GOODWIN 41 12%, 15% even 18% of the outstanding stock of a REIT whose charter contains an ownership limit providing that no person can own more than 9.8% (or less) of the outstanding stock. There are really only two ways this can occur: • the investor has applied to the REIT’s board of directors for, and has received, a waiver from the relevant ownership limitations set forth in the REIT’s charter or other organizational document; or • the parties have concluded that the investor’s ownership does not run afoul of the ownership limitation provisions in the REIT’s charter and that a waiver is accordingly not necessary. The key to understanding either of these approaches is to understand that the 5/50 test speaks of five “individuals,” which generally does not include entities such as mutual funds, corporations or most other legal “persons.”7 Strictly as a matter of the 5/50 test, then, it is possible for, say, a single mutual fund to own a significant percentage of the REIT’s outstanding stock, say, 20%, without triggering a 5/50 test problem under the Internal Revenue Code because a mutual fund is not itself treated as an “individual” for this purpose. Rather, the constructive ownership rules under the Internal Revenue Code look to see whether stock owned directly by one person or entity should be treated as being owned by another person or entity.8 For example, stock owned by an individual person will be considered as owned by certain of his or her family members; stock owned by a corporation or partnership will be considered as being owned proportionately by its shareholders or partners. Because a mutual fund is typically owed by hundreds or thousands of individuals, in calculating percentage ownership for purposes of the 5/50 test the REIT would “look through” the mutual fund’s aggregate ownership to the actual individual holders of interests in the fund. So long as no individual holder is deemed to actually and/ or constructively own REIT shares in excess of the 5/50 ownership limit, there would be no REIT qualification issue under the 5/50 test. The mutual fund’s ownership could still very well be a REIT qualification issue, however, if it would give rise to related party tenant income. If a single mutual fund owns 10% or more of the REIT’s outstanding stock and also owns 10% or more of a tenant of the REIT then all of the rent received from that tenant would fail to qualify as “rents from real property” for purposes of the REIT’s gross income tests, which, in turn, could cause the REIT to fail to qualify as a REIT for U.S. federal income tax purposes. As discussed in further detail below,9 the relevant tax rules and definitions relating to related party rent determinations generally treat legal entities as single persons, irrespective of their “look through” status for purposes of the 5/50 test. 3. PARSING THE CHARTER: VARIATIONS IN OWNERSHIP LIMITATION PROVISIONS So when would an investor or fund manager seek a waiver of the ownership limit from the REIT, when would the REIT’s board of directors consider granting such a waiver, and under what terms/conditions? The question of a waiver – or whether a waiver is even necessary – begins with the particular REIT charter provisions providing for the ownership limitations and related terms and definitions. These provisions come in a variety of forms, often with subtle yet significant differences that impact how the particular charter defines holders subject to the ownership limitations. As we have previously noted in our REIT Alert “Recent Case Raises Questions Affecting Ownership Limits in Publicly Traded REITs,” because ownership limitation provisions are designed to protect the REIT’s essential status as a REIT, it is not surprising that they are drafted broadly rather than surgically tailored to mimic the strict REIT qualification provisions of the tax law. We explained that “the flexibility that might accompany a more surgical application of the tax rules does not lend itself to serving as an effective firewall in the context of a publicly traded REIT,” that may have hundreds of thousands and even millions of shares changing hands anonymously each day over the electronic facilities of a stock exchange. 7 See Sections 856(h) and 542(a)(2) of the Internal Revenue Code. For this purpose, an “Individual” also includes private foundations, certain trusts forming part of a plan for the payment of supplemental unemployment compensation benefits and the portion of a trust permanently set aside or to be used exclusively for charitable purposes described in Section 642(c) of the Internal Revenue Code. 8 See Sections 856(h) and 544 of the Internal Revenue Code. In a typical REIT charter, the constructive ownership rules that apply to the 5/50 test are generally incorporated into the charter’s ownership limitation provisions through the use of the defined term “Beneficial Ownership.” 9 See below under “Related Party Tenant Ownership Limitations.”