NAREIT: Policy and Politics - Government Relations: General Real Estate Issues - Private Parts: Potential Pitfalls For Private REITs

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Private Parts: Potential Pitfalls For Private REITs
(April 28, 1998)

By: Tony M. Edwards
NAREIT Senior Vice President and General Counsel
and Margaret C. Jaffe
NAREIT Associate Counsel

Introduction

REITs that are not registered with the Securities and Exchange Commission ("SEC") or traded on national exchanges can serve many useful purposes. Perhaps the best examples showing how these private REITs carry out Congress' intent to make real estate investment accessible to the small investor are the so-called "incubator REITs." In essence, these REITs are venture capital companies in which a few shareholders provide the "seed capital" to new companies to develop a business plan and track record. These private REITs usually intend to provide their investors with liquidity and access to a greater pool of capital by listing their shares on a national stock exchange, at which point they become available to all investors.1 Public REITs also might invest in private REITs as joint ventures or for state and local tax planning purposes.

REIT Tax Tests

The Internal Revenue Code does not require a REIT to be registered with the SEC or publicly listed on a stock exchange. Instead, Congress has designed two tests to ensure that a REIT is widely held. First, after a REIT's first taxable year, five or fewer individuals may not own more than 50 percent of the value of a REIT's stock during the last half of the REIT's taxable year.2 Second, at least 100 "persons" must own REIT stock, again starting after the REIT's first taxable year.3

The Administration's proposed budget for Fiscal Year 1999, which was released on February 3, 1998, would add a new requirement under which no entity could own more than 50 percent of the vote or value of a REIT's stock. While supporting the Administration's desire to bolster the widely held rules to prevent any misuse of the REIT vehicle, NAREIT believes that any new rules should not unnecessarily restrict incubator REITs or the ability of a REIT to invest in another REIT.

Distributing Stock of Private REITs to Sponsor Employees

To satisfy the "100 person" test, sponsors of private REITs may transfer REIT stock to 100 individuals at prices or values less than the stock sold to the majority owners. For example, one class of stock could be sold at $100,000 per share to institutional investors while another class of stock worth $1,000 per share could be transferred to individuals. Since REIT shares are securities, the sponsor must comply with the applicable securities laws in transferring these shares.

To avoid registering REIT shares with the SEC and to avoid so-called "Blue Sky" registration at the state level, a sponsor of a private REIT must fall within an exemption to the registration regime. One exemption is to comply with the so-called "private placement" rules.4 To qualify as a good private placement, an offering must involve only "accredited investors" or up to 35 other sophisticated purchasers, certain information must be made available to these investors, there may be no general solicitation or advertising, and the securities sold must be subject to transfer restrictions.

A private REIT may choose to utilize the exemption in Rule 701 under the Securities Act of 1933 for offers and sales of securities pursuant to certain compensatory benefit plans or written compensation agreements by issuers not subject to the reporting requirements of the Securities Exchange Act of 1934. Adopted by the SEC in 1988, Rule 701 provides a registration exemption for offers and sales of securities to employees, directors, trustees, officers, consultants or advisors of up to $5 million per year. Importantly, these transactions constitute offers and sales and thus are subject to the anti-fraud provisions of the securities laws. Although there is no requirement in Rule 701 to deliver a specific disclosure document to buyers other than a copy of the relevant compensation plan or agreement, many companies prepare an offering document to provide information to employee investors.5

A recent SEC ruling gave the green light to another exception available to sponsors of private REITs. Keystone Financial Corporation ("Keystone") created a private REIT to "implement state tax planning."6 Keystone or its affiliates planned to own substantially all of the REIT's stock, but needed 100 stockholders to satisfy the REIT widely held test. Keystone distributed non-voting preferred stock shares of the private REIT as a bonus to between 100 and 200 employees of the Keystone affiliated group holding the position of vice president or higher. The Keystone employees presumably recognized income in the amount of the value of the REIT shares ($1,000 par value per share) they received, but they paid nothing for them. With some limited exceptions, the REIT stock received by the Keystone employees could not be transferred. Instead, the shares had to be redeemed by the REIT.7

In response to Keystone's request, the SEC issued a "no-action letter" concluding that the distribution of the private REIT's stock was not a "sale" of securities because of SEC authority excepting broad-based, noncontributory, involuntary stock bonus plans from registration requirements. This ruling provides additional flexibility to REIT sponsors, who could find it difficult to locate a sufficient number of accredited investors who would be willing to purchase or otherwise acquire the private REIT shares.

The Plot Thickens: Who Is A "Person" Under the REIT Rules?

A major reason to provide private REIT shares to a sponsor's employees is to satisfy the "100 person" tax test. However, a recent SEC regulation casts doubt on whether this technique remains effective.

Remember that Congress modeled the REIT rules after the mutual fund tests. 8 As part of this paradigm, any term not specifically defined in the part of the Code dealing with REITs is defined by reference to its meaning under the Investment Company Act of 1940, which regulates most mutual funds.9 Examples of the IRS referring to the 1940 Act include defining "government securities" and "voting securities."10

The many rules and regulations applicable to mutual funds only apply to investment companies that have 100 or more "persons" as investors.11 The National Securities Markets Improvement Act of 1996 (the "Act") directed the SEC to adopt rules permitting "knowledgeable employees" of a privately offered mutual fund to invest in the fund without causing it to have more than 100 investors. The Act also called for the SEC to adopt rules to help privately offered investment companies that found that they were falling under the 1940 Act rules due to transfers by existing investors rather than sales to new investors, e.g., gifts, bequests or transfers caused by divorce.

Accordingly, in an action designed to provide private investment funds with added flexibility, the SEC issued a final Rule (effective on June 9, 1997)12 stating that certain fund employees13 who receive fund shares from the sponsor without consideration are ignored for purposes of the 100 person rule.14 At the same time, the SEC adopted new Rule 3c-6 providing that a transferee receiving shares by gift, bequest or other involuntary transfer from a transferor other than the issuer is not considered a "person" for the 100 person test. Instead, the transferor is considered to be the beneficial owner. Thus, if a parent gifts shares in an investment fund to his or her children, the parent and donees are considered one "person" for purposes of counting to the magic 100 person threshold. Again, the SEC tried to be helpful to private funds by not triggering unnecessarily the 1940 Act and its concomitant regulation and registration burdens.

However, combining the fact pattern in the Keystone no-action letter and the new SEC Rules raises the possibility that the sponsor employees receiving REIT shares may be ignored in counting towards the 100 person level required by the Internal Revenue Code after the REIT's first year. Similarly, executive employees receiving shares pursuant to a Rule 701 benefit plan might not be counted under the 100 person test. Although it is possible that a court could conclude that the 1940 Act interpretation of "100 persons" is not determinative of the parallel REIT tax test, sponsors may wish to consider selling the shares of private REITs instead of giving them away. 15 Of course, such sales must satisfy the applicable securities laws, and perhaps the best methods of doing so would be to sell the shares to accredited investors in a private placement.

Conclusion

Private REITs continue to provide an important role in providing accessible investments in real estate. Private REIT sponsors need to pay attention to new tax and securities laws developments to be certain that they do not fall into a trap for the unwary.

1 Examples of incubator REITs that have "gone public" are Alexandria Real Estate Equities, Inc., AMB Property Corp., Annaly Mortgage Management, Inc., Cornerstone Realty Income Trust, Great Lakes REIT, Inc., Roberts Realty Investors, Inc., Security Capital Industrial Trust and Westfield America, Inc.
2 I.R.C. Sec. 856(a)(6) and (h).
3 I.R.C. Sec. 856(a)(5).
4 Section 4(2) of the Securities Act of 1933 and Regulation D thereunder
5 The SEC recently proposed to amend Rule 701 to require that financial statements and risk factors information be furnished to employees prior to any offer or sale and to simplify and streamline the current volume limits in the Rule. See SEC Release No. 33-7511.
6 Keystone Financial Corp., SEC No-Action Letter (October 1, 1997).
7 It is not clear whether this transferability restriction falls under the exception provided in the regulations allowing a REIT to restrict transferability of shares to prevent the loss of REIT status. See Treas. Reg. Sec. 1.856-1(d)(2).
8 H.R. Rep. No. 2020, 86th Cong., 2d Sess. 3-4 (1960).
9 I.R.C. Sec. 856(c)(5)(F), citing 15 U.S.C.¤ 80a-1 and following. Note that the Internal Revenue Code defines "person" to "mean and include an individual, a trust, estate, partnership, association, company or corporation." I.R.C. Sec. 7701(1).
10 See Rev. Rul. 77-342, 1977-2 C.B. 238 and PLR 9428033.
11 Section 3(c)(1) of the Investment Company Act, 15 USC Sec. 80a.
12 Investment Company Act Rule 3c-5.
13 Rule 3c-5 relates to "an "Executive Officer," meaning the president, any vice president in charge of a principal business unit, division or function (such as sales, administration or finance) or any other officer or person who performs a policy-making function and who has provided such services for at least 12 months.
14 SEC Release No. IC-22597 (1997).
15 Some sponsors gift shares of private REITs to charities. It appears that the same analysis as described in the text of this article would apply to such gifts. Following a gift of REIT shares from the sponsor (but not the REIT) to charities, the sponsor, not the donees, would be considered the beneficial owner for purposes of the 100 person exclusion. Investment Company Act Rule 3c-6(b)(2).