Real Estate Contributions to REITs Tax, Legal and Securities Laws Considerations

Real Estate Contributions to REITs Tax, Legal and Securities Laws Considerations Stephanie Smith, USDA, Washington DC Theodore Grannatt, McCarter English, Boston, MA Christopher Roman, Fried Frank, NY, NY Andrea M. Whiteway, EY, Washington, D.C. 2016 RPTE Spring Symposia Boston, MA Andrea M. Whiteway. Copyright 2016. 1

Discussion Points Brief Overview of the Tax Consequences of Real Estate Dispositions Overview of the UpREIT Structure Tax Aspects of Real Estate Contributions to Partnerships / Tax Protection Agreements Legal Aspects of Real Estate Contributions to REITs Securities Laws Aspects of REIT Contributions Andrea M. Whiteway. Copyright 2016. 2

$ in billions # of REITs The Rise of the REITS REIT market capitalization 1971 2014 $1,000 250 $900 $800 200 $700 $600 150 $500 $400 100 $300 $200 50 $100 $- 0 Market Capitalization ($ in bln) # of REITS Andrea M. Whiteway. Copyright 2016. 3

$ in millions # of Issuances The Rise of the REITS REIT issuance 2000 2015 YTD REITs have become an important investment class Record breaking amounts of capital raised by REITs in 2012 and 2013 $90,000 $80,000 $70,000 300 250 Capital raised in 2014 saw a 17.3% decrease but was still far above all historical levels, excluding 2012 and 2013 2015 is on track to be another record breaking year in January and February alone, there have been 35 offerings for a total amount of $15.8 bln That is far greater than the amount offered during the same period of 2013 (record high year), and greater than the amount offered in the entire first quarter of 2014 $60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $- Capital Raised ($ in mm) # of Equity Offerings 200 150 100 50 0 Andrea M. Whiteway. Copyright 2016. 4

What is a REIT? CORPORATION, TRUST OR ASSOCIATION OTHERWISE TAXABLE AS C CORPORATION MUST MEET REQUIREMENTS OF SECTION 856 AND ELECT REIT STATUS NOT SUBJECT TO CORPORATE TAX TO EXTENT INCOME IS DISTRIBUTED TO SHAREHOLDERS Andrea M. Whiteway. Copyright 2016. 5

What is an UPREIT? UMBRELLA PARTNERSHIP REIT SUBSTANTIALLY ALL ASSETS ARE OWNED THROUGH OPERATING PARTNERSHIP IN WHICH REIT IS GENERAL PARTNER OP UNITS HELD BY LIMITED PARTNERS ARE CONVERTIBLE INTO REIT STOCK Andrea M. Whiteway. Copyright 2016. 6

Transfer to REIT EXCEPT AS SPECIFICALLY MODIFIED BY REIT RULES, SUBCHAPTER C APPLIES SECTION 351(a) GENERALLY PROVIDES FOR NONRECOGNITION TREATMENT ON TRANSFERS TO CORPORATION BUT SECTION 351(e) EXCEPTION FOR INVESTMENT COMPANIES Andrea M. Whiteway. Copyright 2016. 10

Transfer to REIT INVESTMENT COMPANY IF 80% OF ASSETS STOCKS AND SECURITIES AND TRANSFER RESULTS IN DIVERSIFICATION STOCKS AND SECURITIES BROADLY DEFINED UNDER 97 ACT REGULATIONS SAY REIT IS PER SE INVESTMENT COMPANY Andrea M. Whiteway. Copyright 2016. 11

Transfer to REIT DIVERSIFICATION RESULTS IF ONE PERSON TRANSFERS CASH AND ANOTHER TRANSFERS REAL ESTATE REGULATORY EXCEPTION FOR TRANSFERS OF DIVERSIFIED PORTFOLIOS OF SECURITIES Andrea M. Whiteway. Copyright 2016. 12

Transfer to REIT SECTIONS 351(a) AND 368(c) REQUIRE TRANSFERORS TO OWN 80% OF VOTING STOCK IMMEDIATELY AFTER TRANSFER NOT A PROBLEM FOR IPO TRANSACTION, BUT FOR SUBSEQUENT PROPERTY ACQUISITIONS Andrea M. Whiteway. Copyright 2016. 14

Transfer to REIT SECTION 357(c) REQUIRES GAIN RECOGNITION TO EXTENT OF DEBT IN EXCESS OF BASIS SECTION 856(h) PROHIBITS 5 OR FEWER INDIVIDUALS FROM OWNING 50% OR MORE OF REIT Andrea M. Whiteway. Copyright 2016. 15

UPREIT Structure MONEY RAISED IN IPO IS USED TO PAY DOWN DEBT AND/OR FOR ACQUISITIONS OP UNITS ARE CONVERTIBLE INTO STOCK OF PUBLICLY TRADED REIT OR CASH AT REIT S OPTION AVOIDS SECTION 351(e), 368(c), 357(c) AND 856(h) PROBLEMS Andrea M. Whiteway. Copyright 2016. 17

Partnership Anti-Abuse Regulation If a partnership is formed or availed of in connection with a transaction a principal purpose of which is to reduce substantially the present value of the partners aggregate federal tax liability in a manner that is inconsistent with the intent of Subchapter K, Then the Commissioner can recast the transaction as appropriate. Andrea M. Whiteway. Copyright 2016. 18

Partnership Anti-Abuse Regulation EXAMPLE 4 DESCRIBES AN UPREIT TRANSACTION AND BLESSES IT WHILE THERE ARE DIFFERENCES BETWEEN EXAMPLE 4 AND THE TYPICAL UPREIT STRUCTURE, GIVEN THE NUMBER OF DEALS, CHALLENGE IS UNLIKELY Andrea M. Whiteway. Copyright 2016. 19

Conversion Right OP UNITHOLDER IS PERMITTED TO EXCHANGE ONE OP UNIT FOR ONE SHARE OF REIT STOCK REIT MUST HAVE ELECTION TO PAY CASH TO AVOID OPTION ATTRIBUTION RECEIPT OF CONVERSION RIGHT AS BOOT? SEE REV. RUL. 69-265 Andrea M. Whiteway. Copyright 2016. 20

Conversion Right CONVERSION RIGHT PROVIDES LIQUIDITY EXERCISE OF CONVERSION RIGHT WITHIN 2 YEARS MAY TRIGGER DISGUISED SALE TREATMENT IF STOCK OR CASH COMES FROM OP Andrea M. Whiteway. Copyright 2016. 21

Section 704(c) SECTION 704(c) APPLIES TO PROPERTY CONTRIBUTED TO OP BUILT-IN GAIN ON PROPERTY WILL BE ALLOCATED BACK TO CONTRIBUTING PARTNER ON SALE DEPRECIATION WILL BE ALLOCATED AWAY FROM CONTRIBUTING PARTNER Andrea M. Whiteway. Copyright 2016. 24

Example CONTRIBUTED PROPERTY HAS $100 VALUE, $30 BASIS, 10-YEAR REMAINING LIFE, 39- YEAR NEW LIFE; GETS 1% OP INTEREST INCOME TO CONTRIBUTOR DEDUCTION TO REIT TRADITIONAL $0 ($3) CURATIVE $6.90 ($9.90) REMEDIAL $1.75 ($4.75) Andrea M. Whiteway. Copyright 2016. 28

Encumbered Property CASH DISTRIBUTIONS IN EXCESS OF BASIS IN PARTNERSHIP ARE TAXABLE REDUCTION IN SHARE OF LIABILITIES TREATED AS CASH DISTRIBUTION IF LIABILITIES IN EXCESS OF BASIS, MUST MAINTAIN SHARE OF LIABILITIES EQUAL TO NEGATIVE CAPITAL ACCOUNT Andrea M. Whiteway. Copyright 2016. 29

Encumbered Property EXAMPLE: CONTRIBUTE PROPERTY WITH BASIS OF $40, SUBJECT TO DEBT OF $100 BASIS IN PARTNERSHIP IS $40, REDUCED BY DEEMED DISTRIBUTION FROM DEBT SHIFT FOR DEEMED DISTRIBUTION NOT TO EXCEED $40, MUST KEEP AT LEAST $60 OF DEBT (= TO NEGATIVE CAPITAL ACCOUNT) Andrea M. Whiteway. Copyright 2016. 30

Nonrecourse Debt ON CONTRIBUTION OF PROPERTY SUBJECT TO NONRECOURSE DEBT, PARTNER WILL ALWAYS KEEP ENOUGH DEBT PROBLEM IS PAYDOWN, CROSS- COLLATERALIZATION, REFINANCING, ETC. Andrea M. Whiteway. Copyright 2016. 34

Bottom Guarantee EXAMPLE: PROPERTY HAS VALUE OF $100, IS SUBJECT TO NONRECOURSE DEBT OF $60 TAXPAYER GUARANTEES THE BOTTOM $20 TAXPAYER ONLY LIABLE IF PROPERTY DECLINES IN VALUE TO LESS THAN $20 Andrea M. Whiteway. Copyright 2016. 36

Indemnity GUARANTEE OF RECOURSE DEBT WILL NOT SHIFT IT -- SEE REG. SEC. 1.752-2(f) EXAMPLE 3 INDEMNITY OF GENERAL PARTNER (OR DRO AND LOSS ALLOCATION) IS REQUIRED TO SHIFT RECOURSE DEBT Andrea M. Whiteway. Copyright 2016. 38

Term of Guarantee/Indemnity TERMINATION UPON CONVERSION OF OP UNITS INTO STOCK MAY BE PROBLEMATIC TERM OF YEARS, WITH EXTENSION TERMS APPRAISAL OF PROPERTY AT EXPIRATION? Andrea M. Whiteway. Copyright 2016. 39

At-Risk Problems SEC. 465(a) LIMITS LOSSES OF INDIVIDUALS AND CLOSELY HELD C CORPS TO AMOUNT AT RISK AT RISK RULES EXTENDED TO REAL ESTATE IN MODIFIED FORM IN 1986 Andrea M. Whiteway. Copyright 2016. 40

At-Risk Problems UNDER SEC. 465(e), IF AMOUNT AT-RISK REDUCED BELOW $0 AT YEAR END, PRIOR LOSSES RECAPTURED GUARANTEE SHOULD CREATE AMOUNT AT RISK, BUT DOES IT? SEE PROP. REG. SEC. 1.465-6(d); ABRAMSON, 86 T.C. 360 (1986) Andrea M. Whiteway. Copyright 2016. 41

At-Risk Problems QUALIFIED NONRECOURSE FINANCING TREATED AS AT RISK FOR REAL ESTATE QNF MUST BE BORROWED FROM QUALIFIED PERSON OR GOVERNMENT, BE SECURED BY PROPERTY Andrea M. Whiteway. Copyright 2016. 43

At-Risk Problems QUALIFIED PERSON MUST BE ACTIVELY AND REGULARLY ENGAGED IN BUSINESS OF LENDING MONEY DOES PUBLICLY OFFERED DEBT QUALIFY? DOES EXCULPATORY (UNSECURED) DEBT QUALIFY? Andrea M. Whiteway. Copyright 2016. 44

At-Risk Problems FINAL QNF REGS ON LIMITED QUESTIONS ISSUED AUGUST 4, 1998 ALLOW EXCULPATORY DEBT; DISREGARD PERSONAL LIABILITY OF REAL ESTATE PARTNERSHIPS PLRS 9815001 AND 9815022 -- EXCULPATORY (UNSECURED) DEBT QUALIFIES; DISREGARD STEP-TRANSACTION DOCTRINE WHERE UNDERWRITER RE-SELLS DEBT Andrea M. Whiteway. Copyright 2016. 45

Marketable Securities UNDER SEC. 731(c), DISTRIBUTIONS OF MARKETABLE SECURITIES ARE TREATED LIKE CASH OP UNITS MAY CONSTITUTE MARKETABLE SECURITIES BECAUSE OF CONVERSION RIGHT Andrea M. Whiteway. Copyright 2016. 46

Marketable Securities IF PROPERTY PARTNERSHIP DISTRIBUTES OP UNITS PRO RATA, AND NO INSIDE/OUTSIDE BASIS DIFFERENCE, NO GAIN SHOULD BE RECOGNIZED EXCEPTION SHOULD ALSO APPLY TO NON PRO RATA DISTRIBUTION OF OP UNITS BY PROPERTY PARTNERSHIP WITHIN 5 YEARS OF RECEIPT Andrea M. Whiteway. Copyright 2016. 47

Protecting Deferral SALE OF CONTRIBUTED PROPERTY WILL TRIGGER GAIN UNDER SEC. 704(c) PAYDOWN OF DEBT, REFINANCING, CROSS- COLLATERALIZATION, ETC. CAN ALSO TRIGGER GAIN AS GP, THESE EVENTS ARE GENERALLY WITHIN REIT S CONTROL Andrea M. Whiteway. Copyright 2016. 48

Lock-outs REIT AND CONTRIBUTING PARTNER OFTEN AGREE TO A LOCK-OUT PERIOD DURING WHICH OP CANNOT SELL, REFINANCE, ETC. TYPICAL LOCK-OUT PERIOD IS 5 TO 15 YEARS LOCK-OUT UNTIL DEATH? Andrea M. Whiteway. Copyright 2016. 49

Make-Whole Payment UPON PROHIBITED EVENT PRIOR TO LOCK- OUT EXPIRATION, REIT GENERALLY MUST MAKE MAKE-WHOLE PAYMENT PAYMENT MAY BE 100% OF TAX, OR ONLY COMPENSATE FOR PRESENT VALUE HARM FORMULA ISSUES -- GROSS-UP, ACTUAL VS. HYPOTHETICAL TAX, DISCOUNT RATE, ETC. Andrea M. Whiteway. Copyright 2016. 50

Carve-Outs REIT MAY NEGOTIATE FOR CARVE-OUTS FOR INVOLUNTARY EVENTS -- FORECLOSURE, CONDEMNATION, ETC. CARVE-OUT FOR SEC. 1031 EXCHANGES SHARE-THE-PAIN PROVISIONS; RATING AGENCY CONCERNS Andrea M. Whiteway. Copyright 2016. 51

Additional Protections SEC.1031 LIKE-KIND EXCHANGE AND SEC. 1033 INVOLUNTARY CONVERSION BEST EFFORTS UNDERTAKINGS AFTER LOCK- OUT RIGHT OF FIRST OFFER USING OP UNITS AS CURRENCY AFTER LOCK-OUT Andrea M. Whiteway. Copyright 2016. 52

Going Private Issues WILL OP UNIT HOLDERS BE FORCED TO ACCEPT CASH, TRIGGERING GAIN? IF NOT, HOW WILL LIQUIDITY BE ENSURED AFTER ENTITY IS NO LONGER PUBLICLY TRADED? WHAT DISTRIBUTIONS WILL OP UNIT HOLDERS GET GOING FORWARD NO LONGER TIED TO COMMON DIVIDEND Andrea M. Whiteway. Copyright 2016. 54

Going Private Issues OP UNITHOLDER WISH LIST: RIGHT TO RECEIVE SAME CASH AS SHAREHOLDERS RIGHT TO HOLD OP UNITS TO AVOID TRIGGERING GAIN RIGHT TO CONTINUED LOCK-OUT, DEBT AND INDEMNITY PROTECTION Andrea M. Whiteway. Copyright 2016. 55

Extracting Cash WHERE TARGET PROPERTY IS OWNED BY PARTNERSHIP, SOME PARTNERS MAY WANT OP UNITS AND OTHERS CASH PARTNERS IN PROPERTY PARTNERSHIP WHO ARE NOT ACCREDITED MUST RECEIVE CASH UNDER SEC RULES Andrea M. Whiteway. Copyright 2016. 57

Extracting Cash TRANSFERRING THE PROPERTY TO THE OP FOR OP UNITS AND CASH WILL TRIGGER A PORTION OF THE TAXABLE GAIN PARTNERS WILL WANT TO SPECIALLY ALLOCATE TAXABLE GAIN TO PARTNERS RECEIVING CASH Andrea M. Whiteway. Copyright 2016. 58

Extracting Cash IF PROPERTY PARTNERSHIP IS LIQUIDATED OR THERE IS A BOOK-UP, THE ALLOCATION MAY FAIL SUBSTANTIALITY SALE OF PARTNERSHIP INTERESTS MAY BE RECAST UNDER MERGER RULES REG. SEC. 1.708-1(c)(4) ALLOWS PARTNER WHO GETS THE CASH TO RECOGNIZE ALL THE GAIN Andrea M. Whiteway. Copyright 2016. 59

Extracting Cash GENERALLY, IF PROPERTY OWNER RECEIVES CASH AND OP UNITS, GAIN WILL BE TRIGGERED UNDER DISGUISED SALE RULES HOWEVER, TECHNIQUES EXIST TO AVOID DISGUISED SALE TREATMENT Andrea M. Whiteway. Copyright 2016. 60

Preferred Unit Deals POPULAR WHEN REIT COMMON STOCK PRICES NOT DOING WELL PREFERRED OP UNITS ENTITLED TO PRIORITY DISTRIBUTIONS FROM OPERATIONS AND ON LIQUIDATION Andrea M. Whiteway. Copyright 2016. 63

Preferred Unit Deals REIT MAY HAVE OVERRIDE TO GET DISTRIBUTIONS NEEDED TO RETAIN REIT STATUS MAY BE CONVERTIBLE INTO PREFERRED STOCK WITH SIMILAR RIGHTS OR INTO COMMON OP UNITS AND THEN COMMON STOCK Andrea M. Whiteway. Copyright 2016. 64

Preferred Unit Deals TO EXTENT NOT CONVERTED, MANDATORILY REDEEMABLE AFTER 5 TO 7 YEARS (TYPICALLY) CONVERTIBILITY INTO COMMON UNITS GIVES UPSIDE KICKER VALUABLE UNDER BLACK-SCHOLES MODEL Andrea M. Whiteway. Copyright 2016. 65

Preferred Unit Deals CONVERSION INTO COMMON UNITS SHOULD NOT TRIGGER ADVERSE TAX CONSEQUENCES SEE PROPOSED REGULATIONS ON NONCOMPENSATORY PARTNERSHIP OPTIONS PARTNERSHIP SWAP FUNDS ALSO BUYING NONCONVERTIBLE PREFERRED UNITS FOR CASH Andrea M. Whiteway. Copyright 2016. 66

Preferred Unit Deals DISGUISED SALE ISSUES 150% OF AFR SAFE HARBOR FOR PREFERRED RETURNS MANDATORY REDEMPTION FEATURE GROSS VS. NET INCOME ALLOCATIONS EFFECT OF CONVERTIBILITY Andrea M. Whiteway. Copyright 2016. 67

DOWNREIT Terms LPs GET NUMBER OF UNITS EQUAL TO PROPERTY VALUE DIVIDED BY STOCK PRICE EACH UNIT GETS PREFERRED RETURN EQUAL TO DIVIDEND ON SHARE OF STOCK EACH UNIT CONVERTIBLE INTO ONE SHARE OF STOCK Andrea M. Whiteway. Copyright 2016. 69