The Internal Revenue Service has proposed new regulations for REITs (Real Estate Investment Trusts), which could impact future financing, along with the types of property that qualify for tax purposes.
With regulations looming since January, the IRS may lessen the tax advantage available to real estate investors.
If the regulations are enforced, the IRS will put an end to the bottom-dollar guarantee, which essentially allows investors to push back a looming tax gain, Sung H. Hwang of Herrick, Feinstein, LLP told Commercial Observer earlier this year.
“If the bottom-dollar guarantee is done away with as the IRS says, the way things are structured will really change,” he said. “There are people thinking about slicing loans into many shapes to guarantee the whole piece of the deal—now you just guarantee a slice of it.”
A bottom-dollar guarantee or “low-risk guarantee of the partnership’s debt” has been used by contributing partners of UPREITs (Umbrella Partnership Real Estate Investment Trusts) “to avoid an unfavorable tax result from the transaction,” according to a report from Wilkin and Guttenplan PC, Certified Public Accountants and Consultants.
After holding a property in partnership for many years, said Mr. Hwang, a way for investors to exit is to sell the partnership to a REIT and “contribute to a property that the REIT controls.”
This process constitutes the UPREIT transaction and allows investors several benefits in contrast to the continued hold of a property.
“In effect you have exchanged illiquid interest, highly depreciated for the option to convert into a publicly traded stock—you have liquidity that you didn’t have before, but you don’t pay tax until converted and you also have diversified,” according to Mr. Hwang. “The REIT owns interests in other partnerships.”
Without a bottom-dollar guarantee, investors in real estate may have negative capital accounts due to losses in previous years, according to the Wilkin and Guttenplan report. “Upon transfer of the property to an UPREIT partnership, negative capital accounts may result in a taxable event due to recapture of those excess losses and distributions.”
“You take the money out of the partnership and what that does is creates negative capital—but it doesn’t matter because you’re sharing the liability,” said Robert E. Demmett, a partner at Withum Smith + Brown.
The bottom dollar guarantee is “assuming the last dollars of the debt,” said Mr. Hwang. “If the partnership has $100 of debt, I will guarantee the last $20 of the debt. Because real estate never evaporates, the chances of having to pay on the guarantee are very little.”
The IRS is now proposing a guarantee of the full debt for its duration, according to Mr. Hwang. And while the proposed regulations that would eliminate the bottom-dollar guarantee have not yet been imposed, it may only be a matter of time.
“The IRS wants the guarantee to have a true economic meaning,” said Fred Berk, the head of the real estate practice for Friedman LLP. “By having a bottom-dollar guarantee, the actual risk of loss to the guarantor is very insignificant.”
“The way we finance REITs will have to be significantly changed in the future,” said Mr. Hwang, regarding what will occur if the regulations go unchanged and enforced.
But before anybody hits the panic button investors should know that a “seven-year grace period,” for investors who have already utilized the bottom-dollar guarantee will likely ease some of the quake from the regulations if they are enacted, he said.
Until the regulations are finalized, however, the exact impact remains to be seen.—with reporting by Max Gross