sales

When selling a REIT, all quarterly and annual testing, REIT shareholder information, independent contractor lists, dividend resolutions, and more need to be in proper order. In other words, make sure to dot your i's and cross your t's. Also, prepare for heavy scrutiny on all aspects of your REIT compliance. For example, something as simple as conservatively treating an item of income as non-qualifying could lead buyers and their advisers to question the completeness and accuracy of the testing. Document conclusions and back them up with the relevant law or guidance.

REIT buyers must dig deep to avoid foot faults that would terminate the target's REIT status at some point along the way. This includes looking into any predecessor REITs that may have converted or merged long ago, making sure all taxable REIT subsidiaries are properly elected, and examining all corporate mergers and conversions that may result in hidden  tax liabilities.

Ultimately, most problems during REIT due diligence can be resolved. REITs can use taxable REIT subsidiaries to shield non-qualified income, terminate relationships and tenancy where necessary, and ensure the right asset and income mix going forward. But it doesn't end there.

Determining how a REIT or property fits into the overall business structure should not be taken lightly. Acquiring a separate REIT could cause other taxable entities in a structure to be included in a state combined return and taxed in a state where they were not previously subject to tax. With any type of acquisition, state transfer and income taxes can present a structuring opportunity as well.

Nicholas Leider

Nicholas Leider is senior content editor for Commercial Investment Real Estate. Contact him at nleider@ccim.com.

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