CALDERWOOD & HARKNESS LLP Attorneys at Law
1750 K Street NW, Suite 900 Washington, DC 20006
Telephone: (202) 654-8100 Facsimile: (202) 654-8199 www.calderwoodharkness.com
PRIVILEGED AND CONFIDENTIAL ATTORNEY-CLIENT PRIVILEGED ATTORNEY WORK PRODUCT
Matter No.: 1036-00006
MEMORANDUM
TO: Jonathan M. Hirota, Vice President, Tax, Fairwater Real Estate Investment Trust Anita Bashar Reeves, General Counsel, Fairwater Real Estate Investment Trust
FROM: Sylvia Hartwell, Partner, Tax Practice Group, Calderwood & Harkness LLP Garrett Simmons, Associate, Tax Practice Group, Calderwood & Harkness LLP Leila Nazari, Associate, Tax Practice Group, Calderwood & Harkness LLP
DATE: September 12, 2025 (finalized prior to ruling-request circulation on September 15, 2025)
RE: Formation and Capitalization of Fairwater Southgate TRS, Inc. — Taxable REIT Subsidiary Structure Analysis in Connection with the Acquisition of the Southgate Portfolio from Thornfield Development Group, LLC
Right-click to update Table of Contents
I. Executive Summary
The purpose of this memorandum is to analyze the proposed formation of Fairwater Southgate TRS, Inc. ("Southgate TRS") as a Maryland corporation and wholly owned taxable REIT subsidiary ("TRS") of Fairwater Real Estate Investment Trust ("Fairwater" or "FREIT"), a Maryland real estate investment trust publicly traded on the New York Stock Exchange under the ticker symbol "FREIT." The formation of Southgate TRS is proposed in connection with Fairwater's acquisition of a portfolio of eleven mixed-use properties (the "Southgate Portfolio") from Thornfield Development Group, LLC ("Thornfield"), a Delaware limited liability company, pursuant to that certain Purchase and Sale Agreement dated as of August 1, 2025 (the "PSA").
The Southgate Portfolio comprises eleven mixed-use properties located across Virginia, North Carolina, and Georgia, totaling approximately 3.1 million rentable square feet, with an aggregate purchase price of $812 million. Of this total, approximately $148 million of the portfolio's value is attributable to ancillary non-qualifying income-producing operations — specifically, food-and-beverage operations, parking management operations, and co-working-space operations — that generate income not qualifying as "rents from real property" under Section 856(d) of the Internal Revenue Code of 1986, as amended (the "Code" or "IRC"). The remaining approximately $664 million is attributable to qualifying real estate assets, consisting primarily of Class-A office and retail components of the portfolio.
Following closing, the non-qualifying operations will be housed in Southgate TRS, which will hold a projected asset value of $147 million (slightly below $148 million due to working-capital adjustments of approximately $1 million that will be retained by Thornfield at closing). Southgate TRS is projected to generate annual gross revenue from TRS activities of approximately $38.4 million. All real property will remain in the direct ownership of Fairwater or its qualified REIT subsidiaries, and the portions of the properties dedicated to TRS-operated activities will be leased by Fairwater to Southgate TRS under intercompany triple-net lease agreements at an aggregate annual base rent of $18.7 million, which has been independently validated as arm's-length by Caldwell Valuation Group, LLC.
Based on our analysis of the relevant provisions of IRC Sections 856 through 860, the applicable Treasury regulations, and published IRS guidance, and subject to the limitations and disclaimers set forth in Section XII of this memorandum, it is our overall conclusion that the proposed TRS structure satisfies all applicable REIT asset tests and intercompany lease requirements, and that Fairwater's continuous qualification as a real estate investment trust under the Code will not be jeopardized by the formation and capitalization of Southgate TRS. The specific quantitative results of our analysis are summarized as follows:
• 20% TRS Asset Test (IRC § 856(c)(4)(B)(ii)): Southgate TRS's projected asset value of $147 million represents approximately 1.83% of Fairwater's projected post-acquisition total assets of $8.03 billion — well within the 20% statutory limit, with approximately 18.17 percentage points of headroom.
• 75% Asset Test (IRC § 856(c)(4)(A)): Fairwater's qualifying real estate assets of approximately $6.58 billion represent approximately 81.9% of projected total assets of $8.03 billion — exceeding the 75% threshold by 6.9 percentage points.
• 75% Gross Income Test (IRC § 856(c)(3)): Projected qualifying income of $493 million represents approximately 80.3% of projected total gross income of $614 million.
• 95% Gross Income Test (IRC § 856(c)(2)): Projected qualifying and passive income of $596 million represents approximately 97.1% of projected total gross income of $614 million.
• Arm's-Length Rent: The $18.7 million annual base rent payable by Southgate TRS to Fairwater under the intercompany leases has been validated as consistent with arm's-length market rates by the independent appraisal of Caldwell Valuation Group, LLC, dated August 30, 2025.
This memorandum sets forth the factual background, legal framework, and detailed analysis supporting these conclusions, and provides specific compliance recommendations for ongoing monitoring and documentation.
II. Background
A. Fairwater Real Estate Investment Trust
Fairwater Real Estate Investment Trust is a Maryland real estate investment trust with its principal office and headquarters located at 2400 Harbor Promenade, Suite 1100, Baltimore, Maryland 21202. Fairwater's registered agent in the State of Maryland is Capitol Registered Agents, Inc., located at 7 Saint Paul Street, Suite 820, Baltimore, Maryland 21202. Fairwater's federal employer identification number is 52-4718263.
Fairwater's common shares of beneficial interest are publicly traded on the New York Stock Exchange under the ticker symbol "FREIT." As of September 30, 2025, Fairwater's market capitalization is approximately $4.37 billion. Based on Fairwater's most recent Annual Report on Form 10-K, Fairwater's total assets are approximately $7.82 billion.
Fairwater's current executive leadership team includes Margaret Eloise Kwan as Chief Executive Officer, Douglas R. Pellegrini as Chief Financial Officer, Anita Bashar Reeves as General Counsel, and Jonathan M. Hirota as Vice President, Tax. The Board of Trustees consists of nine members, a majority of whom are independent.
Fairwater's primary business consists of the ownership, operation, acquisition, and development of Class-A office, retail, and mixed-use properties concentrated in the Mid-Atlantic and Southeast United States. As of the date of this memorandum, Fairwater's portfolio comprises 94 properties totaling approximately 18.6 million rentable square feet, predominantly in the metropolitan areas of Baltimore, Washington, D.C., Richmond, Charlotte, Raleigh-Durham, and Atlanta. The portfolio is well-diversified across property types and geographic markets, with a tenant roster that includes numerous investment-grade and nationally recognized companies.
Fairwater made its election to be treated as a real estate investment trust under Subchapter M of Chapter 1 of the Code effective for its taxable year ended December 31, 2009, and has continuously qualified as a REIT in every taxable year since that date. For the taxable year ended December 31, 2024, Fairwater distributed approximately 92.7% of its REIT taxable income to its shareholders, comfortably exceeding the 90% minimum distribution requirement of IRC § 857(a)(1).
Fairwater's independent auditor and tax compliance advisor is Gresham Lowell CPAs LLP, located at 100 Light Street, Suite 2000, Baltimore, Maryland 21202. The engagement partner for the Fairwater account is Nolan S. Carruthers, CPA. Gresham Lowell has served as Fairwater's auditor since the 2016 fiscal year and is familiar with the full scope of Fairwater's REIT compliance framework and ongoing tax reporting obligations.
Fairwater maintains a $1.5 billion unsecured revolving credit facility with Ridgeline National Bank, N.A. as administrative agent and lead lender, located at 227 West Trade Street, Charlotte, North Carolina 28202. The relationship manager for the Fairwater credit facility is Patricia F. Langdon. The revolving credit facility, which was amended and restated effective March 15, 2024, provides Fairwater with substantial liquidity for acquisitions and general corporate purposes.
In connection with the acquisition of the Southgate Portfolio, Fairwater engaged Mercer Strauss & Co., LLC as its financial advisor. Mercer Strauss & Co., LLC is headquartered at 399 Park Avenue, 22nd Floor, New York, New York 10022. The lead banker for the Southgate Portfolio engagement is Ian K. Padilla & Ostrander LLP, Managing Director. Mercer Strauss has provided advisory services to Fairwater on multiple prior transactions and is intimately familiar with Fairwater's acquisition strategy and capital structure.
B. The Southgate Portfolio Acquisition
The seller of the Southgate Portfolio is Thornfield Development Group, LLC, a Delaware limited liability company with its principal office at 900 Peachtree Center Avenue NE, Suite 2200, Atlanta, Georgia 30309. Thornfield's federal employer identification number is 83-2956104. Thornfield is a vertically integrated real estate development and operating company that has developed and managed a portfolio of mixed-use properties across the southeastern United States over the past fifteen years.
Thornfield's managing member is Rowan Capital Partners, LP, a Delaware limited partnership, which holds an 87.5% equity interest in Thornfield. The founder and managing partner of Rowan Capital Partners, LP is Calvin J. Murchison. The remaining 12.5% equity interest is held by certain minority members who participated in the original development of the Southgate Portfolio properties.
Thornfield is represented in the transaction by the law firm of Pemberton Locke & Avery LLP, with offices at 191 Peachtree Street NE, Suite 4600, Atlanta, Georgia 30303. The lead partner on the transaction is Rachel D. Whitford. Title insurance and escrow services for the transaction are being provided by Whitecliff Title & Escrow Company, located at 1515 Market Street, Suite 700, Philadelphia, Pennsylvania 19102.
Fairwater and Thornfield entered into a Purchase and Sale Agreement dated as of August 1, 2025 (the "PSA") for the acquisition of the eleven properties constituting the Southgate Portfolio. The expected closing date is in the first quarter of 2026, subject to the satisfaction of customary closing conditions, including receipt of a favorable private letter ruling from the Internal Revenue Service confirming certain aspects of the proposed TRS structure.
The aggregate purchase price under the PSA is $812 million. The eleven properties constituting the Southgate Portfolio, their locations, property types, approximate square footages, and allocated values are set forth in the following table:
The Southgate Portfolio is a well-positioned collection of mixed-use assets in high-growth Southeast U.S. markets with strong demographics and employment growth. The properties are predominantly stabilized, with an overall weighted-average occupancy rate of approximately 93.2% as of the second quarter of 2025. Fairwater's strategic rationale for the acquisition centers on portfolio diversification, geographic expansion into key growth corridors, and the accretive nature of the portfolio's in-place cash flows.
C. Identification of Non-Qualifying Operations
Fairwater's due diligence review of the Southgate Portfolio identified three categories of ancillary operations within the portfolio that produce income not qualifying as "rents from real property" under IRC § 856(d). These non-qualifying operations are embedded within several of the portfolio's mixed-use properties and have been operated by Thornfield (or its affiliates) as integral components of the properties' tenant service and amenity platforms. The three categories are as follows:
1. Food-and-Beverage Operations. Several properties within the Southgate Portfolio include on-site restaurants, cafés, commissary kitchens, and catering services that are operated directly by Thornfield (or its affiliates) rather than leased to independent third-party restaurant operators. The income from these food-and-beverage operations constitutes non-qualifying income because it represents revenue from the provision of services rather than rents from real property. The properties with the most significant food-and-beverage operations are Buckhead Terrace (Atlanta, GA), Southgate Commons I (Richmond, VA), and Piedmont Walk (Durham, NC). These operations collectively generate annual gross revenues of approximately $14.2 million.
2. Parking Management Operations. Certain properties include active parking management operations, including staffed parking garages, valet services, and event parking coordination, that generate revenue beyond customary rent for the use of parking spaces. Where a REIT merely leases parking spaces to tenants, the resulting income generally qualifies as rents from real property. However, where the REIT (or its subsidiary) actively manages parking operations — providing attendants, valet services, and related services — the resulting income constitutes non-qualifying service income. The properties with the most significant parking management operations are Triangle Gateway (Raleigh, NC), Buckhead Terrace (Atlanta, GA), and Midtown Promenade (Atlanta, GA). These operations collectively generate annual gross revenues of approximately $11.6 million.
3. Co-Working-Space Operations. Two properties include furnished, serviced co-working and flexible office spaces that offer bundled amenities including furniture, technology infrastructure, reception services, conference room access, printing and copying services, mail handling, and other concierge-style services. The income from these co-working operations is considered non-qualifying because the bundled services are impermissible tenant services under Section 856(d)(7) — the revenue is attributable to the provision of services rather than the mere use of real property. The properties with the most significant co-working-space operations are Ashford Place (Charlotte, NC) and Charlottesville Crossing (Charlottesville, VA). These operations collectively generate annual gross revenues of approximately $12.6 million.
In the aggregate, the allocated value attributable to the non-qualifying components of the Southgate Portfolio is approximately $148 million. These operations are projected to generate combined annual gross revenue of approximately $38.4 million.
If these non-qualifying operations were held directly by Fairwater (rather than in a TRS), the resulting income would not qualify under either the 75% gross income test or the 95% gross income test of IRC § 856(c)(2) and (3), and the assets associated with these operations would not constitute qualifying real estate assets for purposes of the 75% asset test of IRC § 856(c)(4)(A). Depending on the magnitude of the non-qualifying income relative to Fairwater's total gross income, direct ownership of these operations could potentially jeopardize Fairwater's REIT qualification. Accordingly, the formation of a TRS to isolate these operations from the REIT is the appropriate structural solution. This approach is consistent with the legislative intent underlying the TRS provisions, which were enacted by the REIT Improvement Act of 1999 specifically to allow REITs to engage in non-customary activities through taxable corporate subsidiaries without endangering REIT status.
III. Taxable REIT Subsidiary — Legal Framework
A. Statutory Authority for TRS Formation
The authority for the formation and operation of a taxable REIT subsidiary is found in IRC § 856(l), which was added to the Code by Section 542(a) of the REIT Improvement Act of 1999 (P.L. 106-170) and subsequently amended by the American Jobs Creation Act of 2004 and the Protecting Americans from Tax Hikes Act of 2015 (among other legislation).
Under IRC § 856(l)(1), a "taxable REIT subsidiary" is defined as any corporation (other than a REIT) in which a REIT directly or indirectly holds stock, and which jointly elects with the REIT to be treated as a taxable REIT subsidiary. The election is made by the REIT and the corporation jointly on IRS Form 8875, Taxable REIT Subsidiary Election, and is effective as of the date specified on the form. Once made, the election remains in effect until revoked by the REIT and the TRS, or until the corporation otherwise ceases to qualify.
A TRS is treated as a separate C corporation for all federal income tax purposes and is subject to regular corporate income tax under IRC § 11 on its net taxable income. The TRS is not a pass-through entity, and its income and deductions are not attributed to the parent REIT. Rather, the TRS files its own federal and state income tax returns and pays tax at the applicable corporate rates. This separation is the central feature of the TRS regime — it allows a REIT to engage in activities and earn income that would otherwise disqualify the REIT under the gross income tests and asset tests, by compartmentalizing those activities within a taxable subsidiary whose income is subject to corporate-level tax.
The legislative purpose underlying the TRS provisions was to provide REITs with a flexible mechanism to participate in ancillary business activities — such as property management services, development services, and tenant amenity operations — that complement the REIT's core real estate operations but generate non-qualifying income. Prior to the enactment of the TRS rules, REITs were required to either forgo these activities entirely or rely on independent contractors, which often resulted in operational inefficiencies and loss of control over the tenant experience. The TRS structure addresses these concerns by permitting the REIT to own a corporate subsidiary that conducts these activities, subject to certain safeguards (most notably, the 20% TRS asset cap and the arm's-length rent and pricing requirements) designed to prevent abuse.
For Fairwater, the proposed joint TRS election will be filed on IRS Form 8875 by Fairwater and Southgate TRS promptly following the incorporation of Southgate TRS in Maryland. The election will specify the effective date of the TRS election as the date of incorporation (or, if later, the date on which the non-qualifying assets are contributed to Southgate TRS at closing of the Southgate Portfolio acquisition).
B. Key REIT Asset Tests — IRC § 856(c)(4)
The REIT asset tests are set forth in IRC § 856(c)(4) and must be satisfied at the close of each calendar quarter. Failure to satisfy these tests can result in loss of REIT status, although certain statutory cure provisions (discussed in Section IX.B below) may apply in the case of de minimis or good-faith failures. The following is a summary of the principal asset tests relevant to the proposed TRS structure.
75% Asset Test — IRC § 856(c)(4)(A). At the close of each calendar quarter, at least 75% of the value of the REIT's total assets must consist of "real estate assets" (as defined in IRC § 856(c)(5)(B)), cash and cash items (including receivables), and government securities. The term "real estate assets" includes interests in real property, interests in mortgages on real property or on interests in real property, and shares in other REITs. The corollary to the 75% test is that no more than 25% of the REIT's total assets may consist of non-qualifying assets (i.e., assets that are not real estate assets, cash, or government securities).
20% TRS Asset Test — IRC § 856(c)(4)(B)(ii). The value of the REIT's securities of one or more taxable REIT subsidiaries, in the aggregate, must not exceed 20% of the value of the REIT's total assets at the close of each calendar quarter. This limitation was originally set at 25% when enacted in 1999, was reduced to 25% by the American Jobs Creation Act of 2004, and was further reduced to 20% by the Protecting Americans from Tax Hikes Act of 2015, effective for taxable years beginning after December 31, 2017. The 20% cap represents the current operative threshold and is the primary quantitative constraint on the size of a REIT's TRS operations relative to its overall asset base.
5% Asset Test — IRC § 856(c)(4)(B)(i). With respect to the 25% of assets that are not required to be qualifying real estate assets, the REIT may not hold securities of any single issuer if the value of such securities exceeds 5% of the total value of the REIT's assets. However, this limitation does not apply to securities of a TRS or a qualified REIT subsidiary ("QRS"), or to government securities and securities described in IRC § 856(c)(4)(A).
10% Securities-Value Test — IRC § 856(c)(4)(B)(iii). The REIT may not hold securities of any single issuer possessing more than 10% of the total voting power of the outstanding securities of such issuer (subparagraph (I)), or having a value exceeding 10% of the total value of the outstanding securities of such issuer (subparagraph (II)). Additionally, the value of the REIT's securities of any single issuer (other than a TRS, a QRS, or government securities) may not exceed 10% of the total value of the outstanding securities of such issuer (subparagraph (III)). As with the 5% test, the 10% vote and value limitations expressly exclude TRS and QRS securities from their scope.
Interaction of Tests. The interplay among these tests is significant for the proposed transaction. TRS securities are subject to the 20% TRS asset cap but are expressly excluded from the 5% asset test and the 10% vote/value tests. This means that Fairwater may own 100% of the stock of Southgate TRS without violating the 5% or 10% tests, provided that the aggregate value of all TRS securities does not exceed 20% of Fairwater's total assets. Conversely, any securities that Fairwater holds of non-TRS, non-QRS issuers remain subject to the 5% and 10% constraints.
C. Income Tests — IRC § 856(c)(2) and (3)
The REIT gross income tests are set forth in IRC § 856(c)(2) and (3) and must be satisfied for each taxable year.
75% Gross Income Test — IRC § 856(c)(3). At least 75% of the REIT's gross income for each taxable year must be derived from qualifying real property sources, including: (i) rents from real property (as defined in IRC § 856(d)); (ii) interest on obligations secured by mortgages on real property or on interests in real property; (iii) gain from the sale or other disposition of real property (including interests in real property and interests in mortgages on real property) that is not property described in IRC § 1221(a)(1) (i.e., not dealer property); (iv) dividends or other distributions on, and gain from the sale of, shares in other REITs; (v) abatements and refunds of taxes on real property; (vi) income and gain derived from foreclosure property; and (vii) certain other specified items.
95% Gross Income Test — IRC § 856(c)(2). At least 95% of the REIT's gross income for each taxable year must be derived from the items qualifying under the 75% test, plus (i) dividends; (ii) interest; and (iii) gain from the sale or other disposition of stock or securities (or from any combination of the foregoing that is not otherwise described in the 75% test). The 95% test is the broader of the two income tests and effectively requires that no more than 5% of the REIT's gross income may be derived from non-passive, non-real-property sources.
Treatment of TRS Income. A critical feature of the TRS structure is that income earned by a TRS is not attributed to the parent REIT for purposes of either the 75% or 95% gross income tests. The TRS is a separate taxable entity, and its income is reflected on the REIT's financial statements only to the extent that the REIT receives dividends from the TRS or recognizes gain on the sale of TRS stock. Dividends paid by a TRS to the parent REIT are included in the REIT's gross income and qualify as "dividends" under the 95% gross income test (IRC § 856(c)(2)), but such dividends do not qualify under the 75% gross income test (IRC § 856(c)(3)), because dividends from a TRS are not dividends from another REIT or income derived from real property.
Rents from a TRS. Separately, rents paid by a TRS to the parent REIT can qualify as "rents from real property" under IRC § 856(d) for purposes of both the 75% and 95% gross income tests, provided that the rents satisfy the requirements of IRC § 856(d)(7)(B) (the arm's-length rent requirement). This is a critical provision for the proposed Southgate TRS structure, as the intercompany rents of $18.7 million per annum paid by Southgate TRS to Fairwater are intended to qualify as "rents from real property" and are included in the numerator of both the 75% and 95% gross income tests. The arm's-length requirement and the intercompany lease structure are discussed in detail in Section VI below.
IV. Formation and Capitalization of Fairwater Southgate TRS, Inc.
A. Entity Selection
Southgate TRS will be formed as a Maryland corporation, consistent with the domicile of Fairwater itself. The selection of Maryland as the state of incorporation is driven by several considerations, including administrative convenience, consistency with Fairwater's existing corporate organizational structure (which utilizes Maryland entities for its operating subsidiaries), and the favorable features of Maryland corporate governance statutes, including the Maryland General Corporation Law's flexible provisions regarding director liability, indemnification, and shareholder governance.
Fairwater will be the sole shareholder of Southgate TRS, holding 100% of the issued and outstanding common stock. No preferred stock or other classes of equity will be issued at formation; however, the Articles of Incorporation will authorize a sufficient number of shares to accommodate future capital needs, if any.
The Articles of Incorporation for Southgate TRS will be prepared by Calderwood & Harkness LLP and filed with the Maryland State Department of Assessments and Taxation ("SDAT"). Upon acceptance of the Articles of Incorporation by SDAT, Southgate TRS will become a legally existing Maryland corporation. Promptly following incorporation, Fairwater and Southgate TRS will jointly file IRS Form 8875 (Taxable REIT Subsidiary Election) with the Internal Revenue Service to elect TRS status for Southgate TRS. The election will be effective as of the date specified on the form, which is expected to coincide with the date of incorporation or the date of capitalization of Southgate TRS with the non-qualifying assets at closing.
B. Capitalization. At the closing of the Southgate Portfolio acquisition, Fairwater will capitalize Southgate TRS with the non-qualifying assets and associated working capital extracted from the Southgate Portfolio. The capitalization will be structured as a contribution of assets by Fairwater to Southgate TRS in exchange for 100% of the common stock of Southgate TRS. This contribution is expected to qualify as a tax-free exchange under IRC § 351 (transfer of property to a controlled corporation), as Fairwater will be in "control" of Southgate TRS (within the meaning of IRC § 368(c)) immediately after the exchange.
The projected aggregate value of the assets to be contributed to Southgate TRS is $147 million. This amount reflects the $148 million allocated value of the non-qualifying operations within the Southgate Portfolio, less working-capital adjustments of approximately $1 million that will be retained by Thornfield at closing pursuant to the terms of the PSA.
The specific assets to be contributed to Southgate TRS include the following:
(i) assignment and transfer of all food-and-beverage operating agreements, related equipment, kitchen fixtures, furnishings, smallwares, inventory, and associated intellectual property (including trade names, logos, and menus);
(ii) assignment and transfer of all parking management contracts, parking equipment (including automated pay stations, gate arms, ticketing systems, and signage), and related personal property;
(iii) assignment and transfer of all co-working-space operating agreements, furniture, fixtures, equipment (including desks, chairs, conference tables, audiovisual equipment, printing and copying equipment, and technology infrastructure), and associated software licenses;
(iv) assignment and transfer of all associated licenses, permits, health department certifications, and regulatory approvals, to the extent transferable under applicable law; and
(v) transfer of associated working capital (cash and accounts receivable) attributable to the non-qualifying operations.
Critically, no real property will be contributed to Southgate TRS. All real property interests — including land, buildings, structural improvements, and building systems — will be held directly by Fairwater or its qualified REIT subsidiaries. The real property underlying the TRS-operated activities will be leased from Fairwater to Southgate TRS under separate intercompany lease agreements, as discussed in Section VI of this memorandum. This structure ensures that the real property remains a qualifying real estate asset of Fairwater for purposes of the 75% asset test under IRC § 856(c)(4)(A), while the non-qualifying operating businesses are isolated within the TRS.
C. Corporate Governance and Operations
Southgate TRS will be governed by a board of directors consisting of at least three members, including at least one independent director who is not an officer, employee, or trustee of Fairwater. The inclusion of an independent director is a best practice that reinforces the separate corporate existence of Southgate TRS and supports the arm's-length nature of the intercompany arrangements between Fairwater and Southgate TRS.
Southgate TRS will maintain its own separate books and records, its own bank accounts (to be established at Ridgeline National Bank, N.A. or another nationally recognized financial institution), and its own financial statements prepared in accordance with generally accepted accounting principles. Although Southgate TRS will be consolidated with Fairwater for financial reporting purposes under ASC 810, it will maintain separate accounting records sufficient to demonstrate its independent operations and to support the preparation of separate federal and state corporate income tax returns.
Southgate TRS will file its own federal income tax return on Form 1120 as a C corporation, and will file separate state corporate income tax returns in each state in which it conducts business (currently anticipated to include Virginia, North Carolina, and Georgia). The annual audit of Southgate TRS's financial statements will be coordinated with Gresham Lowell CPAs LLP as part of the consolidated Fairwater engagement, but Southgate TRS's tax compliance will be separately tracked to ensure that all filing and payment obligations are timely satisfied.
Management and strategic oversight of Southgate TRS will be provided by Fairwater's officers, including the Vice President, Tax and the Chief Financial Officer, subject to the oversight of the Southgate TRS board of directors. Day-to-day operations of the food-and-beverage, parking management, and co-working-space businesses will be managed by existing on-site personnel who will become employees of, or independent contractors to, Southgate TRS upon closing. Southgate TRS will enter into appropriate employment agreements, service contracts, and management arrangements as necessary to ensure operational continuity.
V. Compliance with REIT Asset Tests
A. 20% TRS Asset Test — IRC § 856(c)(4)(B)(ii)
The primary asset-test constraint on the proposed TRS structure is the 20% TRS asset test of IRC § 856(c)(4)(B)(ii), which provides that the value of the REIT's securities of one or more taxable REIT subsidiaries, in the aggregate, must not exceed 20% of the total value of the REIT's assets at the close of each calendar quarter.
The following is our calculation of projected compliance with the 20% TRS asset test following the closing of the Southgate Portfolio acquisition and the concurrent implementation of Fairwater's planned asset disposition program:
The projected value of Southgate TRS's securities (i.e., the 100% stock interest in Southgate TRS held by Fairwater) is $147,000,000.
The 20% TRS asset test calculation is as follows:
$147,000,000 ÷ $8,030,000,000 = 1.83%
Result: The projected TRS asset ratio of 1.83% is well within the 20% statutory limit. Fairwater will have approximately 18.17 percentage points of headroom below the 20% threshold at the time of closing, representing approximately $1.46 billion of additional TRS asset capacity before the 20% limit would be reached.
We note that Fairwater does not currently hold any other taxable REIT subsidiary. Southgate TRS would be Fairwater's sole TRS, which simplifies the compliance monitoring process, as there is no need to aggregate TRS asset values across multiple subsidiaries. Should Fairwater form additional TRS entities in the future, the aggregate value of all TRS securities would need to be monitored against the 20% limit.
Sensitivity Analysis. To assess the robustness of the 20% TRS asset test compliance under stress scenarios, we have performed the following sensitivity analysis. Based on projected post-acquisition total assets of $8.03 billion, the maximum permissible TRS asset value under the 20% test is $1,606,000,000 (i.e., 20% × $8,030,000,000). The projected TRS asset value of $147 million is therefore approximately $1,459,000,000 below the maximum permissible amount. Even under adverse scenarios — such as significant appreciation in TRS asset values, depreciation of REIT real property values, or both — the substantial margin of safety would absorb significant fluctuations before the 20% threshold would be approached.
Monitoring Recommendation. Notwithstanding the substantial headroom, we recommend that Jonathan M. Hirota, as Vice President, Tax, implement quarterly asset-value testing procedures coordinated with Gresham Lowell CPAs LLP. These procedures should include a quarterly calculation of the TRS asset ratio as of the close of each calendar quarter, documented in a compliance memorandum for the Fairwater tax department's files. The quarterly monitoring should also include a review of any changes in TRS asset values (e.g., resulting from capital expenditures, asset acquisitions, or changes in the fair market value of TRS operating assets) and any changes in Fairwater's total asset base.
B. 75% Asset Test — IRC § 856(c)(4)(A)
The 75% asset test requires that at least 75% of the value of Fairwater's total assets at the close of each calendar quarter must consist of qualifying real estate assets, cash and cash items, and government securities.
The following is our calculation of projected compliance with the 75% asset test following the closing of the Southgate Portfolio acquisition:
Result: The projected qualifying asset ratio of 81.9% exceeds the 75% threshold by 6.9 percentage points. Fairwater's non-qualifying assets — consisting primarily of the $147 million in TRS securities, cash and cash equivalents held at the REIT level, and other miscellaneous non-qualifying assets — fall well within the permissible 25% non-qualifying asset allocation.
It is important to note that the real property underlying the TRS operations remains a qualifying real estate asset of Fairwater. Because no real property is being contributed to Southgate TRS — only the operating businesses, personal property, and associated assets are being transferred — the land, buildings, and improvements at the properties where TRS operations are conducted continue to be held by Fairwater and count toward the numerator of the 75% asset test. Only the stock of Southgate TRS (valued at $147 million) is classified as a non-qualifying asset for purposes of the 75% test. The intercompany leases between Fairwater and Southgate TRS reinforce this bifurcation: Fairwater retains ownership of the real property and receives rent from the TRS tenant, while the TRS holds only the operating assets and generates operating income from the non-qualifying activities.
C. 10% Securities-Value Test — IRC § 856(c)(4)(B)(iii)
The 10% securities-value test limits the REIT's holdings of securities of any single non-TRS, non-QRS issuer to (I) no more than 10% of the total voting power of the outstanding securities of such issuer, (II) no more than 10% of the total value of the outstanding securities of such issuer, and (III) a value not exceeding 10% of the total value of the issuer's outstanding securities.
As applied to Southgate TRS, these limitations do not pose a constraint. TRS securities are expressly excluded from the scope of the 10% vote and value limitations and the 5% asset limitation by virtue of the parenthetical exclusion in IRC § 856(c)(4)(B)(iii) for securities of "a taxable REIT subsidiary." Accordingly, Fairwater's ownership of 100% of the outstanding common stock of Southgate TRS does not implicate the 10% securities-value test or the 5% asset test.
However, Fairwater must ensure that any securities it holds of issuers other than Southgate TRS and its existing qualified REIT subsidiaries continue to comply with the 10% and 5% limitations. Based on our review, the Southgate Portfolio acquisition does not involve the acquisition of securities of any non-TRS, non-QRS third-party issuer, and therefore does not create any new 10% or 5% test compliance issues.
D. Impact of Asset Dispositions on Test Compliance
As noted above, Fairwater plans to dispose of approximately $602 million in existing portfolio assets during the first quarter of 2026 as part of a broader portfolio recycling program. These dispositions are intended to coincide with the closing of the Southgate Portfolio acquisition to ensure balanced asset-test compliance on a quarter-end measurement date.
The net effect of the acquisition and the concurrent dispositions is a net increase in Fairwater's total assets of approximately $210 million (from $7.82 billion to $8.03 billion). All of the assets being disposed of are expected to be qualifying real estate assets. Therefore, the recycling program has the effect of modestly reducing the numerator of the 75% asset test (by removing qualifying real estate assets) while simultaneously reducing the denominator (by reducing total assets). However, because the Southgate Portfolio acquisition adds a greater amount of qualifying real estate assets ($664 million of qualifying real property plus $147 million of TRS securities) than is being removed through the dispositions, the overall 75% asset test ratio remains comfortably above 75%.
Fairwater's tax department should carefully coordinate the timing of the asset dispositions and the Southgate Portfolio closing to ensure that both transactions settle within the same calendar quarter. If the dispositions were to close in an earlier quarter than the acquisition, there could be a temporary reduction in total assets followed by a significant increase — this timing mismatch could theoretically affect the asset-test ratios on an interim quarter-end date. We recommend that Jonathan M. Hirota work closely with Fairwater's capital markets team and legal advisors to synchronize the timing of these transactions.
VI. Intercompany Lease Structure
A. Overview. The intercompany lease structure is a foundational element of the proposed TRS arrangement. Under this structure, Fairwater (in its capacity as landlord) will lease the portions of the Southgate Portfolio properties dedicated to TRS-operated activities to Southgate TRS (in its capacity as tenant) under separate intercompany lease agreements. Each lease will cover the specific square footage within a given property that is dedicated to the food-and-beverage, parking management, or co-working-space operations to be conducted by Southgate TRS.
The intercompany lease structure serves two essential purposes. First, it ensures that the real property underlying the TRS operations remains a qualifying real estate asset of Fairwater, counted in the numerator of the 75% asset test. Second, it generates rental income for Fairwater that, subject to satisfaction of the arm's-length rent requirement and other conditions of IRC § 856(d), qualifies as "rents from real property" for purposes of both the 75% and 95% gross income tests. The rents thus serve as a mechanism for transferring cash flow from the TRS-operated businesses to the REIT in a tax-efficient manner.
B. Key Lease Terms
The principal terms of the intercompany leases have been negotiated and agreed upon between Fairwater and its advisors, and are summarized as follows:
• Annual Base Rent: $18,700,000 in the aggregate across all intercompany leases. The annual base rent is allocated among the individual property leases based on the relative fair market rental value of the TRS-operated spaces at each property, as determined by the Caldwell Valuation Group appraisal discussed in Section VI.C below.
• Lease Term: Ten (10) years, commencing on the closing date of the Southgate Portfolio acquisition (expected in the first quarter of 2026).
• Renewal Options: Two (2) successive five-year renewal options, exercisable at the election of Southgate TRS, as tenant. The exercise of each renewal option is subject to customary conditions, including the absence of any uncured default under the lease at the time of exercise.
• Annual Rent Escalator: Two and one-half percent (2.5%) fixed per annum, compounding annually. The fixed escalator ensures predictable rental growth for Fairwater without tying the rent to the income or profits of Southgate TRS, which would disqualify the rents under IRC § 856(d)(2)(A).
• Lease Structure: Triple-net (NNN). Southgate TRS, as tenant, will be responsible for all operating expenses, real property taxes, insurance premiums, routine maintenance, and capital expenditures attributable to the leased TRS-operated spaces. The triple-net structure is consistent with market practice for intercompany REIT/TRS leases and ensures that Fairwater, as landlord, receives a net rental stream without bearing the variable operating costs of the TRS businesses.
• Use Restrictions: The leased premises are restricted to use exclusively for food-and-beverage operations, parking management operations, and co-working-space operations, as applicable. No change in use is permitted without the prior written consent of Fairwater.
• Separate Lease Agreements: A separate intercompany lease agreement will be executed for each property where TRS operations are conducted. Key properties for which intercompany leases will be executed include, among others: Triangle Gateway (Raleigh, NC — parking management), Buckhead Terrace (Atlanta, GA — food-and-beverage), Ashford Place (Charlotte, NC — co-working-space), Southgate Commons I (Richmond, VA — food-and-beverage), Piedmont Walk (Durham, NC — food-and-beverage), Charlottesville Crossing (Charlottesville, VA — co-working-space), and Midtown Promenade (Atlanta, GA — parking management).
C. Arm's-Length Rent Requirement — IRC § 856(d)(7)(B)
IRC § 856(d)(7)(B) provides that rents paid by a TRS to its parent REIT are treated as "rents from real property" (and thus qualify under the 75% and 95% gross income tests) only if the rents are established at rates that are "arm's-length," determined as if the REIT and the TRS were unrelated parties dealing at arm's length. This requirement is a critical safeguard intended to prevent REITs from using the intercompany lease mechanism to artificially inflate rental income by charging above-market rents to the TRS, thereby shifting income from the taxable TRS (which pays corporate tax) to the tax-exempt REIT (which does not, provided it distributes sufficient income to shareholders).
The significance of the arm's-length requirement cannot be overstated. If rents charged by Fairwater to Southgate TRS exceed arm's-length amounts, the excess constitutes "redetermined rents" subject to a 100% excise tax under IRC § 857(b)(7)(A), as discussed in Section VIII below. Moreover, there is a risk that rents materially exceeding arm's-length levels could be recharacterized entirely as non-qualifying income, potentially jeopardizing the rents' treatment as "rents from real property" under IRC § 856(d).
To validate the arm's-length nature of the proposed intercompany rents, Fairwater engaged Caldwell Valuation Group, LLC, an independent real estate appraisal and valuation firm headquartered at 4200 Dominion Boulevard, Suite 310, Glen Allen, Virginia 23060, to prepare a comprehensive market rent appraisal. The Caldwell appraisal is dated August 30, 2025, and was prepared by certified appraisers in compliance with the Uniform Standards of Professional Appraisal Practice ("USPAP").
The principal conclusion of the Caldwell appraisal is that the aggregate annual base rent of $18,700,000 is consistent with arm's-length market rates for comparable triple-net leases of similar mixed-use spaces in the relevant markets, including Richmond, Norfolk, Charlottesville, Durham, Raleigh, Charlotte, Savannah, Atlanta, and Decatur. The methodology employed by Caldwell included the following approaches:
(i) Comparable Lease Transactions Analysis: Caldwell identified and analyzed a set of comparable lease transactions for food-and-beverage, parking, and co-working/flexible office spaces in each of the relevant metropolitan markets. The comparable transactions were adjusted for differences in location, property quality, lease term, tenant creditworthiness, and lease structure (gross vs. net).
(ii) Income Capitalization Approach: Caldwell applied an income capitalization methodology to estimate the market rental value of the TRS-operated spaces based on the projected net operating income of the TRS businesses, applying market-derived capitalization rates for each property type and geographic market.
(iii) Direct Comparison Approach: Caldwell employed a direct comparison approach, comparing the proposed per-square-foot rent for each TRS-operated space against published market rental data for comparable spaces in the same or similar buildings and submarkets.
Calderwood & Harkness's review and independent legal validation of the Caldwell appraisal is addressed in a separate Arm's-Length Rent Analysis Memorandum, which is being circulated concurrently with this memorandum.
We strongly recommend that Fairwater obtain updated Caldwell appraisals (or appraisals from another qualified independent appraiser) at each renewal-option exercise date (i.e., at the end of the initial 10-year term and at the end of the first 5-year renewal period) and periodically during the initial lease term — at a minimum, every three years. Maintaining contemporaneous, independent appraisal documentation is the single most effective measure to mitigate the risk of a Section 857(b)(7) excise tax assessment in the event of an IRS examination.
D. Rents from Real Property Analysis — IRC § 856(d)
IRC § 856(d)(1) defines "rents from real property" and establishes the framework for determining whether rental income received by a REIT qualifies as such. The definition includes rents from interests in real property and charges for services customarily furnished or rendered in connection with the rental of real property, but excludes certain categories of income that are deemed inconsistent with passive real property rental activities.
The rents to be received by Fairwater from Southgate TRS under the intercompany leases should qualify as "rents from real property" under IRC § 856(d), provided that the following conditions are satisfied:
First, rents are not based on the income or profits of any person — IRC § 856(d)(2)(A). Amounts received or accrued by a REIT as rent from real property do not include any amount based in whole or in part on the income or profits of any person, with certain limited exceptions for amounts based on a fixed percentage of gross receipts or revenues. The intercompany leases between Fairwater and Southgate TRS provide for a fixed annual base rent of $18,700,000, escalating at a fixed rate of 2.5% per annum. The rent is not linked to, or contingent upon, the income, profits, or financial performance of Southgate TRS or any other person. Accordingly, this condition is satisfied.
Second, the REIT does not furnish or render impermissible services — IRC § 856(d)(7). Amounts received by a REIT as rents from real property do not include any amount if the REIT directly furnishes or renders non-customary services to the tenants of the property, unless the services are furnished through an independent contractor (as defined in IRC § 856(d)(3)) or through a TRS. In the present structure, Southgate TRS is itself the tenant under the intercompany leases. The services provided to end-users and customers of the food-and-beverage, parking management, and co-working-space operations are furnished by Southgate TRS (a TRS), not by Fairwater. The structure is therefore permissible — the REIT is not furnishing impermissible services; rather, the TRS is the tenant and the operator. This condition is satisfied.
Third, rents meet the arm's-length standard — IRC § 856(d)(7)(B). As discussed in detail in Section VI.C above, the aggregate annual base rent of $18,700,000 has been validated as arm's-length by the independent appraisal of Caldwell Valuation Group, LLC, dated August 30, 2025. This condition is satisfied.
We note that the private letter ruling request submitted by Calderwood & Harkness on behalf of Fairwater includes, as Ruling No. 1, a request for IRS confirmation that the intercompany rents paid by Southgate TRS to Fairwater under the proposed intercompany lease agreements constitute "rents from real property" within the meaning of IRC § 856(d). A favorable ruling on this point would provide significant additional comfort and certainty regarding the tax treatment of the intercompany rental income.
VII. Treatment of TRS Revenue and the REIT Gross Income Tests
A. Projected TRS Revenue Segregation
As discussed in Section II.C above, Southgate TRS is projected to generate annual gross revenue of approximately $38,400,000 from its food-and-beverage, parking management, and co-working-space operations. This revenue will be earned by Southgate TRS in its capacity as a separate C corporation and will be reported on Southgate TRS's federal and state corporate income tax returns.
The $38.4 million in TRS revenue is not included in Fairwater's gross income for purposes of either the 75% or 95% REIT gross income tests. As discussed in Section III.C above, income earned by a TRS is not attributed to the parent REIT; only dividends declared and paid by the TRS to the REIT flow through to the REIT's gross income. Accordingly, the segregation of the non-qualifying operations within Southgate TRS effectively isolates the non-qualifying revenue from Fairwater's REIT-level gross income computations.
To the extent that Southgate TRS declares and pays dividends to Fairwater, those dividends will be included in Fairwater's gross income. TRS dividends qualify as "dividends" for purposes of the 95% gross income test under IRC § 856(c)(2), but they do not qualify under the 75% gross income test under IRC § 856(c)(3), as they are not dividends from another REIT or income derived from real property. Fairwater's tax department should therefore monitor the amount of TRS dividends relative to Fairwater's total gross income to ensure that the 75% gross income test is not impaired by excessive TRS dividend distributions. Given the current projections, TRS dividends are not expected to create any compliance concerns, but ongoing monitoring is prudent.
B. Post-Acquisition Gross Income Test Projections
Based on the financial projections provided by Fairwater and Gresham Lowell CPAs LLP, the post-acquisition gross income test calculations for the first full taxable year following the closing of the Southgate Portfolio acquisition are as follows:
75% Gross Income Test:
The qualifying income figure of $493 million includes, among other items, the $18,700,000 in annual intercompany rent paid by Southgate TRS to Fairwater, which is treated as "rents from real property" under IRC § 856(d) (subject to satisfaction of the arm's-length and other requirements discussed above). The 80.3% result exceeds the 75% threshold by 5.3 percentage points, providing a reasonable cushion above the minimum requirement.
95% Gross Income Test:
The qualifying and passive income figure of $596 million includes the $493 million of qualifying real property income, plus dividends from Southgate TRS and other domestic corporations, interest income, and gain from the sale of securities. The 97.1% result exceeds the 95% threshold by 2.1 percentage points.
Conclusion: The TRS structure preserves Fairwater's compliance with both the 75% and 95% gross income tests. By housing the non-qualifying operations in Southgate TRS, the $38.4 million of non-qualifying revenue is excluded from Fairwater's REIT-level gross income, and the $18.7 million of intercompany rent is included as qualifying income. The net effect is a substantial improvement in Fairwater's income-test position compared to the alternative of holding the non-qualifying operations directly at the REIT level.
VIII. 100% Excise Tax Risk — IRC § 857(b)(7)
IRC § 857(b)(7)(A) imposes a 100% excise tax on "redetermined rents," which are defined as rents from real property that are overstated as a result of services furnished or rendered by a TRS to tenants of its parent REIT, or as rents received by a REIT from a TRS to the extent such rents exceed the amounts that would have been charged if the parties were unrelated. The statutory purpose of this excise tax is to prevent REITs from using intercompany rental arrangements to artificially inflate qualifying rental income by charging above-market rents to TRS tenants, thereby transferring income from the tax-paying TRS to the tax-exempt REIT.
The 100% excise tax is arguably the most punitive penalty in the REIT taxation regime, as it applies at a confiscatory rate and is calculated on the full amount of the excess rents, without regard to the REIT's marginal tax rate or distribution status. The severity of this penalty underscores the importance of rigorous arm's-length documentation and periodic rent validation.
Mitigation. In the case of the proposed Southgate TRS structure, the $18.7 million annual base rent has been independently validated as arm's-length by Caldwell Valuation Group, LLC, as described in Section VI.C above. Based on this appraisal, no redetermined rents are anticipated, and the 100% excise tax under IRC § 857(b)(7)(A) should not apply.
Ongoing Compliance Recommendation. We recommend that Fairwater adopt the following practices to mitigate the risk of a Section 857(b)(7) excise tax assessment:
(i) Annual Market Rent Review: Fairwater should conduct an annual review of the TRS intercompany rents against then-current market comparables to confirm that the rents remain within the range of arm's-length rates. This review need not involve a full formal appraisal each year, but should at minimum include a desktop analysis by Fairwater's in-house tax team or an outside advisor, comparing the intercompany rents to published market rental data and comparable lease transactions.
(ii) Periodic Independent Appraisal: In addition to annual reviews, Fairwater should engage Caldwell Valuation Group (or another qualified independent appraiser) to prepare an updated formal market rent appraisal at least every three years during the initial lease term and at each renewal-option exercise date. These appraisals should follow the same USPAP-compliant methodology as the initial August 30, 2025 appraisal.
(iii) Documentation. All intercompany pricing documentation — including appraisals, desktop analyses, market comparables, and internal memoranda — should be maintained in a manner analogous to transfer pricing documentation under IRC § 482 and the corresponding Treasury regulations. This documentation should be organized, indexed, and readily accessible in the event of an IRS examination.
IX. Risk Factors and Considerations
A. Valuation Fluctuation Risk
The 20% TRS asset test under IRC § 856(c)(4)(B)(ii) is measured based on the value of the REIT's assets at the close of each calendar quarter. Asset values are not static; they fluctuate over time in response to market conditions, capital expenditures, depreciation, and other factors. If the value of Southgate TRS's assets were to increase significantly (for example, due to appreciation in the value of the TRS-operated businesses), or if the value of Fairwater's overall asset base were to decline significantly (for example, due to a downturn in real estate markets), the TRS asset ratio could increase from the projected 1.83% toward the 20% threshold.
However, given the substantial headroom of approximately 18.17 percentage points between the projected TRS asset ratio and the 20% statutory limit, this risk is assessed as minimal under currently foreseeable scenarios. The TRS asset value would need to increase by approximately $1.46 billion — nearly a ten-fold increase — before the 20% threshold would be reached, assuming total REIT assets remain constant. Even under a severe stress scenario combining significant TRS asset appreciation with significant REIT asset depreciation, the probability of approaching the 20% limit is remote.
Notwithstanding this assessment, we recommend that Jonathan M. Hirota and Gresham Lowell CPAs LLP implement quarterly asset-value monitoring procedures, as described in Section V.A above, to ensure that any material changes in the TRS asset ratio are identified and addressed promptly.
B. Safe Harbor for De Minimis Asset-Test Failures
The Code provides certain statutory cure provisions for REIT asset-test failures, which serve as safety nets in the event of inadvertent or de minimis noncompliance.
IRC § 856(c)(7) provides a cure period for certain asset-test failures that are discovered after the close of a calendar quarter. Specifically, if the failure is attributable to the ownership of assets the total value of which does not exceed the lesser of (A) 1% of the total value of the REIT's assets at the end of the quarter in which the failure was identified or (B) $10,000,000, and if the failure is cured within six months after the last day of the quarter in which the failure was identified (or such other period as may be prescribed by the Secretary), then the REIT is treated as having met the asset-test requirements for such quarter.
For larger failures that do not qualify for the de minimis exception, IRC § 856(c)(6) provides a "qualified-error" exception. Under this provision, if the REIT establishes that the failure was due to reasonable cause and not due to willful neglect, and if the REIT disposes of the assets causing the failure within six months (or pays a tax as described in the statute), the REIT may retain its REIT status. This provision requires, among other things, that the REIT file a schedule describing each asset that caused the failure, including the date acquired, the identity of the issuer, and the basis of the REIT's belief that the asset was a qualifying asset.
While these safety nets provide important protections, they should not be relied upon as primary compliance mechanisms. Proper quarterly testing and proactive monitoring are the appropriate first line of defense against asset-test fail