Real Estate Investment Trust Simplification Act of 1997 ("REITSA")
Summary Of REIT Simplification Provisions In The Taxpayer Relief Act
The tax provisions in the Real Estate Investment Trust Simplification Act ('REITSA') passed as part of the budget package fall within three broad categories. All provisions are effective for taxable years beginning after August 5, 1997.
- Traps For The Unwary. First, prior law disqualified a REIT that satisfied all required ownership tests but did not follow certain administrative details relating to shareholder demand letters. REITSA replaces the potential disqualification with a reporting penalty imposed on a REIT's failure to follow IRS notification rules. Also, a REIT that sends out shareholder letters and does not know of a violation of the 'five or fewer' ownership test is now deemed to satisfy this test.
Second, REITSA creates a de minimis exception to prior law so that a REIT's rental income is not disqualified if it performs nominal, although impermissible, services for a tenant. For example, an apartment REIT can now offer tennis lessons to its tenants without 'tainting' the underlying rents.
Third, REITSA corrects a technical "glitch" in which stock ownership attribution may occur between unrelated partners. The prior constructive ownership rule could have resulted in: (1) certain rents received by a REIT not qualifying for the REIT income tests; or (2) certain parties not being qualified as independent contractors.
- Mutual Fund Conformity. First, prior law taxed a REIT that retained capital gains, and imposed a second level of the tax on the REIT shareholders when later they received the capital gain distribution. REITSA mirrors the corresponding mutual fund rules governing taxation of retained capital gains by passing through a credit to shareholders for capital gains taxes paid at the corporate level.
Second, REITSA repeals the 30% gross income test (in conformity with the repeal of the analogous 'short-short' test for mutual funds). The 100% excise tax on prohibited transactions (i.e., sales for which the REIT is a dealer) is not materially changed.
- Other Simplification Measures. First, REITSA makes a technical change to how a REIT computes its earnings & profits ("E&P"). Since 1986, a REIT must distribute all pre-REIT earnings and profits within its first REIT taxable year or lose its REIT status. However, if a REIT has unexpected year-end earnings, the normal ordering rules governing E&P distributions created a substantial risk that a new REIT (or a REIT into which a C corporation merges in a tax-free reorganization) may fail to distribute all of its pre-REIT E&P, notwithstanding its good faith efforts to comply with the distribution requirement. REITSA corrects the ordering rules for accumulated E&P distributions to make it easier for a new REIT (or a REIT into which a C corporation merges) to comply with the distribution requirement.
Second, REITSA simplifies the administration of the REIT foreclosure property rules by: (a) extending the time period for the foreclosure election from 2 to 3 years; and (b) coordinating the foreclosure property independent contractor rule with the primary independent contractor rule for REITs.
Third, REITSA updates the current REIT hedging rule to include income from all hedges of REIT liabilities.
Fourth, REITSA extends an exception to the current 95% distribution rule to include other forms of phantom income, e.g., income from the discharge of indebtedness.
Fifth, REITSA corrects a problem in the wording of Congress' past liberalization of the safe harbor from the 100% excise tax on prohibited transactions, i.e., sales of property in the ordinary course of business. The provision does not count as a dealer sale property that is involuntarily converted.
Sixth, REITSA creates a safe harbor to the shared appreciation mortgage ("SAM") rules that does not penalize a REIT lender for the borrower's bankruptcy. The provision also clarifies that SAMs may be based on appreciation in value as well as gain.
Last, REITSA codifies an IRS ruling position by allowing a REIT to use a wholly-owned subsidiary to hold property even if the subsidiary previously had been owned by a non-REIT.