Since the passage of the Tax Cuts and Jobs Act (TCJA) in 2017, Real Estate Investment Trusts have emerged as a dominant capital structuring tool for private lending operations. Fund managers across the country have adopted REIT conversions to unlock meaningful tax advantages for their investors. But with the Section 199A deduction facing a potential sunset at the end of 2025, private lenders must now reassess whether REITs remain a sound strategic choice — and what alternatives may exist if the legislative landscape shifts.
What Is a REIT in the Context of Private Lending?
A Real Estate Investment Trust, despite its name, is not a trust at all. It is a standard business entity — an LLC, corporation, or limited partnership — that elects to be treated as a REIT under the Internal Revenue Code. In the private lending world, this election is typically layered onto an existing debt fund structure.
The most common approach involves establishing a subsidiary REIT beneath an existing fund. The parent fund maintains its standard LP/GP or LLC/manager structure, while the subsidiary entity holds the loan portfolio and makes the REIT election. This subsidiary then dividends all of its income up to the parent fund, which distributes to investors according to the existing waterfall.
This subsidiary REIT model has become the industry standard for several important reasons:
- Minimal disruption to existing investors. There is no need for an investor vote or amendment to fund documents.
- Reduced risk of corporate-level taxation. Because the subsidiary dividends 100% of its income, there is no retained income that could trigger C corporation tax rates.
- Simplified compliance. The subsidiary can be structured specifically to satisfy all IRS testing requirements without altering the parent fund’s operations.
The alternative — converting an entire fund directly into a REIT — introduces complications around the 90% income distribution test, the fund’s existing waterfall structure, and potential disruption to investors. Very few fund managers have pursued this path successfully.
The Tax Benefits Driving REIT Adoption
The appeal of REITs for private debt funds centers on four primary tax advantages that benefit investors.
The Section 199A Deduction
Under IRC Section 199A, qualified REIT dividends entitle investors to a 20% pass-through deduction on distributed income. The critical distinction from standard pass-through entities is that REIT dividends carry no income cap. In a traditional fund structure, investors in the highest tax brackets are ineligible for the 199A deduction. Through a REIT structure, every investor qualifies regardless of their income level.
For a fund distributing $10,000 annually to an investor, this translates to taxation on only $8,000 — a meaningful savings that compounds across the investor base.
UBTI Elimination
Unrelated Business Taxable Income (UBTI) presents a significant barrier for certain categories of investors. When a fund employs leverage — which most modern debt funds do — the arbitrage income generated from borrowed capital creates a UBTI obligation for tax-exempt investors such as IRAs, pension funds, endowments, and charitable organizations.
For many of these entities, UBTI is not merely inconvenient — it can be fatal to their ability to invest. Charitable organizations whose bylaws prohibit UBTI would violate their charter by participating in a leveraged fund. Endowments face similar restrictions. The REIT structure eliminates this problem entirely, opening the door to an entirely new class of institutional and quasi-institutional capital.
State Filing and Withholding Relief
Fund managers who originate loans across multiple states face substantial administrative burdens. Each state where lending activity occurs may require separate tax filings, and investors residing in income-tax states trigger withholding obligations. The REIT election consolidates these obligations into a single federal return, significantly reducing operational overhead and the annual cost of tax preparation.
Effective Connected Income (ECI) Considerations
For funds with foreign investors or those exploring offshore feeder structures, the REIT framework provides additional advantages by eliminating active trade or business treatment that would otherwise apply to certain income streams.
Key Compliance Requirements for REIT-Electing Funds
Electing REIT status subjects a fund to ongoing IRS testing obligations. While there are numerous requirements, four tests carry the most practical significance for private lending operations.
The 90% Income Distribution Test
REITs must distribute at least 90% of their taxable income to maintain their election. Any retained income above this threshold is taxed at the corporate rate, creating an undesirable double-taxation scenario. In a subsidiary REIT structure, this requirement is straightforward: the subsidiary dividends 100% of its income monthly or quarterly to the parent fund, eliminating any retention risk.
The 75% Asset Composition Test
At least 75% of a REIT’s assets must qualify as real estate-related. For private lending funds, this test is rarely problematic since loan portfolios, cash, treasury instruments, CMBS, RMBS, and loan participations all qualify under the broad statutory definition.
The 100 Shareholder Test
Within a specified timeframe after REIT election, the entity must demonstrate ownership by at least 100 shareholders. The subsidiary REIT model simplifies this requirement because third-party vendors can facilitate meeting the threshold without requiring amendments to the parent fund’s offering documents.
The 5/50 Closely Held Test
Five or fewer individuals cannot own 50% or more of the REIT on a fully diluted basis. The IRS defines “individual” broadly for this purpose, encompassing not just the person but also their spouse, parents, grandparents, children, grandchildren, and siblings. This attribution rule has created compliance challenges for fund managers who fail to account for familial ownership concentrations.
Timing is critical. Once a REIT election is filed, the entity must satisfy this test by the second half of the following fiscal year. Failure to meet the deadline can necessitate unwinding the REIT and establishing a new entity, often accompanied by penalties.
Prohibited Transactions and Bad Income
REITs are inherently passive entities under the tax code, and income derived from active trading or business operations can jeopardize the election. Two scenarios present the greatest risk for private lending funds:
- Loan sales at volume for profit. While occasional loan sales do not necessarily trigger prohibited transaction treatment, a pattern of high-volume sales intended to generate trading profits may cross the line. Each case depends on the specific facts and circumstances.
- Retained foreclosure properties generating operating income. If a fund forecloses on a property that produces operating income — hotels, short-term rentals, senior housing — and retains operational control, this can create active business income. The standard mitigation strategy is establishing a master tenant relationship to insulate the REIT from direct operational involvement.
The Section 199A Sunset: What Private Lenders Should Know
The most widely discussed benefit of the REIT structure — the 20% pass-through deduction under Section 199A — is set to expire at the end of 2025 unless Congress acts. Understanding the legislative outlook is essential for fund managers making structural decisions today.
The TCJA’s provisions were always designed to sunset, and extending or making them permanent has been a central priority of the current administration. Legislative efforts to extend the deduction are underway through the broader reconciliation process, which requires only a simple majority in the Senate.
If Section 199A expires without extension, investors in REIT-structured funds would lose the 20% deduction on qualified dividends. However, the other three core benefits of the REIT structure — UBTI blocking, state filing elimination, and ECI treatment — remain intact regardless of the legislative outcome. These are not tied to the TCJA and will continue to provide value even without the 199A deduction.
Weighing the Decision Without 199A
For fund managers evaluating whether to pursue a REIT conversion in the current environment, the calculus remains favorable in several scenarios:
- Funds utilizing significant leverage. The UBTI protection alone may justify the conversion for funds whose investor base includes tax-exempt entities.
- Funds with endowment, charitable, or IRA investors. These investors are often prohibited from participating in funds that generate UBTI, making the REIT structure a prerequisite for their capital.
- Multi-state lending operations. The administrative savings from consolidated state filing can be substantial for operations spanning numerous jurisdictions.
- Competitive positioning. The largest and most established private lending funds have already adopted REIT structures. For fund managers seeking to attract sophisticated investors, the absence of a REIT option may put them at a competitive disadvantage.
CFL Licensing Considerations for Subsidiary REITs
Fund managers operating in California should be aware that a subsidiary REIT originating and funding loans directly will require its own California Finance Lender (CFL) license. Alternatively, the parent fund can hold the CFL and transfer loans down to the subsidiary, though loans must close in the name of the entity holding the license. Current processing times for new CFL applications run approximately 10 to 12 months, making early planning essential.
Structuring Capital Vehicles for the Road Ahead
Regardless of the 199A outcome, the debt fund structure remains the most viable framework for private lenders building balance sheet lending operations. Funds provide the flexibility to add leverage, participate in loan sales, and accommodate a diverse investor base in ways that note-based programs cannot replicate.
For managers who believe the TCJA extension will pass, incorporating REIT conversion optionality into fund documents from the outset is a cost-effective approach. Building in the structural flexibility to elect REIT status later is significantly less expensive than retrofitting existing documents after the fact.
For those who are uncertain about the legislative outcome, the core advantages of a well-structured debt fund — access to institutional capital, balance sheet lending capability, and operational scalability — remain compelling on their own merits.
Practical Takeaways for Private Lending Fund Managers
1. Funds exceeding $10 million in assets under management should evaluate the REIT conversion opportunity, particularly if their investor base includes high-net-worth individuals in the top tax brackets.
2. The subsidiary REIT structure remains the preferred approach for conversion, offering compliance simplicity, minimal investor disruption, and reduced risk of corporate-level taxation.
3. The 5/50 closely held test is the most common compliance pitfall. Fund managers should assess their cap table and familial attribution rules before filing an election.
4. Even without Section 199A, the UBTI, state filing, and ECI benefits provide meaningful value that may justify the incremental cost of maintaining a REIT structure.
5. Capital is actively seeking alternatives to traditional Wall Street and bond market investments. Private lending funds with strong performance track records are well-positioned to attract this capital, and having a tax-efficient REIT structure enhances the value proposition.
How Geraci LLP Can Help
Geraci LLP has extensive experience advising private lending fund managers on REIT structuring, compliance, and conversion strategies. Our securities and corporate attorneys work alongside tax professionals to design fund architectures that maximize investor benefits while maintaining full regulatory compliance.
Whether you are establishing a new fund with REIT optionality, converting an existing fund to a subsidiary REIT structure, or evaluating how pending tax legislation may affect your operations, our team is prepared to guide you through every stage of the process.
Contact Geraci LLP today at (949) 403-3488 or visit us at 90 Discovery, Irvine, CA 92618 to schedule a consultation about your capital structuring strategy.
