Real Estate Investment Trusts, or REITs, are the shiny new object in Regulation A. What is a REIT and what good are they?

REIT is just a tax concept. A REIT is an entity that is treated as a corporation for Federal income tax purposes and satisfies a long list of requirements listed in section 856 of the Internal Revenue Code. These requirements include:

• The kinds of assets it owns
• The kind of income it generates
• Who owns it
• How much of its income it distributes to its owners

Conversely a REIT is not a function of securities laws, contrary to what many people believe. Thus, many REITs have “gone public” by offering their securities in offerings that are registered under the Securities Act of 1933, while many other REITs are still private. Some “public” REITs have registered their shares on a national securities exchange, allowing the shares to be publicly traded, while the shares of other “public” REITs are traded privately. There are very large REITs and very small REITs, and everything in between. Some REITs invest in one class of real estate assets, others invest in completely different classes of real estate assets (e.g., only mortgages), and still others invest in multiple classes of real estate assets. The only thing all these companies have in common, being REITs, is that they all satisfy the requirement in section 856 of the Code.

A REIT may raise capital the same way any other company may raise capital. It may raise capital from accredited investors under Rule 506(c), or from accredited and non-accredited investors under Rule 506(b), or in a quasi-public offering under Regulation A, or in a fully-registered public offering, or in an intrastate offering, or in an offering under Rule 504.

A REIT may offer any kind of financial instrument to its investors:  common stock, preferred stock, straight debt, convertible debt, etc.

So if a REIT is just a tax label, rather than a securities label, why bother to use a REIT for real estate Crowdfunding? The answer is, again, just taxes.

If we’re going to create a fund of real estate assets, we have three choices:  a REIT; a corporation that is not a REIT; and a regular limited liability company or limited partnership. Here’s the logic:

• If we use a corporation that does not qualify as a REIT, it will be subject to tax on its income at the corporate level, and investors would then be subject to tax again when the corporation distributes its income, resulting in two levels of tax on the same income. Forget that.
• If we use a regular limited liability company or limited partnership, it will send each equity investor an IRS Form K-1 each year, reporting all of its categories of income, gains, deductions, and distributions.
• If we use a REIT, it will send each equity investor a simple IRS Form 1099.

Now, if all your investors are wealthy, sophisticated Republicans, they don’t care about receiving another K-1. But if you’re trying to market your fund to simple Democrats, it’s a different story. Say your typical simple Democrat can afford only a $1,000 investment, and a tax filing service charges $49.95 to add the K-1 to her Form 1040 (assuming she files a Form 1040). That’s a 5% annual cost of investing in your fund! A 1099, in contrast, is free.

That’s why we never saw REITs in Title II Crowdfunding, which allows only accredited investors to participate, while we’re seeing a lot of them in Title IV, which allows everyone. The REIT has to spend money complying with Code section 856, but has an easier time attracting non-accredited investors simply as a matter of tax reporting.

Finally, perceptive readers might ask “If REITs are corporations, why do I see REITs on the market with ‘LLC’ after their names?” The answer is that REITs don’t have to be corporations, they have to be taxed as corporations for Federal income tax purposes. A limited liability company that elects to be taxed as a corporation (yep, that’s possible) can qualify as a REIT.

PUBLISHED BY: MARK RODERICK