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REIT Provisions Proposed Fiscal Year 2000

REIT Provisions in the Administration's
Proposed Fiscal Year 2000 Budget

Excerpt from the Treasury Department Explanation of the REIT-Related Items in the Fiscal Year 2000 Budget (February 1, 1999)

MODIFY STRUCTURE OF BUSINESSES INDIRECTLY
CONDUCTED BY REITs

Current Law

Real estate investment trusts (REITs) generally are restricted to making passive investments in real estate and certain securities. In furtherance of this purpose, REITs generally are limited under a 95 percent gross income test to receiving income that qualifies as rents from real property and, to a more limited degree, portfolio income.

The REIT provisions also contain a number of rules that limit a REIT's ownership of other corporations in order to prevent REITs from becoming active in the management and operations of companies that engage in activities that currently are prohibited activities for a REIT. One of these rules provides that a R.EIT may not own more than 10 percent of the outstanding voting securities of any issuer. Another rule provides that no single corporation can account for more than five percent of the total value of a REIT's assets.

Reasons for Change

The Administration understands that REITs are conducting businesses through subsidiary corporations that, if operated directly, would generate nonqualifying income under the 95-percent gross income test. Through the use of multiple subsidiaries, up to 25 percent of the value of a REIT's assets can consist of subsidiaries that conduct these currently prohibited activities. Through the retention of non-voting preferred stock and debt, the REIT is able to retain most, if not all, of the income generated by the impermissible businesses and, due to the transmuting of operating income into interest paid to the REIT and other non-arm's length pricing arrangements, that income often is not subject to any corporate level tax.

Many of the businesses performed by the REIT subsidiaries are natural outgrowths of a REIT's traditional operations, such as third-party management and development businesses. While it is inappropriate for the earnings from these non-REIT businesses to be sheltered through a REIT, it also is counter-intuitive to prevent these entities from taking advantage of their evolving experiences and expanding into areas where their expertise may be of significant value.

Currently, a REIT cannot derive more than a de minimis amount of income from the provision of services to REIT tenants unless such income would be excluded from unrelated business taxable income if received by certain tax-exempt entities. These services generally must be rendered by an independent contractor from whom the REIT does not derive or receive any income. The determination of what are permissible services for a REIT consumes substantial time and resources for both REITs and the Internal Revenue Service. In addition, the prohibition of a REIT performing, either directly or indirectly, non-customary services can put REITs at a competitive disadvantage in relation to others in the same market.

Proposal

Under the proposal, the 10-percent vote test in section 856(c)(4)(B) would be changed to a "vote or value" test. This would prevent REITs from undertaking prohibited activities through preferred stock subsidiaries, as is the current practice.

The proposal also would provide an exception to the five-percent and 10-percent asset tests so that REITs could have "taxable REIT subsidiaries." Under the proposal, there would be two types of taxable REIT subsidiaries, a "qualified independent contractor subsidiary" and a "qualified business subsidiary." A qualified business subsidiary would be allowed to undertake non-tenant related activities that currently generate non-qualifying income for a REIT, such as third-party management and development. A qualified independent contractor subsidiary would be allowed to perform non-customary and other currently prohibited services with respect to REIT tenants as well as activities that could be performed by a qualified business subsidiary.

A number of constraints would be imposed on a taxable REIT subsidiary to ensure that the REIT could not, through a taxable REIT subsidiary, engage in substantial non-real estate activities, and also to ensure that the taxable REIT subsidiary pays a corporate level tax on its earnings. First, the value of all taxable REIT subsidiaries owned by a REIT could not represent more than 15 percent of the value of the REIT's total assets, and within that 15-percent limitation, no more than five percent of the total value of a REIT's assets could consist of qualified independent contractor subsidiaries. Second, a taxable REIT subsidiary would not be entitled to deduct any interest incurred on debt funded directly or indirectly by the REIT. Third, a 100-percent excise tax would be imposed on excess payments to ensure arm's length (1) pricing for services provided to REIT tenants (i.e. REIT tenants could not pay for services provided by the taxable REIT subsidiary through increased rental payments to the REIT) and (2) allocation of shared expenses between the REIT and the taxable REIT subsidiary. Fourth, there would be significant limits placed upon intercompany rentals between the REIT and a taxable REIT subsidiary. Finally, certain additional limitations may apply.

This proposal would be effective after the date of enactment. REITs would be allowed to combine and convert preferred stock subsidiaries into taxable REIT subsidiaries tax-free prior to a certain date. There would be a transition period to allow for conversion of preferred stock subsidiaries before the 10-percent vote or value test would become effective. Persons other than the REIT who hold stock in a preferred stock subsidiary would recognize gain to the extent that they received consideration other than REIT stock for their interest in the subsidiary.

MODIFY TREATMENT OF CLOSELY HELD REITs

Current Law

When originally enacted, the real estate investment trust ("REIT") legislation was intended to provide a tax-favored vehicle through which small investors could invest in a professionally managed real estate portfolio. H.R. Rep. No. 2020, 86th Cong., 2d Sess., 2 (1960). REITs are intended to be widely held entities, and certain requirements of the REIT rules are designed to ensure this result. Among other requirements, in order for an entity to qualify for REIT status, the beneficial ownership of the entity must be held by 100 or more persons. In addition, a REIT cannot be closely held, which is determined by reference to the stock ownership requirement in the personal holding company rules. Under these rules, generally no more than 50 percent of the value of the REIT's stock can be owned by five or fewer individuals during the last half of the taxable year. Certain attribution rules apply in making this determination.

Reasons for Change

A number of tax avoidance transactions involve the use of closely held REITs. In these transactions, in order to meet the 100 or more shareholder requirement, the REIT generally issues common stock and a separate class of non-voting preferred stock. The common stock, which reflects virtually all of the REIT's economic value, is acquired by a single shareholder, and the preferred stock is acquired by 99 other "friendly" shareholders (generally, employees of the majority shareholder). The current-law closely held limitation does not disqualify the REITs that are utilizing this ownership structure because the majority shareholder of these REITs is not an individual.

The Administration believes that certain closely held structures may facilitate the use and development of corporate tax shelters in ways unintended by Congress. The Administration proposes modifying the closely held REIT requirements to address these potential abuses without frustrating the intended viability of REITs.

Proposal

The proposal would impose as an additional requirement for REIT qualification that no person can own stock of a REIT ssessing 50 percent or more of the total combined voting power of all classes of voting stock or 50 percent or more of the total value of all shares of all classes of stock. For purposes of determining a person's stock ownership, rules similar to the attribution rules contained in section 856(d)(5) would apply. This proposal would not apply to ownership by a REIT of 50 percent or more of the stock (vote or value) of another REIT.

The proposal would be effective for entities electing REIT status for taxable years beginning on or after the date of first committee action. An entity that elects REIT status for a taxable year beginning prior to the date of first committee action will be subject to this proposal if it does not have significant business assets or activities as of such date.


REPEAL TAX-FREE CONVERSIONS OF LARGE C CORPORATIONS TO S CORPORATIONS


Current Law

C corporations generally are subject to a two-tier tax. A corporation can avoid this two-tier tax by electing to be treated as an S corporation or by converting to a partnership. Converting to a partnership is a taxable event that generally requires the corporation to recognize any built-in gain in their corporate stock. In contrast, the conversion of a C corporation to an S corporation generally is tax-free for both the corporation and its shareholders. Under section 1374, however, the S corporation must recognize the built-gain on assets held at the time of conversion if the assets are sold within ten years.

A corporation generally also can avoid the two-tier tax if it can qualify as a regulated investment company (RIC) or a real estate investment trust (REIT) (by deducting dividends paid to its shareholders). The conversion of a C corporation to a RIC or REIT, however, is treated as if the corporation had sold all of its assets at their fair market value and immediately liquidated, thereby requiring the corporation to recognize any built-in gain in its assets at the time of the conversion. Notice 88-19, 1988-1 C.B. 486. The IRS, however, permits the corporation to avoid the immediate recognition of its built-in gain if the corporation elects to be subject to rules similar to section 1374.

Reasons for Change

The tax treatment of the conversion of a C corporation to an S corporation generally should be consistent with the tax treatment of the conversion of a C corporation to a partnership. Any appreciation in corporate assets that occurred during the time the corporation is a C corporation should be subject to the corporate-level tax.

Proposal

The proposal would repeal section 1374 for large corporations. A C-to-S corporation conversion by a large corporation S corporation status (whether by a C corporation electing S corporation status or by a C corporation merging into an S corporation) would be treated as a liquidation of the C corporation followed by a contribution of the assets to an S corporation by the recipient shareholders. Thus, the proposal would require immediate gain recognition by both the corporation (with respect to its appreciated assets) and its shareholders (with respect to their stock) upon the conversion to S corporation status.

For this purpose, a large corporation is one with a value of more than $5 million of the time of conversion. The value of the corporation would be the fair market value of all the stock of the corporation on the date of conversion.