Real Estate Tax Alert REITs and real estate funds

Real Estate Tax Alert
A practical guide to the proposed 385 regulations for
REITs and real estate funds
Overview
The purpose of this alert is to highlight the ways in which the new proposed regulations under Section 385 1 will
affect real estate funds and REITs. For a broader and more detailed review of the rules, we recommend
“Proposed Treasury Regulations under Section 385 would have profound impact on related party
financings.” You can also view our introductory webcast.
At a high level, the proposed regulations provide situations in which certain related party debt will be
recharacterized as equity. While a debt-equity analysis has historically been a question of fact, the proposed
regulations indicate that in specified situations debt would automatically be treated as equity without regard to
the remainder of the facts. In particular, debt will be treated as equity if (i) documentation requirements are not
followed, (ii) the debt is issued in certain types of transactions, (iii) the purpose of the loan is intended to allow
the borrower to engage in specified transactions or (iv) the borrower engages in particular transactions before
or after receiving the cash from debt funding. The proposed regulations also provide that the IRS can bifurcate
a loan into an instrument that is part debt and part equity.
What follows is a series of questions that one should consider to determine how the rules might apply to their
particular situation.
These regulations are only proposed. Do I still need to think about these rules
and read on?
In short, the answer is yes. Unlike many other proposed regulations, these proposed regulations provide that
some aspects of the rules will be effective for loans entered into on or after April 4, 2016. While the proposed
regulations may be changed before finalization, one should consider the risk that debt issued during this period
would be recharacterized as equity.
In addition, many real estate fund structures that are currently in place or that are being established may be
planning to utilize loans in connection with investments, and it would be prudent to consider whether plans
should be changed in light of the current rules.
That said, the documentation requirements are only expected to apply once regulations are finalized. Therefore,
if one was prioritizing a response regarding the potential impact of the proposed regulations, it might be
prudent to prioritize consideration of the transactions that could cause debt to be treated as equity over the
documentation requirements.
Does a loan need to have a tax avoidance purpose to be covered?
No. Simple loans between entities for cash management purposes can be recharacterized. Therefore, cash
pooling arrangements and other intercompany borrowings should be scrutinized.
1
Section references refer to the Internal Revenue Code of 1986, as amended.
Real Estate Alert | May 2016
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Why do I care if the debt is treated as equity?
The obvious answer in many cases is that the borrower will not have an interest deduction and the payee will be
treated as receiving dividends instead of interest. This can have a dramatic impact on the tax consequences to
the parties.
However, the potential consequences can go well beyond traditional debt-equity concerns as a loan recharacterized
as equity under the regulations is treated as equity for all tax purposes. For example, if a REIT has a loan secured by
a mortgage on real property and the loan is recharacterized as equity for tax purposes - that could cause the
“interest” to be recharacterized as a dividend. This would convert income which might have been qualifying income
for purposes of the REIT 75% income test, to become non-qualifying income for purposes of that test. In another
example, if a non-U.S. member of an expanded group makes a loan to a REIT, recharacterization of the loan as
equity could adversely impact whether the REIT would be treated as a domestically controlled REIT.
In addition to substantive tax consequences, recharacterization of debt to equity can simply lead to additional
complications. For example, if one entity lends cash to another as part of an expanded group’s cash management
system simply to fund the cash needs of one member, the loan could be recharacterized as equity and can lead to a
new shareholder in the borrowing entity which was likely not envisioned. This could, in turn, lead to reporting and
other issues with respect to that new investor.
I know that these rules apply to related parties, how do I determine if the parties
making loans are related?
There are two general concepts of relatedness that come into play in the new rules: the expanded group and the
modified expanded group. The expanded group rules apply to most of the proposed regulations. The modified
expanded group rules apply to the IRS’ authority to bifurcate a loan between debt and equity.
At a very high level, an expanded group would include entities that have an 80% relationship (by vote or value) and
a modified expanded group includes entities that have a 50% relationship (by vote or value).
While that sounds simple enough, in actuality the rules are far more complicated. The rules that apply for purposes
of determining whether a lender and a borrower are part of an expanded group or a modified expanded group
include a combination of (i) a modified set of rules related to determining if entities are members of a consolidated
group, (ii) the rules that apply in Section 304(c)(3) (which apply a modified set of the Section 318 rules), and (iii)
specific rules that apply to partnerships (that vary depending on the aspect of the regulations being applied).
Still, in some cases it is relatively easy to identify relationships that would be covered by the proposed regulations.
For example, loans from a REIT to a TRS (at least where the REIT has an 80% interest in the TRS) would be treated
as part of an expanded group and covered by the new proposed regulations.
In other cases, particularly in the context of real estate funds, the analysis can be far more complicated. For
example, if Real Estate Fund X makes a loan to a wholly owned subsidiary corporation Y, those entities might not
be part of an expanded group.2 However, if the partners in Fund X are shareholders (or deemed to be shareholders
under the attribution rules) in another corporation, perhaps a corporation in another fund with similar investors,
that could cause X and Y to be part of the same expanded group for purposes of the documentation requirements.
Once it is determined that a lender and a borrower would be part of an expanded group, it would be prudent to
consider whether the lender could be a party that would not be a member of the expanded group. For example, if a
loan from X to Y is treated as a loan within an expanded group, a loan from the owners of X to Y might not be
treated as a loan between members of an expanded group.
2
Note that these entities would be part of a modified expanded group
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Unfortunately, it may be a time consuming process to determine whether entities are members of the same
expanded group. At the end of the day, taxpayers may decide in some cases that it would be easier to assume that
certain entities are treated as part of the same expanded group and to try to comply with the rules, as opposed to
trying to work through all of the possible permutations of the attribution rules that could cause two parties to be
treated as related.
Assuming I am treating a loan as being between members of an expanded group,
what type of documentation requirements will I need to put in place?
The proposed regulations require that certain documentation must be in place. The rules provide varying time
frames for when the documentation must be in place.
The documentation requirements provide that there must be written documentation evidencing an unconditional
obligation to pay a sum certain on demand or on fixed dates and that the lender has the rights of a creditor to
enforce the obligation. These seem relatively straight forward and would likely be covered in most loan agreements
used today. However, to the extent an expanded group has loans among its members for cash management
purposes, it may not have formally documented those loans in the past and it would be worth considering whether
formal documentation should be prepared in the future.
In addition, the documentation requirements provide that there must be written documentation that supports a
reasonable expectation that the issuer intended to, and would be able to, meet its obligations under the instrument.
The proposed regulations provide that this documentation may include, among other things, cash flow projections,
financial statements, business forecasts, asset appraisals, debt-to-equity ratios and other relevant financial ratios.
Many REITs and real estate funds already obtain transfer pricing studies or otherwise document the ability of the
borrower to repay its obligations. However, in cases where this is not currently being done in a formal manner, a
more formal process of documenting the borrower’s ability to repay loans of an expanded group should be
undertaken on a going forward basis.
Documentation evidencing appropriate actions in a debtor-creditor relationship also need to be maintained. This
would include documenting payments of principal and interest and compliance with debt covenants. This might
entail more contemporaneous documentation regarding whether a payment to a shareholder/borrower is a
payment on debt or an equity distribution.
Documentation must also be maintained for creditor actions in connection with events of defaults or similar events.
Therefore, in cases where the creditor has rights with respect to a loan to a member of its expanded group, not only
should it act in a manner similar to a third party lender, but the lenders actions and the reason that the lender took
a particular course of action should be documented.
Should I follow the documentation requirements for loans not between members
of an expanded group?
While the proposed regulations do not require that the documentation requirements be followed in the context of
loans made between entities that are not members of the same expanded group, it may be prudent to use these
rules as a minimum level of documentation that one should perform in connection with debt and equity between
parties that might be viewed as related in one way or another. Even if a loan is not specifically covered in the
regulations, the documentation requirements would be part of any debt-equity analysis and one would expect that
the chances of the debt being respected as debt would be diminished if the documentation requirements in the
proposed regulations are not followed.
Real Estate Alert | May 2016
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What types of transactions do I need to look out for that could cause the debt to
be treated as equity?
If a loan is between members of an expanded group, any of the following transactions should be analyzed further to
determine if they would cause the debt to be treated as equity under the proposed regulations. This would include
debt issued in a distribution, certain debt issued in exchange for stock of member of an expanded group and certain
debt or a reorganization under Sections 368(a)(1)(A), (C), (D), (F) or (G).
What types of transactions by the borrower do I need to look out for that could
cause the debt to be treated as equity?
If the loan is made to a member of the expanded group for particular purposes, the transaction should be examined
in more detail to determine if the purpose for the funds could cause the debt to be treated as equity. The purposes
outlined in the regulations are a loan (i) to fund certain distributions from the borrower to a member of the
borrower’s expanded group; (ii) to allow the borrower to acquire certain stock of a member of the borrower’s
expanded group and (iii) to allow the borrower to acquire property in certain reorganizations under Sections
368(a)(1)(A), (C), (D), (F) or (G).
Even if one does not undertake a loan with the particular purposes described above, there are certain per se rules
that will treat the entities as having a particular purpose, even if no such purpose exists. Effectively, any
distribution or acquisition described above that is made within 36 months of a loan would be treated as having the
requisite purpose to cause the debt to be treated as equity. Therefore, one needs to look back three years before a
loan, and three years after the loan, to determine if there is a transaction that could cause the debt to be treated as
equity. Several regular operating activities, such as regular distributions and acquisitions, would warrant
heightened scrutiny under the new rules.
For example, if a corporation receives a loan from a member of its expanded group and the corporation makes a
distribution either three years before or after the loan to a member of the expanded group, the distribution may
need to be recharacterized as equity. While there is an exception for distributions to the extent of current E&P,
making distributions to the extent of current E&P would require real-time knowledge of that year’s E&P at the time
of the distribution.
In the real estate context, one case where this may arise is in connection with loans from a REIT to a TRS. In
particular, if a REIT makes a loan to a wholly owned taxable REIT subsidiary and the TRS makes a distribution
within three years in excess of the TRS’s current E&P, then part of the loan to the TRS may be recharacterized
as equity.
Acquisitions by a borrowing entity can also cause debt to be recharacterized as equity. For example, if a corporate
borrower in a real estate fund that is a member of an expanded group acquires an interest in a REIT that is a
member of the expanded group, that acquisition could cause the debt to be recharacterized as equity. While there is
an exception for capitalizations in which the borrower owns more than 50% of the vote and value of the stock of the
corporation that was capitalized, the exception is only valid if the 50% threshold is satisfied for the three year
period following capitalization. As a result, if the entity is disposed of in the three year period following the loan,
the exception would not appear to apply.
For additional information concerning this issue, please contact:
Adam Feuerstein
703-918-6802
[email protected]
Adam Handler
213-356-6499
[email protected]
David Leavitt
646-471-6776
[email protected]
Wade Sutton
202-346-5188
[email protected]
Real Estate Alert | May 2016
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PwC Real Estate Tax Practice – National and regional contacts:
National
David Voss
US RE Tax Leader
New York
646-471-7462
[email protected]
Regional
Atlanta
Chris Nicholaou
678-419-1388
[email protected]
Steve Tyler
678-419-1224
[email protected]
Boston
Timothy Egan
617-530-7120
[email protected]
Rachel Kelly
617-530-7208
[email protected]
John Sheehan
646-471-6206
[email protected]
Chicago
Jill Loftus
312-298-3294
[email protected]
Alan Naragon
312-298-3228
[email protected]
Dallas
William Atkiels
214-754-5388
[email protected]
Denver
Robert Lund
720-931-7358
[email protected]
Real Estate Alert | May 2016
Los Angeles
Adam Handler
213-356-6499
[email protected]
Phil Sutton
213-830-8245
[email protected]
Miranda Tse
213-356-6032
[email protected]
New York, cont.
Oliver Reichel
646-471-5673
[email protected]
Paul Ryan
646-471-8419
[email protected]
Christian Serao
646-471-0694
[email protected]
New York
Brandon Bush
646-471-2498
[email protected]
Eugene Chan
646-471-0240
[email protected]
Dan Crowley
646-471-5123
[email protected]
James Guiry
646-471-3620
[email protected]
Sean Kanousis
646-471-4858
[email protected]
Christine Lattanzio
646-471-8463
[email protected]
David Leavitt
646-471-6776
[email protected]
James Oswald
646-471-4671
[email protected]
San Francisco
Kevin Nishioka
415-498-7086
[email protected]
Howard Ro
415-498-6842
[email protected]
Neil Rosenberg
415-498-6222
[email protected]
Washington, DC
Karen Bowles
703-918-1576
[email protected]
Adam Feuerstein
703-918-6802
[email protected]
Laura Hewitt
617-530-5331
[email protected]
Kelly Nobis
703-918-3104
[email protected]
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