FAQ Real Estate Investment Trust Morrison Foerster | 24 from recognizing gain upon the contribution transaction and for a specified period thereafter (typically 7-10 years). This is accomplished by the Operating Partnership agreeing that, for the specified period: (i) there will be sufficient Operating Partnership liabilities allocated, for income tax purposes, to the contributing partner and/or available to be guaranteed by the contributing partner to prevent the recognition of gain; and (ii) the Operating Partnership will not dispose of the contributed property in a taxable transaction that triggers the taxable built-in gain to the contributing partner. While fairly common, TPAs can be viewed negatively by investors and public market analysts, especially when their terms are “off market.” Because the additional costs associated with indemnifying the contributor from tax liabilities resulting from the pay down of debt or sale of the contributed assets, the terms of the TPAs may restrict the REIT’s ability to sell one or more properties or pay off indebtedness when it would otherwise be favorable or prudent. What are some of the key terms of tax protection agreements? TPAs typically address some or all of the issues just discussed and certain other tax matters, particularly to the extent such issues and matters are outside a contributor’s control after the OP Unit transaction. For example, a TPA may require the Operating Partnership to indemnify a contributor if the Operating Partnership (i) sells the contributed real estate asset in a taxable transaction, triggering the original built-in gain to the contributor, (ii) engages in certain taxable M&A transactions that trigger such gain, or gain in the OP Units received by the contributor, or (iii) fails to maintain sufficient liabilities so that the contributor is allocated liabilities sufficient to cover its “negative tax basis” or “negative tax capital account.” The TPA may require, with varying degrees of exceptions, that the Operating Partnership allocate liabilities under the nonrecourse liability sharing rules (more contributor-favorable) or pursuant to a guarantee of the contributor (less contributor-favorable, particularly given the inability to use “bottom-dollar” guarantees). Other issues TPAs may cover include the overall tax treatment of the OP Unit transaction and the “Section 704(c) method,” which governs how the Operating Partnership will allocate taxable income and loss in relation to the built-in gain in the contributed real estate assets. The “traditional” method is by far the most common, with the “remedial” method generally not used, given that it undermines the tax-deferral purpose of the OP Unit transaction by creating “phantom” income for the contributor. TPAs are often subject to significant negotiation, especially with respect to (i) length of term, meaning how long the Operating Partnership must indemnify the contributor, which ranges significantly in the market but often falls within the range of 7 to 10 years, and (ii) the nature of protection, if any, with respect to liability allocations, which may require an Operating Partnership to maintain an amount or type of debt that is suboptimal from a business perspective. The tax rules underpinning OP Unit transactions, such as those governing “disguised sales,” the allocation of liabilities and the “Section 704(c) methods,” can be dauntingly complex, and contributors and Operating Partnerships typically require significant input from legal counsel and other advisors to understand and negotiate the issues at play.
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