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Audits of REITs Increasing

08/26/2011 | By Carisa Chappell

The economic climate and increased tax audits are among the factors that have had an impact on how REITs do business lately, according to Jennifer Weiss, partner at the law firm Alston & Bird LLP who specializes in REIT taxation issues.

In a recent interview with REIT.com, Weiss talked about tax reform, possible changes in the commercial mortgage-backed securities (CMBS) market and some of the issues facing non-traded REITs.

What would you say are the most pressing tax-related issues today for REITs?

Because of the economic climate, many REITs are contracting their portfolios, selling under-performing properties and/or refining their business strategies. Although I generally view property sales made under such circumstances as not being subject to a "prohibited transaction" tax, there is always some level of concern, given the punitive nature of the tax, and this creates tension between the business needs of the company and the potential tax issues.

We are also seeing—and anecdotally have heard about—an increased level of audit activity with respect to REITs, which raises sensitivities even further, both in the prohibited transaction area and with respect to other areas. This is particularly in connection with taxable REIT subsidiary (TRS) activities—often focusing on issues that tax practitioners have not previously been concerned about. This is causing management, in some cases, to make decisions to not use their TRSs in permissible strategic activities simply to avoid audit risks.

Obviously, there has been a lot of talk lately about tax reform. Does this have any implications for REITs?

Well, until we see the detail, that's hard to predict. But as the REIT legislation was originally enacted to allow smaller investors to invest their capital in diversified portfolios of real property, which otherwise would not be accessible, and this has proved to be very successful, both from the perspective of those investors and the real estate industry, I would not anticipate significant changes with respect to the favorable tax treatment currently permitted to REITs.

Have there been any developments in the area of commercial mortgage-backed securities (CMBS) that you are keeping an eye on?

Certainly the volatility in credit markets has affected the commercial real estate sector across the board, and many lenders have generally been sitting on the sidelines, although this situation had improved during the first half of 2011. The current fluctuations in rates have caused lenders that were previously engaged in commercial mortgage-backed securities transactions to retrench, which can ultimately impact their willingness to provide credit and negatively impact a recovery in the real estate market. This is something to watch over the next several months.

You represent both publicly traded REITs and non-traded REITs. Are there any legal issues specific to the non-traded side that is receiving greater scrutiny or attention?

The non-listed REITs are receiving increased scrutiny from FINRA, primarily related to the sales practices used by the broker-dealers who sell them and whether they are appropriately determining that the investments are suitable for their clients due to their generally illiquid nature. Broker-dealers are also facing scrutiny because they are not looking behind the valuations published by the REITs to determine if they are reasonable.

The SEC is scrutinizing valuations as well. In particular, after a non-listed REIT completes its offering period and publishes a valuation, the SEC wants more disclosure about the assumptions and other factors used to support the valuation, and the valuations need to be updated at least every 18 months, but there is little guidance as to how the valuations should be implemented. While we view the increased disclosure and transparency as to valuations as good for the industry overall, the transition is creating some uncertainties.