REIT Joint Ventures with Tax-Exempt Investors
[November/December, 2000]

by Howard Roth and Steve Adler

Although the Real Estate industry's fundamentals are strong, with rising rents, increasing occupancies and minimal new construction, the public equity market has yet to show great interest in real estate. Reasonably priced mortgage financing is available, but Wall Street permits lower leverage—approximately 50 percent—than real estate owners traditionally have sought—75–80 percent. In this capital restricted environment, joint venture structures, enhanced via Tax Code Section 704(c) tax strategies, are providing significant incentives for REITs and tax-exempt entities to create joint ventures to fuel growth.

Current Investment Strategies

Historically, tax-exempt entities would acquire properties outright and hire property and asset managers. This strategy maximizes the investor's operational control at the price of reduced portfolio liquidity and diversification. Also, the depreciation deductions on the real estate are wasted. Purchasing blocks of REIT stock overcomes these problems but gives the investor virtually no control over the real estate. A third investment strategy, forming a joint venture (JV) with a REIT, combines the economic advantages of real property and stock ownership and, additionally, can enable the REIT to receive a significant portion of the tax benefits from the real estate. However, only certain tax-exempt entities (generally pension trusts and educational institutions) are not taxed on income from leveraged real estate investments.

Advantages of Joint Ventures

As a JV partner, the tax-exempt entity can wield significant control or veto power over the operations, financing and disposition of the real estate. Additionally, the institution receives access to the REIT's property and asset management capabilities. An option to convert the institution's JV interest into REIT stock preserves the advantages of stock ownership. From the REIT's perspective, a JV with a tax-exempt investor is no different from any other partnership, except for certain tax rules that limit the JV's structure and financing options.

Leveraged real estate joint ventures with certain tax-exempt partners (generally pension trusts and educational institutions) must comply with certain stringent allocation rules to avoid tainting the exempt partners' otherwise tax-free income. Among other requirements, a tax-exempt investor cannot be allocated a percentage of joint venture income in excess of its lowest percentage share of joint venture loss in any year that it is a partner (investor's "fractions rule percentage"). This rule generally prohibits the allocation of disproportionately greater losses to taxable partners and, conversely, greater income to tax-exempt partners. The fractions rule must be satisfied both currently and prospectively.

The Code does contain several exceptions to the strict application of the fractions rule. Guaranteed payments and preferred returns are excluded from the test if they are calculated on unreturned capital and are commercially reasonable. Additionally, IRC Section 704(c) requires special allocations of built-in gains and depreciation with respect to contributed property. This provision offers REITs the ability to utilize tax benefits that are "hidden in plain sight." Reducing taxable income has become especially important as REITs seek to find ways to minimize required distributions and to retain gains from property sales.

Section 704(c) Enhances Two JV Strategies

The Section 704(c) rules effectively override the fractions rule. This is one instance when special allocations are not only permitted but are mandated for a JV with a tax-exempt investor. Under the rules, a tax-exempt investor can shift unusable tax benefits to a REIT. As the following examples illustrate, by effectively utilizing the various allocation methods permitted under IRC Section 704(c), a tax-exempt investor can become an exceptionally attractive capital source.

1) Tax-exempt Contributes Cash. The traditional method under Section 704(c) is appropriate when a tax-exempt investor (non-contributor) contributes cash and the REIT (contributor) contributes appreciated property. Because this method considers only the JV's actual tax depreciation deductions, the non-contributor may receive a tax deduction that is less than its full amount of book depreciation. Any such deduction shortfall is called the "ceiling rule." Unlike the other 704(c) methods, a portion of the built-in gain on the property is shifted, tax-free, to the non-contributor.

A tax-exempt entity contributes $200 cash and a REIT contributes real property (10 year remaining depreciable life) with a fair market value of $200 and tax basis of $50. The partners are each 50 percent owners. Each year, under the traditional method, each partner would be allocated $10 of book depreciation and the non-contributor would receive the entire $5 of the available tax depreciation. The ceiling rule limits the allocation of deductions to the non-contributor to those available for tax depreciation. Consequently, over the remaining life of the property, the contributor's $150 built-in gain will amortize by $15 per year ($20 book depreciation less $5 tax depreciation) and 50 percent of the amortized gain will be allocated to the non-contributor upon sale of the property. Because the contributor "pays" only $2.50 per year in foregone tax depreciation for a $7.50 reduction in its share of allocable gain on sale, the built-in gain will shift to the non-contributor at the rate of $5 per year. Assuming the property is sold after 10 years for $200, the entire gain would be split equally—$100 per partner. Effectively, the contributor gave up $25 of depreciation deductions (the difference between 50 percent and 100 percent of the tax depreciation) and shifted $50 of gain to the non- contributor.

If both partners were taxable, then the choice of 704(c) method would be subject to arm's-length negotiations, since the non-contributor would object to the reduced depreciation and additional gain allocations.

2) Tax-exempt Contributes Property. Assume the same facts as in the previous example except that a) the tax-exempt partner is the property contributor; b) the REIT is the cash contributor; and c) the JV elects the traditional method with curative allocations (curative method) under 704(c). To "cure" the ceiling rule, the non-contributor would be allocated other tax deductions to equal the total amount of deductions "owed" to it. Each partner would be allocated $10 of book depreciation, and the non-contributor would receive the $5 of available tax depreciation plus $5 of other tax deductions that would otherwise have gone to the contributor. (The remedial method under 704(c) would produce generally similar results for the REIT.)

The non-contributor is allocated all of the available tax depreciation (up to its share of book depreciation) and then receives other deductions (e.g., interest expense, operating expenses, property taxes) to make up any shortfall due to the ceiling rule. Additionally, the curative method does not shift built-in gain to the non-contributor. Thus, a tax-exempt partner contributes property with large built-in gains, the curative method maximizes the REIT's tax benefits without any offsetting cost to the tax- exempt contributor.

Control and Liquidity

REITs are seeking out new capital sources to fund growth. JVs offer the tax-exempt investor a unique combination of control and liquidity. A tax-exempt investor's ability to absorb taxable income combined with a REIT's need to minimize its required distributions offers more planning "bang for the buck." Additionally, the special allocations allowable under IRC Section 704(c) can provide tax benefits to the REIT with no offsetting detriment to the tax-exempt partner. This creates a symbiotic relationship between the REIT and the tax-exempt investor and makes the JV an even more attractive vehicle to raise capital.