REIT tax due diligence – best practices

As real estate investment trusts (REITs) continue to grow in popularity, so does the need for tax advisors who understand the importance of REIT tax due diligence when a REIT is acquiring assets or a buyer is acquiring REIT stock. Generally, a REIT is a company that owns and usually operates real estate assets or finances real estate assets owned by others. REITs are generally taxed like regular C corporations but receive favorable tax treatment in that they can deduct dividends they pay to their shareholders from their taxable income. This deduction essentially eliminates the double tax incurred by a regular C corporation that pays dividends to its shareholders. In exchange for that favorable tax treatment, REITs are subject to strict requirements regarding their ownership, distributions, assets and income sources. If a REIT fails to meet any of these requirements, at a minimum, a penalty charge or tax may apply. In a worst-case scenario, a REIT can lose its REIT status resulting in regular C corporation status for a minimum of four years. This article focuses on various due diligence procedures that can be implemented to help mitigate this risk and identify other areas where tax exposure may exist.

REIT asset acquisition due diligence procedures

When a REIT is buying assets either directly or indirectly, the REIT tax due diligence process should begin as soon as the asset is being evaluated for acquisition. It is important to understand, early on, what type of income is being generated by the asset, the composition of the asset and the impact the asset’s inclusion has on the overall REIT tests for the entire portfolio. Typically, a REIT  will require the seller to complete a property services questionnaire when buying real property. The questionnaire would include a host of questions that would allow the REIT to determine if the property is generating any income that would not qualify for REIT purposes or could jeopardize all of the income being generated by the property (i.e., impermissible tenant services income).

A best practice would be to include delivery of the completed property questionnaire as a due diligence requirement within the purchase and sale agreement. This completed questionnaire along with review of the property’s leases and service contracts should uncover potential REIT income issues. In addition, a review of the property’s financials along with discussions with the seller should identify other items, not addressed in the questionnaire, which could affect a REIT’s income or asset tests. If the REIT is acquiring a loan, instead of having the seller complete a property questionnaire, the REIT may require completion of a checklist that would document terms of the loan and security for the loan to ensure it qualifies as being fully secured by real property. Issues that are discovered early can generally be managed by structuring the deal in a way that avoids REIT qualification issues.

REIT stock acquisition due diligence procedures

REIT stock sellers are often interested in selling their REIT stock rather than their properties to avoid subjecting their foreign shareholders to tax withholding and U.S. tax reporting obligations that might otherwise apply under the Foreign Investment in Real Property Tax Act. Not surprisingly, when a buyer is evaluating the purchase of a REIT’s stock, the REIT tax due diligence process gets more complicated. Now, instead of analyzing a single asset, the buyer must also analyze the REIT’s entire balance sheet including all assets and liabilities (past, present and future) it will acquire as part of the stock purchase. Included among the acquired liabilities is the potential that the REIT may not have qualified for REIT status in past years in which case corporate tax may be due upon audit. The REIT tax due diligence process should focus on the REIT’s qualification for all years open under audit and should include a review of its annual organizational tests, gross income tests, quarterly asset tests and distribution requirements. In addition to REIT requirements, the buyer will need to understand if there are any other potential tax exposures including but not limited to:

Areas of focus for stock acquisition due diligence

The following is a list of key areas to focus on when testing for REIT qualification and potential tax exposures associated with the acquisition of REIT stock:

A thorough due diligence process is critical for finding potential tax issues that could jeopardize REIT status and create tax exposure. In extreme cases, the buyer may determine that they do not want to acquire the REIT stock. Alternatively, any potential tax exposures could be addressed through purchase price adjustments or indemnities in the purchase and sale agreement. In addition to potential REIT and tax exposure issues, a thorough due diligence process could uncover other nontax-related issues that will need to be addressed as part of the negotiation process.

Buyer status as eligible REIT shareholder

Finally, it is critical that the buyer of REIT stock is able to maintain REIT status even if the intent is to liquidate the REIT post acquisition. This means that the REIT needs to continue to meet all income, asset, distribution and ownership requirements, even if the buyer is holding the REIT stock for a day. Generally, if the REIT’s income and assets were qualifying while held by the seller, they would also be qualifying while held by the buyer. However, the REIT’s ownership requirements (100 shareholders and 5 or fewer individuals cannot own 50 percent of more of the REIT’s stock) can create some obstacles and may render as ineligible certain buyers such as individuals, family offices, family partnerships and other closely held entities. Not meeting these requirements would be detrimental as the REIT would lose its REIT status retroactive to the beginning of the taxable year resulting in C corporation status. In the event of this type of disqualification, the buyer would now have to pay corporate tax on the entity’s earnings and if the intent was to liquidate, the liquidation would trigger tax on any built-in gain inherent in the assets.   

How much tax due diligence is enough?

The scope of the tax due diligence procedures will vary depending on many factors including but not limited to:

How many years should be reviewed?

The number of years that should be included in the review depends on many factors such as the REIT’s transaction history, available documentation and the buyer’s tolerance for risk. But, most advisors would recommend reviewing all years since the REIT’s inception. At a minimum, diligence should be done on all open tax years of the REIT with appropriate consideration given to the four-year lock out on REIT status if such REIT lost its status in any of the four years before the last tax year still open under statute. Once this determination has been made, documents are gathered and the review process can begin.

Do your homework

Clearly, understanding any asset is critical during the acquisition process but particularly so when REITs are involved given the high exposure to potential tax liabilities.  Not doing enough due diligence on the front end can result in very negative, and often very expensive, consequences.