SEC Targets Use of REIT Structures in Funds

A new ruling could force GPs to issue audited financial statements to all shareholders of REITs used within private funds for tax purposes.

Real estate investment managers are rushing to comply with a new Securities and Exchange Commission requirement that could upend a long-standing practice of using real estate investment trust (REIT) structures within private funds for tax purposes.

The move that could force GPs to issue audited financial statements to all shareholders of REITs used within private funds follows an SEC audit of one real estate GP in late 2014.

Typically, GPs use REITs to help mitigate tax and reporting issues for institutional investors. Under federal law, REITs require a minimum of 100 shareholders, with the fund typically being one shareholder and the remaining 99 “accommodation” shareholders provided by third-party vendors. The accommodation shareholders get a preferred return paid to them but have no economic interest in the performance of the REIT subsidiary.

However, during the 2014 SEC audit, conducted by the commission’s Philadelphia field office, a deficiency letter was issued to the GP requiring that audited financial statements be sent to all REIT accommodation shareholders.

The issue, which relates to the application of the custody rule to special-purpose vehicles and pass-through entities under the Dodd-Frank Act, was first highlighted by Beacon Capital Partners’ chief compliance officer, Doug Cornelius, on his blog post “Compliance Bricks and Mortar” in December 2014. In January, he revealed that the GP in question had fought the deficiency letter “through several rounds, [but] ultimately…decided to cede to the SEC’s position.”

Sources tell PrivcapRE that fund compliance officials, general counsels, and legal advisors are now working feverishly to ensure compliance with the deficiency letter interpretation. Audited financial statements are expensive, and the cost of preparing them could prompt the industry to try to find a new of form of REIT to help with structuring purposes or to absorb some of the additional costs of reporting.

Industry sources repeatedly declined to speak on the record about the matter due to concerns about attracting SEC attention. Six major law firms specializing in the practice either declined to comment or failed to respond to requests for comment, and real estate CFOs and compliance officers also refused to comment publicly.

In his post from January, Cornelius says: “I don’t have the details on how [the GP in question] used REITs in its structure. The deficiency [letter] jumps right into the position that the REITs are advisory clients.

“But [the deficiency ruling] also makes an overly broad statement: ‘This guidance indicates that registrant must distribute the audited financial statements of all pass-through entities or special-purpose vehicles that are controlled by registrant or a related person and have outside investors to each such entity’s beneficial owners.’ That is not what the custody rule requires and it is not what the guidance on the custody rule requires.”

Cornelius’ blog post notes that the deficiency letter argues compliance with the custody rule “can only be achieved through providing audited financial statements.” Other avenues exist, he writes, such as the “standard custody rule method of having information sent directly to investors by a third-party custodian and a surprise exam.”

But for now, sources say, most lawyers and compliance officers have interpreted the letter to say they must provide audited financial statements to their accommodation shareholders. “Everybody in the industry is feeling it, everybody who’s an investment advisor and has private REITs in their structures,” says one advisor.