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Revenue Provisions FY 2000

NAREIT's Written Statement to the House Ways & Means Committee on Revenue Provisions in the Administration's FY 2000 Budget (March 10, 1999)

Comments of the National Association of Real Estate Investment Trusts® to the Committee on Ways and Means U.S. House of Representatives regarding certain Revenue Provisions in the Administration's Fiscal Year 2000 Budget

Submitted by Steven A. Wechsler
NAREIT President & Chief Executive Officer
Hearing held on March 10, 1999
 

As requested in Press Release No. FC-7 (February 18, 1999), the National Association of Real Estate Investment Trusts® ("NAREIT") respectfully submits these comments in connection with the Ways and Means Committee's review of certain revenue provisions presented to the Committee as part of the Administration's Fiscal Year 2000 Budget.

NAREIT's comments address the Administration proposals to (1) modify the real estate investment trust ("REIT") asset tests to permit REITs to own taxable REIT subsidiaries; (2) modify the treatment of closely held REITs; and (3) amend section 1374(1) to treat an "S" election by a large C corporation as a taxable liquidation of that C corporation. We appreciate the opportunity to present these comments.

NAREIT is the national trade association for real estate companies. Members are REITs and other publicly-traded businesses that own, operate and finance income-producing real estate, as well as those firms and individuals who advise, study and service these businesses. REITs are companies whose income and assets are mainly connected to income-producing real estate. By law, REITs regularly distribute most of their taxable income to shareholders as dividends. NAREIT represents over 200 REITs or other publicly-traded real estate companies, as well as over 2,000 investment bankers, analysts, accountants, lawyers and other professionals who provide services to REITs.

Executive Summary
Taxable REIT Subsidiaries. NAREIT welcomes the Administration's taxable REIT subsidiary proposal as a very significant step in the right direction to modernize the REIT rules. Current law requires REITs to use awkward methods in order to provide services to third parties, and also prevents REITs from remaining competitive in providing needed and emerging services to their tenants. The taxable REIT subsidiary structure would codify, yet simplify, the current law structure, while simultaneously allowing a REIT to provide new services to its tenants so long as these services are subject to a corporate level tax.

As an alternative to the Administration's REIT subsidiary proposal, NAREIT recommends that Congress enact the Real Estate Investment Trust Modernization Act of 1999 being drafted by Representatives Thomas and Cardin (the "Thomas/Cardin Bill"). The Thomas/Cardin Bill would incorporate the principles of the Administration proposal, with four significant exceptions. First, The Thomas/Cardin Bill would require taxable REIT subsidiaries to fit within the current, unified 25 percent asset test, rather than the complex and cumbersome 5 and 15 percent assets tests under the Administration proposal. Second, the Thomas/Cardin Bill would limit interest deductions on debt between a REIT and its taxable subsidiary in accordance with the current earnings stripping rules of section 163(j), whereas the Administration would eliminate even a reasonable amount of intra-party interest deductions. Third, the Thomas/Cardin Bill would prohibit a taxable REIT subsidiary from operating or managing hotels, while allowing a subsidiary to lease a hotel from its affiliated REIT so long as (a) the rents are set at market levels, and (b) the rents are not tied to net profits, and (c) the hotel is operated by an independent contractor. Fourth, the Thomas/Cardin Bill would not apply the new rules on taxable REIT subsidiaries to current arrangements so long as a new trade or business is not engaged in and substantial new property is not acquired, unless the REIT affirmatively elects taxable REIT subsidiary status. Conversely, the Administration proposal would apply to current arrangements after an undefined period of time.

Closely Held REITs. NAREIT supports the Administration's intention to craft a new ownership test intended to correspond to a REIT's primary mission: to make investment in income-producing real estate accessible to ordinary investors. However, we believe that the Administration's proposal is too broad, and therefore should be narrowed to prevent non-REIT C corporations from owning 50 percent or more of a REIT's stock (by vote or value). In addition, the new rules should not apply to so-called "incubator REITs" that have proven to be a viable method by which ordinary investors can access publicly traded real estate investments.

Built-in Gain Tax. Congress has rejected the Administration's call for a change in the section 1374 rules for three straight budgets. NAREIT recommends that Congress again reject this proposal. We also ask Congress to conduct oversight of the IRS to ensure that it does not do administratively what it has not been able to achieve by legislation.

Background on REITs

A REIT is essentially a corporation or business trust combining the capital of many investors to own and, in most cases, operate income-producing real estate, such as apartments, shopping centers, offices and warehouses. Some REITs also are engaged in financing real estate. REITs must comply with a number of requirements, some of which are discussed in detail in this statement, but the most fundamental of these are as follows: (1) REITs must pay at least 95 percent of their taxable income to shareholders;(2) (2) REITs must derive most of their income from real estate held for the long term; and (3) REITs must be widely held.

In exchange for satisfying these requirements, REITs (like mutual funds) benefit from a dividends paid deduction so that most, if not all, of a REIT's earnings are taxed only at the shareholder level. On the other hand, REITs pay the price of not having retained earnings available to expand their business. Instead, capital for growth, capital expenditures and payment of loan principal largely comes from new money raised in the investment marketplace from investors who have confidence in the REIT's future prospects and business plan.

Congress created the REIT structure in 1960 to make investments in large-scale, significant income-producing real estate accessible to the smaller investor. Based in part on the rationale for mutual funds, Congress decided that the only way for the average investor to access investments in larger-scale commercial properties was through pooling arrangements. In much the same ways as shareholders benefit by owning a portfolio of securities in a mutual fund, the shareholders of REITs can unite their capital into a single economic pursuit geared to the production of income through commercial real estate ownership. REITs offer distinct advantages for smaller investors: greater diversification through investing in a portfolio of properties rather than a single building and expert management by experienced real estate professionals.

Despite the advantages of the REIT structure, the industry experienced very little growth for over 30 years mainly for two reasons. First, at the beginning REITs were handcuffed. REITs were basically passive portfolios of real estate. REITs were permitted only to own real estate, not to operate or manage it. This meant that REITs needed to use third party independent contractors, whose economic interests might diverge from those of the REIT's owners, to operate and manage the properties. This was an arrangement the investment marketplace did not accept warmly.

Second, during these years the real estate investment landscape was colored by tax shelter-oriented characteristics. Through the use of high debt levels and aggressive depreciation schedules, interest and depreciation deductions significantly reduced taxable income -- in many cases leading to so-called "paper losses" used to shelter a taxpayer's other income. Since a REIT is geared specifically to create "taxable" income on a regular basis and a REIT is not permitted to pass "losses" through to shareholders like a partnership, the REIT industry could not compete effectively for capital against tax shelters.

In the Tax Reform Act of 1986 (the "1986 Act"), Congress changed the real estate investment landscape. On the one hand, by limiting the deductibility of interest, lengthening depreciation periods and restricting the use of "passive losses," the 1986 Act drastically reduced the potential for real estate investment to generate tax shelter opportunities. This meant, going forward, that real estate investment needed to be on a more economic and income-oriented footing.

On the other hand, as part of the 1986 Act, Congress took the handcuffs off REITs. The Act permitted REITs not merely to own, but also to operate and manage most types of income producing commercial properties by providing "customary" services associated with real estate ownership. Finally, for most types of real estate (other than hotels, health care facilities and some other activities that consist of a higher degree of personal services), the economic interests of the REIT's shareholders could be merged with those of the REIT's operators and managers.

Despite Congress' actions in 1986, significant REIT growth did not begin until 1992. One reason was the real estate recession in the early 1990s. During the late 1980s banks and insurance companies kept up real estate lending at a significant pace. Foreign investment, particularly from Japan, also helped buoy the marketplace. But by 1990 the combined impact of the Savings and Loan crisis, the 1986 Act, overbuilding during the 1980s by non-REITs and regulatory pressures on bank and insurance lenders, led to a nationwide depression in the real estate economy. During the early 1990s commercial property values dropped between 30 and 50 percent. Credit and capital for commercial real estate became largely unavailable. As a result of this capital crunch, many building owners defaulted on loans, resulting in huge losses by financial institutions. The Resolution Trust Corporation took over the real estate assets of insolvent financial institutions.

Against this backdrop, starting in 1992, many private real estate companies realized that the best and most efficient way to access capital was from the public marketplace through REITs. At the same time, many investors decided that it was a good time to invest in commercial real estate -- assuming recovering real estate markets were just over the horizon. They were right.

Since 1992, the REIT industry has attained impressive growth as new publicly traded REITs infused much needed equity capital into the over-leveraged real estate industry. Today there are over 200 publicly traded REITs with an equity market capitalization exceeding $140 billion. These REITs are owned primarily by individuals, with 49 percent of REIT shares owned directly by individual investors and 37 percent owned by mutual funds, which are owned mostly by individuals. Today's REITs offer smaller real estate investors three important qualities never accessible and available before: liquidity, security and performance.

  Liquidity. REITs have helped turn real estate liquid. Through the public REIT marketplace of over 200 real estate companies, investors can buy and sell interests in portfolios of properties and mortgages -- as well as the management associated with them - on an instantaneous basis. Illiquidity, the bane of real estate investors, is gone.

  Security. Because real estate is a physical asset with a long life during which it has the potential to produce income, investors always have viewed real estate as an investment option with security. But now, through REITs, small investors have an added level of security never available before in real estate investment. Today's security comes from information. Through the advent of the public REIT industry (which is governed by SEC and securities exchange-mandated information disclosure and reporting), the flow of available information about the company and its properties, the management and its business plan, and the property markets and their prospects are available to the public at levels never before imagined. As a result, REIT investors are provided a level of security never available before in the real estate investment marketplace.

  Performance. Since their inception, REITs have provided competitive investment performance. Over the past 20 years, REIT market performance has been comparable to that of the Russell 2000 and has exceeded the returns from fixed income and direct real estate investments. Because REITs annually pay out almost all of their taxable income, a significant component of total return on investment reliably comes from dividends. In 1998, REITs paid out almost $11 billion in dividends to their shareholders. Just as Congress intended, today small investors have access through REITs to large-scale, income producing real estate on a basis competitive with large institutions and wealthy individuals.

But REITs certainly do not just benefit investors. The lower debt levels associated with REITs compared to real estate investment overall have a positive effect on the overall economy. Average debt levels for REITs are 35-40 percent of market capitalization, compared to leverage of 80 percent and higher used by privately owned real estate (which has the effect of minimizing income tax liabilities). The higher equity capital cushions REITs from the severe effects of fluctuations in the real estate market that have traditionally occurred. The ability of REITs to better withstand market downturns has a stabilizing effect on the real estate industry and lenders, resulting in fewer bankruptcies and work-outs. The general economy benefits from lower real estate losses by federally insured financial institutions.

NAREIT believes the future of the REIT industry will see a continuous and significant shift from private to public ownership of U.S. real estate. At the same time, future growth may be limited by the competitive pressures for REITs to be able to provide more services to their tenants than they are currently allowed to perform. Although the 1986 Act took off the handcuffs and the Taxpayer Relief Act of 1997 included additional helpful REIT reforms, REITs still must operate under certain significant, unnecessary restrictions. NAREIT looks forward to working with Congress and the Administration further to modernize and improve the REIT rules so that REITs can continue to offer smaller investors opportunities for rewarding investments in income-producing real estate.

I. TAXABLE REIT SUBSIDIARIES

As part of the asset diversification tests applied to REITs, a REIT may not own more than 10 percent of the outstanding voting securities of a non-REIT corporation pursuant to section 856 (c)(5)(B).(3) The Administration's Fiscal Year 1999 Budget proposed to amend section 856(c)(5)(B) to prohibit REITs from holding stock possessing more than 10 percent of the vote or value of all classes of stock of a non-REIT corporation.(4) Significantly, the Administration's Fiscal Year 2000 Budget proposes an exception to this vote or value rule for taxable REIT subsidiaries.

A. Background and Current Law

The activities of REITs are strictly limited by a number of requirements that are designed to ensure that REITs serve as a vehicle for public investment in real estate. First, a REIT must comply with several income tests. At least 75 percent of the REIT's gross income must be derived from real estate, such as rents from real property, mortgage interest and gains from sales of real property (not including dealer sales).(5) In addition, at least 95 percent of a REIT's gross income must come from the above real estate sources, dividends, interest and sales of securities.(6)

Second, a REIT must satisfy several asset tests. On the last day of each quarter, at least 75 percent of a REIT's assets must be real estate assets, cash and government securities. Real estate assets include interests in real property and mortgages on real property. As mentioned above, the asset diversification rules require that a REIT not own more than 10 percent of the outstanding voting securities of an issuer (other than a qualified REIT subsidiary under section 163(j)). In addition, no more than 5 percent of a REIT's assets can be represented by securities of a single issuer (other than a qualified REIT subsidiary).

REITs have been so successful in operating their properties and providing permissible services to their tenants that they have been asked to provide these services to non-tenants, building off of expertise and capabilities associated with the REIT's real estate activities. In addition, mortgage REITs are presented with substantial opportunities to service the mortgages that they securitize. The asset and income tests, however, restrict how REITs can engage in these activities. A REIT can earn only up to 5 percent of its income from sources other than rents, mortgage interest, capital gains, dividends and interest. However, many REITs have had the opportunity to maximize shareholder value by earning more than 5 percent from third party services.

Starting in 1988, the Internal Revenue Service ("IRS") issued private letter rulings to REITs approving a structure to facilitate a REIT providing a limited amount of services to third parties.(7) These rulings sanctioned a structure under which a REIT owns no more than 10 percent of the voting stock and up to 99 percent of the value of a non-REIT corporation through nonvoting stock. Usually, managers or shareholders of the REIT own the voting stock of the "Third Party Subsidiary" ("TPS," also known as a "Preferred Stock Subsidiary"). The TPS typically either provides to unrelated parties services already being delivered to a REIT's tenants, such as landscaping and managing a shopping mall in which the REIT owns a joint venture interest, or engages in other real estate activities, such as development, which the REIT cannot undertake to the same extent. A TPS of a mortgage REIT typically services a pool of securitized mortgages and sells mortgages as part of the securitization process that has the effect of lowering homeowners' interest rates.

The REIT receives dividends from the TPS that are treated as qualifying income under the 95 percent income test, but not the 75 percent income test.(8) Accordingly, a REIT continues to be principally devoted to real estate operations. While the IRS has approved using the TPS for services to third parties and "customary" services to tenants the REIT could otherwise provide, the IRS has not permitted the use of these subsidiaries to provide impermissible, non-customary real estate services to REIT tenants.(9)

B. Administration Proposal

In 1998, the Administration proposed changing the asset diversification tests to prevent a REIT from owning securities in a C corporation that represent 10 percent of either the corporation's vote or its value. The proposal would have applied with respect to stock acquired on or after the date of first committee action. In addition, to the extent that a REIT's ownership of TPS stock would have been grandfathered by virtue of the effective date, the grandfather status would have terminated if the TPS engaged in a new trade or business or acquired substantial new assets on or after the date of first committee action.

In its Fiscal Year 2000 Budget, the Administration again proposes to base the 10 percent asset test on either vote or value. However, it also proposes an exception for two types of taxable REIT subsidiaries ("TRS"). A qualified business subsidiary ("QBS") would be the successor to the current TPS and could engage in the same activities as can a TPS today. A REIT could not own more than 15 percent of its assets in QBSs. The second type of TRS would be a qualified independent contractor subsidiary ("QIKS"), which could provide non-customary services to the affiliated REIT's tenants. A REIT could not own more than 5 percent of its assets in QIKSs as part of its 15 percent TRS allocation.

A TRS could not deduct any interest payments to its affiliated REIT, and 100% excise tax penalties would be imposed to the extent that any pricing between a TRS and either its affiliated REIT or that REIT's tenants was not set on an arms' length basis. The new TRS rules would apply to all existing TPSs after a time period to be determined by Congress.

C. Statement in Support of Taxable REIT Subsidiaries

The REIT industry has grown significantly during the 1990s, from an equity market capitalization under $10 billion to a level approaching $135 billion. The TPS structure is used extensively by today's REITs and has been a small, but important, part of recent industry growth. These subsidiaries help ensure that the small investors who own REITs are able to maximize the return on their capital by taking full economic advantage of core business competencies developed by REITs in owning and operating the REIT's real estate or mortgages. NAREIT appreciates the Administration's recognition that it makes sense to allow a REIT to utilize these core competencies through taxable subsidiaries so long as the REIT remains focused on real estate and the subsidiary's operations are appropriately subject to a corporate level tax.

In addition, the Administration's proposal recognizes that the REIT rules need to be modernized to permit REITs to remain competitive. By virtue of the "customary" standard in defining permissible REIT rental activities, REITs must wait until their competitors have established new levels of service before providing that service to their customers. This "lag effect" assures that REITs are never leaders in their markets, but only followers, to the detriment of their shareholders. Under the Administration proposal, the REIT could render such services to its tenants through a subsidiary that is subject to corporate tax.

The Administration's TRS' proposal is a significant step in the right direction, but NAREIT requests Congress instead to enact the Thomas/Cardin Bill. The Thomas/Cardin closely follows the Administration's subsidiary proposal, but improves and clarifies this concept in four major ways.

First, the Thomas/Cardin Bill would require taxable REIT subsidiaries to fit within the current, unified 25 percent asset test, rather than the unnecessarily complex and cumbersome 5 and 15 percent assets tests under the Administration proposal described above. Requiring two types of TRSs would cause severe complexity and administrative burdens, such as allocating costs between a QBS and a QIKS without incurring a 100% excise tax. Further, the Code should encourage, rather than prohibit, the same TRS providing the same service to its affiliated REIT's tenants and to third parties to make it easier to ensure that the pricing of those services is set at market rates. Moreover, the 5 and 15 percent limits are unnecessarily restrictive given the fact that the subsidiary is subject to a corporate level tax on all of its activities. The Thomas/Cardin Bill adopts the better approach of treating TRS stock as an asset that must fit within the current 25 percent basket of non-real estate assets a REIT can own, along with other non-real estate assets such as personal property.

Second, the Thomas/Cardin Bill would limit interest deductions on debt between a REIT and its taxable REIT subsidiary in accordance with the current earnings stripping rules of section 163(j), whereas the Administration would eliminate even a reasonable amount of intra-party interest deductions. Congress confronted very similar earnings stripping concerns in the 1980s with respect to foreign organizations and their U.S. subsidiaries and resolved these concerns by enacting section 163(j). This section permits interest deductions on objective, modest amounts of related party debt. Section 163(j) is easily implemented and guidance has been provided by final regulations. The Thomas/Cardin Bill would adopt even more strict rules for REITs and their subsidiaries by limiting the interest deductions to market rates. Clearly, REITs should not be forced to comply with an absolute denial of legitimate interest deductions when foreign organizations in similar circumstances are not so limited.

Third, the Administration's proposal does not address whether REITs could use a TRS to own or operate hotels. Given Congress' decision in 1998 to curtail the activities of so-called hotel paired share REITs, NAREIT believes it appropriate to ensure that taxable REIT subsidiaries cannot replicate the activities of these entities. The Thomas/Cardin Bill would prohibit a taxable REIT subsidiary from operating or managing hotels, while allowing a subsidiary to lease a hotel from its affiliated REIT so long as (a) the rents are set at a market levels, (b) the rents are not tied to net profits, and (c) the hotel is operated by an independent contractor.

Fourth, the Thomas/Cardin Bill would not apply the new rules on subsidiaries to current arrangements so long as a new trade or business is not engaged in and substantial new property is not acquired, unless the REIT affirmatively elects, on a timely basis, taxable REIT subsidiary status for such TPS. Conversely, the Administration proposal would become effective after an undefined period of time. REITs have planned their operations based on IRS rulings starting in 1988 that have sanctioned TPSs and should not be penalized for following established law. The Thomas/Cardin Bill wisely would adopt the concepts in last year's Administration's effective date that acknowledged the IRS' acquiescence to the TPS structure.

II. CLOSELY HELD REITS

The Administration's Fiscal Year 1999 Budget proposes to add a new rule, creating a limit of 50 percent on the vote or value of stock any entity could own in any REIT.

A. Background and Current Law

As discussed above, Congress created REITs to make real estate investments easily and economically accessible to the small investor. To carry out this purpose, Congress mandated two rules to ensure that REITs are widely held. First, five or fewer individuals cannot own more than 50% of a REIT's stock.(10) In applying this test, most entities owning REIT stock are "looked through" to determine the ultimate ownership of the stock by individuals. Second, at least 100 persons (including corporations and partnerships) must be REIT shareholders.(11) Both tests do not apply during a REIT's first taxable year, and the "five or fewer" test only applies in the last half of all taxable years.(12)

The Administration appears to be concerned about non-REITs establishing "captive REITs" and REITs doing "step-down preferred" transactions used for various tax planning purposes the Administration finds abusive such as the "liquidating REIT" structure curtailed by the 1998 budget legislation.(13) The Administration proposes changing the "five or fewer" test by imposing an additional requirement. The proposed new rule would prevent any "person" (i.e., a corporation, partnership or trust, including a pension or profit sharing trust) from owning stock of a REIT possessing more than 50 percent of the total combined voting power of all classes of voting stock or more than 50 percent of the total value of shares of all classes of stock. Certain existing REIT attribution rules would apply in determining such ownership, and the proposal would be effective for entities electing REIT status for taxable years beginning on or after the date of first committee action.

Statement Providing Limited Support for Administration Proposal on Closely Held REITs

NAREIT shares the Administration's concern that the REIT structure not be used for abusive tax avoidance purposes, and therefore NAREIT concurs as to the intent of the proposal. We are concerned, however, that the Administration proposal casts too broad a net, prohibiting legitimate and necessary use of "closely held" REITs. A limited number of exceptions are necessary to allow certain entities to own a majority of a REIT's stock. NAREIT certainly agrees with the Administration's decision to exclude a REIT's ownership of another REIT's stock from the proposed new ownership limit.(14) NAREIT would like to work with Congress and the Administration to ensure that any action to curb abuses does not disallow legitimate and necessary transactions.

First, an exception should be allowed to enable a REIT's organizers to have a single large investor for a temporary period, such as in preparation for a public offering of the REIT's shares. Such an "incubator REIT" sometimes is majority owned by its sponsor to allow the REIT to accumulate a track record that will facilitate its going public. The Administration proposal would prohibit this important approach which, in turn, could curb the emergence of new public REITs in which small investors may invest.

Second, there is no reason why a partnership, mutual fund, pension or profit-sharing trust or other pass-through entity should be counted as one entity in determining whether any "person" owns 50 percent of the vote or value of a REIT. A partnership, mutual fund or other pass-through entity is usually ignored for tax purposes. The partners in a partnership and the shareholders of a mutual fund or other pass-through entity should be considered the "persons" owning a REIT for purposes of any limits on investor ownership. Similarly, the Code already has rules preventing a "pension held" REIT from being used to avoid the unrelated business income tax rules,(15) and therefore the new ownership test should not apply to pension or profit-sharing plans. Instead, NAREIT suggests that the new ownership test apply only to non-REIT C corporations that own more than 50 percent of a REIT's stock.(16)

�C;C. Summary

NAREIT supports a change in the REIT rules to prevent the abusive use of closely held REITs, but is concerned that the Administration proposal is overly broad. NAREIT looks forward to working with Congress and the Administration to craft a solution that will prevent such abuses without impeding legitimate and necessary transactions, such as those mentioned above.

III. SECTION 1374

The Administration's Fiscal Year 2000 Budget proposes to amend section 1374 to treat an "S" election by a C corporation valued at $5 million or more as a taxable liquidation of that C corporation followed by a distribution to its shareholders. This proposal also was included in the Administration's Fiscal Year 1997, 1998 and 1999 proposed budgets.

A. Background and Current Law

Prior to its repeal as part of the Tax Reform Act of 1986, the holding in a court case named General Utilities permitted a C corporation to elect S corporation, REIT or mutual fund status (or transfer assets to an S corporation, REIT or mutual fund in a carryover basis transaction) without incurring a corporate-level tax. With the repeal of the General Utilities doctrine in 1986, such transactions arguably would have been immediately subject to tax but for Congress' enactment of section 1374. Under section 1374, a C corporation making an S corporation election pays any tax that otherwise would have been due on the "built-in gain" of the C corporation's assets only if and when those assets are sold or otherwise disposed of during a 10-year "recognition period." The application of the tax upon the disposition of the assets, as opposed to the election of S status, works to distinguish legitimate conversions to S status from those made for purposes of tax avoidance.

In Notice 88-19, 1988-1 C.B. 486 (the "Notice"), the IRS announced that it intended to issue regulations under section 337(d)(1) that in part would address the avoidance of the repeal of General Utilities through the use of REITs and regulated investment companies ("RICs," i.e. mutual funds). In addition, the IRS noted that those regulations would enable the REIT or RIC to be subject to rules similar to the principles of section 1374. Thus, a C corporation can elect REIT status and incur a corporate-level tax only if the REIT sells assets in a recognition event during the 10-year "recognition period."

In a release issued February 18, 1998, the Treasury Department announced that it intends to revise Notice 88-19 to conform to the Administration's proposed amendment to limit section 1374 to corporations worth less than $5 million, with an effective date similar to the statutory proposal. This proposal would result in a double layer of tax: once to the shareholders of the C corporation in a deemed liquidation and again to the C corporation itself upon such deemed liquidation.

Because of the Treasury Department's intent to extend the proposed amendment of section 1374 to REITs, these comments address the proposed amendment as if it applied to both S corporations and REITs.

B. Statement in Support of the Current Application of Section 1374 to REITs

As stated above, the Administration proposal would limit the use of the 10-year election to REITs valued at $5 million or less. NAREIT believes that this proposal would contravene Congress' original intent regarding the formation of REITs, would be both inappropriate and unnecessary in light of the statutory requirements governing REITs, would impede the recapitalization of commercial real estate, likely would result in lower tax revenues, and ignores the basic distinction between REITs and partnerships.

A fundamental reason for a continuation of the current rules regarding a C corporation's decision to elect REIT status is that the primary rationale for the creation of REITs was to permit small investors to make investments in real estate without incurring an entity level tax, and thereby placing those persons in a comparable position to larger investors. H.R. Rep. No. 2020, 86th Cong., 2d. Sess. 3-4 (1960).

By placing a toll charge on a C corporation's REIT election, the proposed amendment would directly contravene this Congressional intent, as C corporations with low tax bases in assets (and therefore a potential for a large built-in gains tax) would be practically precluded from making a REIT election. As previously noted, the purpose of the 10-year election is to allow C corporations to make S corporation and REIT elections when those elections are supported by non-tax business reasons (e.g., access to the public capital markets), while protecting the Treasury from the use of such entities for tax avoidance.

Additionally, REITs, unlike S corporations, have several characteristics that support a continuation of the current section 1374 principles. First, there are statutory requirements that make REITs long-term holders of real estate. The 100 percent REIT prohibited transactions tax(17) complements the 10-year election mechanism.

Second, while S corporations may have no more than 75 shareholders, a REIT faces no statutory limit on the number of shareholders it may have and is required to have at least 100 shareholders. In fact, some REITs have hundreds of thousands of beneficial shareholders. NAREIT believes that the large number of shareholders in a REIT and management's responsibility to each of those shareholders preclude the use of a REIT as a vehicle primarily to circumvent the repeal of General Utilities. Any attempt to benefit a small number of investors in a C corporation through the conversion of that corporation to a REIT is impeded by the REIT widely-held ownership requirements.

The consequence of the Administration proposal would be to preclude C corporations in the business of managing and operating income-producing real estate from accessing the substantial capital markets' infrastructure comprised of investment banking specialists, analysts, and investors that has been established for REITs. In addition, other C corporations that are not primarily in the business of operating commercial real estate would be precluded from recognizing the value of those assets by placing them in a professionally managed REIT. In both such scenarios, the hundreds of thousands of shareholders owning REIT stock would be denied the opportunity to become owners of quality commercial real estate assets.

Furthermore, the $5 million dollar threshold that would limit the use of the current principles of section 1374 is unreasonable for REITs. While many S corporations are small or engaged in businesses that require minimal capitalization, REITs as owners of commercial real estate have significant capital requirements. As previously mentioned, it was Congress' recognition of the significant capital required to acquire and operate commercial real estate that led to the creation of the REIT as a vehicle for small investors to become owners of such properties. The capital intensive nature of REITs makes the $5 million threshold essentially meaningless for REITs.

It should be noted that this proposed amendment is unlikely to raise any substantial revenue with respect to REITs, and may in fact result in a loss of revenues. Due to the high cost that would be associated with making a REIT election if this amendment were to be enacted, it is unlikely that any C corporations would make the election and incur the associated double level of tax without the benefit of any cash to pay the taxes. In addition, by remaining C corporations, those entities would not be subject to the REIT requirement that they make taxable distributions of 95% of their income each tax year. While the REIT is a single-level of tax vehicle, it does result in a level of tax on nearly all of the REIT's income each year.

Moreover, the Administration justifies its de facto repeal of section 1374 by stating that "[t]he tax treatment of the conversion of a C corporation to an S corporation generally should be consistent with the treatment of its [sic] conversion of a C corporation to a partnership." Regardless of whether this stated reason for change is justifiable for S corporations, in any event it should not apply to REITs because of the differences between REITs and partnerships.

Unlike partnerships, REITs cannot (and have never been able to) pass through losses to their investors. Further, REITs can and do pay corporate level income and excise taxes. Simply put, REITs are C corporations. Thus, REITs are not susceptible to the tax avoidance concerns raised by the 1986 repeal of the General Utilities doctrine.

We note that on March 9, 1999, the Treasury Department and the IRS released their 1999 Business Plan, in which it listed a project for "[r]egulations regarding conversion of C corporation to [sic] RIC or REIT status." On February 22, 1996, the Treasury Department issued a release stating that "the IRS intends to revise Notice 88-19 to conform to the proposed amendment to section 1374, with an effective date similar to the statutory proposal." We urge the Congress to use its oversight authority to be certain that the Treasury Department does not enact the "built-in gain" tax on REITs and RICs administratively. Any such action would directly contravene Congress' repeated rejection of any statutory change in this area.

C. Summary

The 10-year recognition period of section 1374 currently requires a REIT to pay a corporate-level tax on assets acquired from a C corporation with a built-in gain, if those assets are disposed of within a 10-year period. Combined with the statutory requirements that a REIT be a long-term holder of assets and be widely-held, current law assures that the REIT is not a vehicle for tax avoidance. The proposal's two level tax would frustrate Congress' intent to allow the REIT to permit small investors to benefit from the capital-intensive real estate industry in a tax efficient manner.

Accordingly, NAREIT believes that tax policy considerations are better served if the Administration's section 1374 proposal is not enacted. Further, the Administration should not contravene the Congress' clear intent in this area by attempting to impose this double level tax on REITs and RICs by administrative means.
 


FOOTNOTES

(1) For purposes of this Statement, "section" refers to the Internal Revenue Code of 1986, as amended.
(2) From 1960 until 1980, both REITs and regulated investment companies (mutual funds) shared a requirement to distribute at least 90 percent of their taxable income to their shareholders. Although mutual funds continue this 90 percent distribution test, since 1980 REITs have had to distribute 95 percent of their taxable income. To conform to the mutual fund rules once again and to provide more after-tax funds to pay for capital expenditures and debt amortization, NAREIT supports returning the REIT's distribution test to the 90 percent threshold.
(3) The shares of a wholly-owned "qualified REIT subsidiary" ("QRS") of the REIT are ignored for this test.
(4) Since it is a disregarded entity for tax purposes, a qualified REIT subsidiary would be excepted from the requirement that a REIT not own more than 10 percent of the vote or value of another corporation.
(5) I.R.C. § 856(c)(3).
(6) I.R.C. § 856(c)(2).
(7) PLRs 9440026, 9436025, 9431005, 9428033, 9340056, 8825112. See also PLRs 9507007, 9510030, 9640007, 9733011, 9734011, 9801012, 9808011, 9835013.
(8) The REIT does not qualify for a dividends received deduction with respect to TPS dividends. I.R.C. § 857(b)(2)(A).
(9) But see PLR 9804022. In addition, the IRS has been flexible in allowing a TPS to engage in an "independent line of business" in which it provides a service to the public and a minority of the users are REIT tenants. See, e.g., PLRs 9627017, 9734011, 9835013.
(10) I.R.C. § 856(h)(1). There is no apparent reason why the proposed ownership test similarly should not be aimed at limiting more than 50 percent stock ownership, rather than 50 percent or more as now proposed.
(11) I.R.C. § 856(a)(5).
(12) I.R.C. §§ 542(a)(2) and 856(h)(2).
(13) AREIT supported the Administration's and Congress' move to limit the tax benefits of liquidating REITs.
(14) If the proposed test remains applicable to all persons owning more than 50 percent of a REIT's stock, then Congress should apply the exception for a REIT owning another REIT's stock by examining both direct and indirect ownership so as not to preclude an UPREIT owning more than 50 percent of another REIT's stock.
(15) I.R.C. § 856(h)(3).
(16) As under the current "five or fewer" test, any new ownership test should not apply to a REIT's first taxable year or the first half of subsequent taxable years. See I.R.C. §§ 542(a)(2) and 856(h)(2).
(17) I.R.C. § 857(b)(6).

 

NAREIT's Written Statement to the House Ways & Means Committee on Revenue Provisions in the Administration's FY 2000 Budget (March 10, 1999)

 

Comments of the National Association of Real Estate Investment Trusts® to the Committee on Ways and Means U.S. House of Representatives regarding certain Revenue Provisions in the Administration's Fiscal Year 2000 Budget

Submitted by Steven A. Wechsler
NAREIT President & Chief Executive Officer
Hearing held on March 10, 1999
 

As requested in Press Release No. FC-7 (February 18, 1999), the National Association of Real Estate Investment Trusts® ("NAREIT") respectfully submits these comments in connection with the Ways and Means Committee's review of certain revenue provisions presented to the Committee as part of the Administration's Fiscal Year 2000 Budget.

NAREIT's comments address the Administration proposals to (1) modify the real estate investment trust ("REIT") asset tests to permit REITs to own taxable REIT subsidiaries; (2) modify the treatment of closely held REITs; and (3) amend section 1374(1) to treat an "S" election by a large C corporation as a taxable liquidation of that C corporation. We appreciate the opportunity to present these comments.

NAREIT is the national trade association for real estate companies. Members are REITs and other publicly-traded businesses that own, operate and finance income-producing real estate, as well as those firms and individuals who advise, study and service these businesses. REITs are companies whose income and assets are mainly connected to income-producing real estate. By law, REITs regularly distribute most of their taxable income to shareholders as dividends. NAREIT represents over 200 REITs or other publicly-traded real estate companies, as well as over 2,000 investment bankers, analysts, accountants, lawyers and other professionals who provide services to REITs.

Executive Summary
Taxable REIT Subsidiaries. NAREIT welcomes the Administration's taxable REIT subsidiary proposal as a very significant step in the right direction to modernize the REIT rules. Current law requires REITs to use awkward methods in order to provide services to third parties, and also prevents REITs from remaining competitive in providing needed and emerging services to their tenants. The taxable REIT subsidiary structure would codify, yet simplify, the current law structure, while simultaneously allowing a REIT to provide new services to its tenants so long as these services are subject to a corporate level tax.

As an alternative to the Administration's REIT subsidiary proposal, NAREIT recommends that Congress enact the Real Estate Investment Trust Modernization Act of 1999 being drafted by Representatives Thomas and Cardin (the "Thomas/Cardin Bill"). The Thomas/Cardin Bill would incorporate the principles of the Administration proposal, with four significant exceptions. First, The Thomas/Cardin Bill would require taxable REIT subsidiaries to fit within the current, unified 25 percent asset test, rather than the complex and cumbersome 5 and 15 percent assets tests under the Administration proposal. Second, the Thomas/Cardin Bill would limit interest deductions on debt between a REIT and its taxable subsidiary in accordance with the current earnings stripping rules of section 163(j), whereas the Administration would eliminate even a reasonable amount of intra-party interest deductions. Third, the Thomas/Cardin Bill would prohibit a taxable REIT subsidiary from operating or managing hotels, while allowing a subsidiary to lease a hotel from its affiliated REIT so long as (a) the rents are set at market levels, and (b) the rents are not tied to net profits, and (c) the hotel is operated by an independent contractor. Fourth, the Thomas/Cardin Bill would not apply the new rules on taxable REIT subsidiaries to current arrangements so long as a new trade or business is not engaged in and substantial new property is not acquired, unless the REIT affirmatively elects taxable REIT subsidiary status. Conversely, the Administration proposal would apply to current arrangements after an undefined period of time.

Closely Held REITs. NAREIT supports the Administration's intention to craft a new ownership test intended to correspond to a REIT's primary mission: to make investment in income-producing real estate accessible to ordinary investors. However, we believe that the Administration's proposal is too broad, and therefore should be narrowed to prevent non-REIT C corporations from owning 50 percent or more of a REIT's stock (by vote or value). In addition, the new rules should not apply to so-called "incubator REITs" that have proven to be a viable method by which ordinary investors can access publicly traded real estate investments.

Built-in Gain Tax. Congress has rejected the Administration's call for a change in the section 1374 rules for three straight budgets. NAREIT recommends that Congress again reject this proposal. We also ask Congress to conduct oversight of the IRS to ensure that it does not do administratively what it has not been able to achieve by legislation.

Background on REITs

A REIT is essentially a corporation or business trust combining the capital of many investors to own and, in most cases, operate income-producing real estate, such as apartments, shopping centers, offices and warehouses. Some REITs also are engaged in financing real estate. REITs must comply with a number of requirements, some of which are discussed in detail in this statement, but the most fundamental of these are as follows: (1) REITs must pay at least 95 percent of their taxable income to shareholders;(2) (2) REITs must derive most of their income from real estate held for the long term; and (3) REITs must be widely held.

In exchange for satisfying these requirements, REITs (like mutual funds) benefit from a dividends paid deduction so that most, if not all, of a REIT's earnings are taxed only at the shareholder level. On the other hand, REITs pay the price of not having retained earnings available to expand their business. Instead, capital for growth, capital expenditures and payment of loan principal largely comes from new money raised in the investment marketplace from investors who have confidence in the REIT's future prospects and business plan.

Congress created the REIT structure in 1960 to make investments in large-scale, significant income-producing real estate accessible to the smaller investor. Based in part on the rationale for mutual funds, Congress decided that the only way for the average investor to access investments in larger-scale commercial properties was through pooling arrangements. In much the same ways as shareholders benefit by owning a portfolio of securities in a mutual fund, the shareholders of REITs can unite their capital into a single economic pursuit geared to the production of income through commercial real estate ownership. REITs offer distinct advantages for smaller investors: greater diversification through investing in a portfolio of properties rather than a single building and expert management by experienced real estate professionals.

Despite the advantages of the REIT structure, the industry experienced very little growth for over 30 years mainly for two reasons. First, at the beginning REITs were handcuffed. REITs were basically passive portfolios of real estate. REITs were permitted only to own real estate, not to operate or manage it. This meant that REITs needed to use third party independent contractors, whose economic interests might diverge from those of the REIT's owners, to operate and manage the properties. This was an arrangement the investment marketplace did not accept warmly.

Second, during these years the real estate investment landscape was colored by tax shelter-oriented characteristics. Through the use of high debt levels and aggressive depreciation schedules, interest and depreciation deductions significantly reduced taxable income -- in many cases leading to so-called "paper losses" used to shelter a taxpayer's other income. Since a REIT is geared specifically to create "taxable" income on a regular basis and a REIT is not permitted to pass "losses" through to shareholders like a partnership, the REIT industry could not compete effectively for capital against tax shelters.

In the Tax Reform Act of 1986 (the "1986 Act"), Congress changed the real estate investment landscape. On the one hand, by limiting the deductibility of interest, lengthening depreciation periods and restricting the use of "passive losses," the 1986 Act drastically reduced the potential for real estate investment to generate tax shelter opportunities. This meant, going forward, that real estate investment needed to be on a more economic and income-oriented footing.

On the other hand, as part of the 1986 Act, Congress took the handcuffs off REITs. The Act permitted REITs not merely to own, but also to operate and manage most types of income producing commercial properties by providing "customary" services associated with real estate ownership. Finally, for most types of real estate (other than hotels, health care facilities and some other activities that consist of a higher degree of personal services), the economic interests of the REIT's shareholders could be merged with those of the REIT's operators and managers.

Despite Congress' actions in 1986, significant REIT growth did not begin until 1992. One reason was the real estate recession in the early 1990s. During the late 1980s banks and insurance companies kept up real estate lending at a significant pace. Foreign investment, particularly from Japan, also helped buoy the marketplace. But by 1990 the combined impact of the Savings and Loan crisis, the 1986 Act, overbuilding during the 1980s by non-REITs and regulatory pressures on bank and insurance lenders, led to a nationwide depression in the real estate economy. During the early 1990s commercial property values dropped between 30 and 50 percent. Credit and capital for commercial real estate became largely unavailable. As a result of this capital crunch, many building owners defaulted on loans, resulting in huge losses by financial institutions. The Resolution Trust Corporation took over the real estate assets of insolvent financial institutions.

Against this backdrop, starting in 1992, many private real estate companies realized that the best and most efficient way to access capital was from the public marketplace through REITs. At the same time, many investors decided that it was a good time to invest in commercial real estate -- assuming recovering real estate markets were just over the horizon. They were right.

Since 1992, the REIT industry has attained impressive growth as new publicly traded REITs infused much needed equity capital into the over-leveraged real estate industry. Today there are over 200 publicly traded REITs with an equity market capitalization exceeding $140 billion. These REITs are owned primarily by individuals, with 49 percent of REIT shares owned directly by individual investors and 37 percent owned by mutual funds, which are owned mostly by individuals. Today's REITs offer smaller real estate investors three important qualities never accessible and available before: liquidity, security and performance.

  Liquidity. REITs have helped turn real estate liquid. Through the public REIT marketplace of over 200 real estate companies, investors can buy and sell interests in portfolios of properties and mortgages -- as well as the management associated with them - on an instantaneous basis. Illiquidity, the bane of real estate investors, is gone.

  Security. Because real estate is a physical asset with a long life during which it has the potential to produce income, investors always have viewed real estate as an investment option with security. But now, through REITs, small investors have an added level of security never available before in real estate investment. Today's security comes from information. Through the advent of the public REIT industry (which is governed by SEC and securities exchange-mandated information disclosure and reporting), the flow of available information about the company and its properties, the management and its business plan, and the property markets and their prospects are available to the public at levels never before imagined. As a result, REIT investors are provided a level of security never available before in the real estate investment marketplace.

  Performance. Since their inception, REITs have provided competitive investment performance. Over the past 20 years, REIT market performance has been comparable to that of the Russell 2000 and has exceeded the returns from fixed income and direct real estate investments. Because REITs annually pay out almost all of their taxable income, a significant component of total return on investment reliably comes from dividends. In 1998, REITs paid out almost $11 billion in dividends to their shareholders. Just as Congress intended, today small investors have access through REITs to large-scale, income producing real estate on a basis competitive with large institutions and wealthy individuals.

But REITs certainly do not just benefit investors. The lower debt levels associated with REITs compared to real estate investment overall have a positive effect on the overall economy. Average debt levels for REITs are 35-40 percent of market capitalization, compared to leverage of 80 percent and higher used by privately owned real estate (which has the effect of minimizing income tax liabilities). The higher equity capital cushions REITs from the severe effects of fluctuations in the real estate market that have traditionally occurred. The ability of REITs to better withstand market downturns has a stabilizing effect on the real estate industry and lenders, resulting in fewer bankruptcies and work-outs. The general economy benefits from lower real estate losses by federally insured financial institutions.

NAREIT believes the future of the REIT industry will see a continuous and significant shift from private to public ownership of U.S. real estate. At the same time, future growth may be limited by the competitive pressures for REITs to be able to provide more services to their tenants than they are currently allowed to perform. Although the 1986 Act took off the handcuffs and the Taxpayer Relief Act of 1997 included additional helpful REIT reforms, REITs still must operate under certain significant, unnecessary restrictions. NAREIT looks forward to working with Congress and the Administration further to modernize and improve the REIT rules so that REITs can continue to offer smaller investors opportunities for rewarding investments in income-producing real estate.

I. TAXABLE REIT SUBSIDIARIES

As part of the asset diversification tests applied to REITs, a REIT may not own more than 10 percent of the outstanding voting securities of a non-REIT corporation pursuant to section 856 (c)(5)(B).(3) The Administration's Fiscal Year 1999 Budget proposed to amend section 856(c)(5)(B) to prohibit REITs from holding stock possessing more than 10 percent of the vote or value of all classes of stock of a non-REIT corporation.(4) Significantly, the Administration's Fiscal Year 2000 Budget proposes an exception to this vote or value rule for taxable REIT subsidiaries.

A. Background and Current Law

The activities of REITs are strictly limited by a number of requirements that are designed to ensure that REITs serve as a vehicle for public investment in real estate. First, a REIT must comply with several income tests. At least 75 percent of the REIT's gross income must be derived from real estate, such as rents from real property, mortgage interest and gains from sales of real property (not including dealer sales).(5) In addition, at least 95 percent of a REIT's gross income must come from the above real estate sources, dividends, interest and sales of securities.(6)

Second, a REIT must satisfy several asset tests. On the last day of each quarter, at least 75 percent of a REIT's assets must be real estate assets, cash and government securities. Real estate assets include interests in real property and mortgages on real property. As mentioned above, the asset diversification rules require that a REIT not own more than 10 percent of the outstanding voting securities of an issuer (other than a qualified REIT subsidiary under section 163(j)). In addition, no more than 5 percent of a REIT's assets can be represented by securities of a single issuer (other than a qualified REIT subsidiary).

REITs have been so successful in operating their properties and providing permissible services to their tenants that they have been asked to provide these services to non-tenants, building off of expertise and capabilities associated with the REIT's real estate activities. In addition, mortgage REITs are presented with substantial opportunities to service the mortgages that they securitize. The asset and income tests, however, restrict how REITs can engage in these activities. A REIT can earn only up to 5 percent of its income from sources other than rents, mortgage interest, capital gains, dividends and interest. However, many REITs have had the opportunity to maximize shareholder value by earning more than 5 percent from third party services.

Starting in 1988, the Internal Revenue Service ("IRS") issued private letter rulings to REITs approving a structure to facilitate a REIT providing a limited amount of services to third parties.(7) These rulings sanctioned a structure under which a REIT owns no more than 10 percent of the voting stock and up to 99 percent of the value of a non-REIT corporation through nonvoting stock. Usually, managers or shareholders of the REIT own the voting stock of the "Third Party Subsidiary" ("TPS," also known as a "Preferred Stock Subsidiary"). The TPS typically either provides to unrelated parties services already being delivered to a REIT's tenants, such as landscaping and managing a shopping mall in which the REIT owns a joint venture interest, or engages in other real estate activities, such as development, which the REIT cannot undertake to the same extent. A TPS of a mortgage REIT typically services a pool of securitized mortgages and sells mortgages as part of the securitization process that has the effect of lowering homeowners' interest rates.

The REIT receives dividends from the TPS that are treated as qualifying income under the 95 percent income test, but not the 75 percent income test.(8) Accordingly, a REIT continues to be principally devoted to real estate operations. While the IRS has approved using the TPS for services to third parties and "customary" services to tenants the REIT could otherwise provide, the IRS has not permitted the use of these subsidiaries to provide impermissible, non-customary real estate services to REIT tenants.(9)

B. Administration Proposal

In 1998, the Administration proposed changing the asset diversification tests to prevent a REIT from owning securities in a C corporation that represent 10 percent of either the corporation's vote or its value. The proposal would have applied with respect to stock acquired on or after the date of first committee action. In addition, to the extent that a REIT's ownership of TPS stock would have been grandfathered by virtue of the effective date, the grandfather status would have terminated if the TPS engaged in a new trade or business or acquired substantial new assets on or after the date of first committee action.

In its Fiscal Year 2000 Budget, the Administration again proposes to base the 10 percent asset test on either vote or value. However, it also proposes an exception for two types of taxable REIT subsidiaries ("TRS"). A qualified business subsidiary ("QBS") would be the successor to the current TPS and could engage in the same activities as can a TPS today. A REIT could not own more than 15 percent of its assets in QBSs. The second type of TRS would be a qualified independent contractor subsidiary ("QIKS"), which could provide non-customary services to the affiliated REIT's tenants. A REIT could not own more than 5 percent of its assets in QIKSs as part of its 15 percent TRS allocation.

A TRS could not deduct any interest payments to its affiliated REIT, and 100% excise tax penalties would be imposed to the extent that any pricing between a TRS and either its affiliated REIT or that REIT's tenants was not set on an arms' length basis. The new TRS rules would apply to all existing TPSs after a time period to be determined by Congress.

C. Statement in Support of Taxable REIT Subsidiaries

The REIT industry has grown significantly during the 1990s, from an equity market capitalization under $10 billion to a level approaching $135 billion. The TPS structure is used extensively by today's REITs and has been a small, but important, part of recent industry growth. These subsidiaries help ensure that the small investors who own REITs are able to maximize the return on their capital by taking full economic advantage of core business competencies developed by REITs in owning and operating the REIT's real estate or mortgages. NAREIT appreciates the Administration's recognition that it makes sense to allow a REIT to utilize these core competencies through taxable subsidiaries so long as the REIT remains focused on real estate and the subsidiary's operations are appropriately subject to a corporate level tax.

In addition, the Administration's proposal recognizes that the REIT rules need to be modernized to permit REITs to remain competitive. By virtue of the "customary" standard in defining permissible REIT rental activities, REITs must wait until their competitors have established new levels of service before providing that service to their customers. This "lag effect" assures that REITs are never leaders in their markets, but only followers, to the detriment of their shareholders. Under the Administration proposal, the REIT could render such services to its tenants through a subsidiary that is subject to corporate tax.

The Administration's TRS' proposal is a significant step in the right direction, but NAREIT requests Congress instead to enact the Thomas/Cardin Bill. The Thomas/Cardin closely follows the Administration's subsidiary proposal, but improves and clarifies this concept in four major ways.

First, the Thomas/Cardin Bill would require taxable REIT subsidiaries to fit within the current, unified 25 percent asset test, rather than the unnecessarily complex and cumbersome 5 and 15 percent assets tests under the Administration proposal described above. Requiring two types of TRSs would cause severe complexity and administrative burdens, such as allocating costs between a QBS and a QIKS without incurring a 100% excise tax. Further, the Code should encourage, rather than prohibit, the same TRS providing the same service to its affiliated REIT's tenants and to third parties to make it easier to ensure that the pricing of those services is set at market rates. Moreover, the 5 and 15 percent limits are unnecessarily restrictive given the fact that the subsidiary is subject to a corporate level tax on all of its activities. The Thomas/Cardin Bill adopts the better approach of treating TRS stock as an asset that must fit within the current 25 percent basket of non-real estate assets a REIT can own, along with other non-real estate assets such as personal property.

Second, the Thomas/Cardin Bill would limit interest deductions on debt between a REIT and its taxable REIT subsidiary in accordance with the current earnings stripping rules of section 163(j), whereas the Administration would eliminate even a reasonable amount of intra-party interest deductions. Congress confronted very similar earnings stripping concerns in the 1980s with respect to foreign organizations and their U.S. subsidiaries and resolved these concerns by enacting section 163(j). This section permits interest deductions on objective, modest amounts of related party debt. Section 163(j) is easily implemented and guidance has been provided by final regulations. The Thomas/Cardin Bill would adopt even more strict rules for REITs and their subsidiaries by limiting the interest deductions to market rates. Clearly, REITs should not be forced to comply with an absolute denial of legitimate interest deductions when foreign organizations in similar circumstances are not so limited.

Third, the Administration's proposal does not address whether REITs could use a TRS to own or operate hotels. Given Congress' decision in 1998 to curtail the activities of so-called hotel paired share REITs, NAREIT believes it appropriate to ensure that taxable REIT subsidiaries cannot replicate the activities of these entities. The Thomas/Cardin Bill would prohibit a taxable REIT subsidiary from operating or managing hotels, while allowing a subsidiary to lease a hotel from its affiliated REIT so long as (a) the rents are set at a market levels, (b) the rents are not tied to net profits, and (c) the hotel is operated by an independent contractor.

Fourth, the Thomas/Cardin Bill would not apply the new rules on subsidiaries to current arrangements so long as a new trade or business is not engaged in and substantial new property is not acquired, unless the REIT affirmatively elects, on a timely basis, taxable REIT subsidiary status for such TPS. Conversely, the Administration proposal would become effective after an undefined period of time. REITs have planned their operations based on IRS rulings starting in 1988 that have sanctioned TPSs and should not be penalized for following established law. The Thomas/Cardin Bill wisely would adopt the concepts in last year's Administration's effective date that acknowledged the IRS' acquiescence to the TPS structure.

II. CLOSELY HELD REITS

The Administration's Fiscal Year 1999 Budget proposes to add a new rule, creating a limit of 50 percent on the vote or value of stock any entity could own in any REIT.

A. Background and Current Law

As discussed above, Congress created REITs to make real estate investments easily and economically accessible to the small investor. To carry out this purpose, Congress mandated two rules to ensure that REITs are widely held. First, five or fewer individuals cannot own more than 50% of a REIT's stock.(10) In applying this test, most entities owning REIT stock are "looked through" to determine the ultimate ownership of the stock by individuals. Second, at least 100 persons (including corporations and partnerships) must be REIT shareholders.(11) Both tests do not apply during a REIT's first taxable year, and the "five or fewer" test only applies in the last half of all taxable years.(12)

The Administration appears to be concerned about non-REITs establishing "captive REITs" and REITs doing "step-down preferred" transactions used for various tax planning purposes the Administration finds abusive such as the "liquidating REIT" structure curtailed by the 1998 budget legislation.(13) The Administration proposes changing the "five or fewer" test by imposing an additional requirement. The proposed new rule would prevent any "person" (i.e., a corporation, partnership or trust, including a pension or profit sharing trust) from owning stock of a REIT possessing more than 50 percent of the total combined voting power of all classes of voting stock or more than 50 percent of the total value of shares of all classes of stock. Certain existing REIT attribution rules would apply in determining such ownership, and the proposal would be effective for entities electing REIT status for taxable years beginning on or after the date of first committee action.

Statement Providing Limited Support for Administration Proposal on Closely Held REITs

NAREIT shares the Administration's concern that the REIT structure not be used for abusive tax avoidance purposes, and therefore NAREIT concurs as to the intent of the proposal. We are concerned, however, that the Administration proposal casts too broad a net, prohibiting legitimate and necessary use of "closely held" REITs. A limited number of exceptions are necessary to allow certain entities to own a majority of a REIT's stock. NAREIT certainly agrees with the Administration's decision to exclude a REIT's ownership of another REIT's stock from the proposed new ownership limit.(14) NAREIT would like to work with Congress and the Administration to ensure that any action to curb abuses does not disallow legitimate and necessary transactions.

First, an exception should be allowed to enable a REIT's organizers to have a single large investor for a temporary period, such as in preparation for a public offering of the REIT's shares. Such an "incubator REIT" sometimes is majority owned by its sponsor to allow the REIT to accumulate a track record that will facilitate its going public. The Administration proposal would prohibit this important approach which, in turn, could curb the emergence of new public REITs in which small investors may invest.

Second, there is no reason why a partnership, mutual fund, pension or profit-sharing trust or other pass-through entity should be counted as one entity in determining whether any "person" owns 50 percent of the vote or value of a REIT. A partnership, mutual fund or other pass-through entity is usually ignored for tax purposes. The partners in a partnership and the shareholders of a mutual fund or other pass-through entity should be considered the "persons" owning a REIT for purposes of any limits on investor ownership. Similarly, the Code already has rules preventing a "pension held" REIT from being used to avoid the unrelated business income tax rules,(15) and therefore the new ownership test should not apply to pension or profit-sharing plans. Instead, NAREIT suggests that the new ownership test apply only to non-REIT C corporations that own more than 50 percent of a REIT's stock.(16)

�C;C. Summary

NAREIT supports a change in the REIT rules to prevent the abusive use of closely held REITs, but is concerned that the Administration proposal is overly broad. NAREIT looks forward to working with Congress and the Administration to craft a solution that will prevent such abuses without impeding legitimate and necessary transactions, such as those mentioned above.

III. SECTION 1374

The Administration's Fiscal Year 2000 Budget proposes to amend section 1374 to treat an "S" election by a C corporation valued at $5 million or more as a taxable liquidation of that C corporation followed by a distribution to its shareholders. This proposal also was included in the Administration's Fiscal Year 1997, 1998 and 1999 proposed budgets.

A. Background and Current Law

Prior to its repeal as part of the Tax Reform Act of 1986, the holding in a court case named General Utilities permitted a C corporation to elect S corporation, REIT or mutual fund status (or transfer assets to an S corporation, REIT or mutual fund in a carryover basis transaction) without incurring a corporate-level tax. With the repeal of the General Utilities doctrine in 1986, such transactions arguably would have been immediately subject to tax but for Congress' enactment of section 1374. Under section 1374, a C corporation making an S corporation election pays any tax that otherwise would have been due on the "built-in gain" of the C corporation's assets only if and when those assets are sold or otherwise disposed of during a 10-year "recognition period." The application of the tax upon the disposition of the assets, as opposed to the election of S status, works to distinguish legitimate conversions to S status from those made for purposes of tax avoidance.

In Notice 88-19, 1988-1 C.B. 486 (the "Notice"), the IRS announced that it intended to issue regulations under section 337(d)(1) that in part would address the avoidance of the repeal of General Utilities through the use of REITs and regulated investment companies ("RICs," i.e. mutual funds). In addition, the IRS noted that those regulations would enable the REIT or RIC to be subject to rules similar to the principles of section 1374. Thus, a C corporation can elect REIT status and incur a corporate-level tax only if the REIT sells assets in a recognition event during the 10-year "recognition period."

In a release issued February 18, 1998, the Treasury Department announced that it intends to revise Notice 88-19 to conform to the Administration's proposed amendment to limit section 1374 to corporations worth less than $5 million, with an effective date similar to the statutory proposal. This proposal would result in a double layer of tax: once to the shareholders of the C corporation in a deemed liquidation and again to the C corporation itself upon such deemed liquidation.

Because of the Treasury Department's intent to extend the proposed amendment of section 1374 to REITs, these comments address the proposed amendment as if it applied to both S corporations and REITs.

B. Statement in Support of the Current Application of Section 1374 to REITs

As stated above, the Administration proposal would limit the use of the 10-year election to REITs valued at $5 million or less. NAREIT believes that this proposal would contravene Congress' original intent regarding the formation of REITs, would be both inappropriate and unnecessary in light of the statutory requirements governing REITs, would impede the recapitalization of commercial real estate, likely would result in lower tax revenues, and ignores the basic distinction between REITs and partnerships.

A fundamental reason for a continuation of the current rules regarding a C corporation's decision to elect REIT status is that the primary rationale for the creation of REITs was to permit small investors to make investments in real estate without incurring an entity level tax, and thereby placing those persons in a comparable position to larger investors. H.R. Rep. No. 2020, 86th Cong., 2d. Sess. 3-4 (1960).

By placing a toll charge on a C corporation's REIT election, the proposed amendment would directly contravene this Congressional intent, as C corporations with low tax bases in assets (and therefore a potential for a large built-in gains tax) would be practically precluded from making a REIT election. As previously noted, the purpose of the 10-year election is to allow C corporations to make S corporation and REIT elections when those elections are supported by non-tax business reasons (e.g., access to the public capital markets), while protecting the Treasury from the use of such entities for tax avoidance.

Additionally, REITs, unlike S corporations, have several characteristics that support a continuation of the current section 1374 principles. First, there are statutory requirements that make REITs long-term holders of real estate. The 100 percent REIT prohibited transactions tax(17) complements the 10-year election mechanism.

Second, while S corporations may have no more than 75 shareholders, a REIT faces no statutory limit on the number of shareholders it may have and is required to have at least 100 shareholders. In fact, some REITs have hundreds of thousands of beneficial shareholders. NAREIT believes that the large number of shareholders in a REIT and management's responsibility to each of those shareholders preclude the use of a REIT as a vehicle primarily to circumvent the repeal of General Utilities. Any attempt to benefit a small number of investors in a C corporation through the conversion of that corporation to a REIT is impeded by the REIT widely-held ownership requirements.

The consequence of the Administration proposal would be to preclude C corporations in the business of managing and operating income-producing real estate from accessing the substantial capital markets' infrastructure comprised of investment banking specialists, analysts, and investors that has been established for REITs. In addition, other C corporations that are not primarily in the business of operating commercial real estate would be precluded from recognizing the value of those assets by placing them in a professionally managed REIT. In both such scenarios, the hundreds of thousands of shareholders owning REIT stock would be denied the opportunity to become owners of quality commercial real estate assets.

Furthermore, the $5 million dollar threshold that would limit the use of the current principles of section 1374 is unreasonable for REITs. While many S corporations are small or engaged in businesses that require minimal capitalization, REITs as owners of commercial real estate have significant capital requirements. As previously mentioned, it was Congress' recognition of the significant capital required to acquire and operate commercial real estate that led to the creation of the REIT as a vehicle for small investors to become owners of such properties. The capital intensive nature of REITs makes the $5 million threshold essentially meaningless for REITs.

It should be noted that this proposed amendment is unlikely to raise any substantial revenue with respect to REITs, and may in fact result in a loss of revenues. Due to the high cost that would be associated with making a REIT election if this amendment were to be enacted, it is unlikely that any C corporations would make the election and incur the associated double level of tax without the benefit of any cash to pay the taxes. In addition, by remaining C corporations, those entities would not be subject to the REIT requirement that they make taxable distributions of 95% of their income each tax year. While the REIT is a single-level of tax vehicle, it does result in a level of tax on nearly all of the REIT's income each year.

Moreover, the Administration justifies its de facto repeal of section 1374 by stating that "[t]he tax treatment of the conversion of a C corporation to an S corporation generally should be consistent with the treatment of its [sic] conversion of a C corporation to a partnership." Regardless of whether this stated reason for change is justifiable for S corporations, in any event it should not apply to REITs because of the differences between REITs and partnerships.

Unlike partnerships, REITs cannot (and have never been able to) pass through losses to their investors. Further, REITs can and do pay corporate level income and excise taxes. Simply put, REITs are C corporations. Thus, REITs are not susceptible to the tax avoidance concerns raised by the 1986 repeal of the General Utilities doctrine.

We note that on March 9, 1999, the Treasury Department and the IRS released their 1999 Business Plan, in which it listed a project for "[r]egulations regarding conversion of C corporation to [sic] RIC or REIT status." On February 22, 1996, the Treasury Department issued a release stating that "the IRS intends to revise Notice 88-19 to conform to the proposed amendment to section 1374, with an effective date similar to the statutory proposal." We urge the Congress to use its oversight authority to be certain that the Treasury Department does not enact the "built-in gain" tax on REITs and RICs administratively. Any such action would directly contravene Congress' repeated rejection of any statutory change in this area.

C. Summary

The 10-year recognition period of section 1374 currently requires a REIT to pay a corporate-level tax on assets acquired from a C corporation with a built-in gain, if those assets are disposed of within a 10-year period. Combined with the statutory requirements that a REIT be a long-term holder of assets and be widely-held, current law assures that the REIT is not a vehicle for tax avoidance. The proposal's two level tax would frustrate Congress' intent to allow the REIT to permit small investors to benefit from the capital-intensive real estate industry in a tax efficient manner.

Accordingly, NAREIT believes that tax policy considerations are better served if the Administration's section 1374 proposal is not enacted. Further, the Administration should not contravene the Congress' clear intent in this area by attempting to impose this double level tax on REITs and RICs by administrative means.
 


FOOTNOTES

(1) For purposes of this Statement, "section" refers to the Internal Revenue Code of 1986, as amended.
(2) From 1960 until 1980, both REITs and regulated investment companies (mutual funds) shared a requirement to distribute at least 90 percent of their taxable income to their shareholders. Although mutual funds continue this 90 percent distribution test, since 1980 REITs have had to distribute 95 percent of their taxable income. To conform to the mutual fund rules once again and to provide more after-tax funds to pay for capital expenditures and debt amortization, NAREIT supports returning the REIT's distribution test to the 90 percent threshold.
(3) The shares of a wholly-owned "qualified REIT subsidiary" ("QRS") of the REIT are ignored for this test.
(4) Since it is a disregarded entity for tax purposes, a qualified REIT subsidiary would be excepted from the requirement that a REIT not own more than 10 percent of the vote or value of another corporation.
(5) I.R.C. § 856(c)(3).
(6) I.R.C. § 856(c)(2).
(7) PLRs 9440026, 9436025, 9431005, 9428033, 9340056, 8825112. See also PLRs 9507007, 9510030, 9640007, 9733011, 9734011, 9801012, 9808011, 9835013.
(8) The REIT does not qualify for a dividends received deduction with respect to TPS dividends. I.R.C. § 857(b)(2)(A).
(9) But see PLR 9804022. In addition, the IRS has been flexible in allowing a TPS to engage in an "independent line of business" in which it provides a service to the public and a minority of the users are REIT tenants. See, e.g., PLRs 9627017, 9734011, 9835013.
(10) I.R.C. § 856(h)(1). There is no apparent reason why the proposed ownership test similarly should not be aimed at limiting more than 50 percent stock ownership, rather than 50 percent or more as now proposed.
(11) I.R.C. § 856(a)(5).
(12) I.R.C. §§ 542(a)(2) and 856(h)(2).
(13) AREIT supported the Administration's and Congress' move to limit the tax benefits of liquidating REITs.
(14) If the proposed test remains applicable to all persons owning more than 50 percent of a REIT's stock, then Congress should apply the exception for a REIT owning another REIT's stock by examining both direct and indirect ownership so as not to preclude an UPREIT owning more than 50 percent of another REIT's stock.
(15) I.R.C. § 856(h)(3).
(16) As under the current "five or fewer" test, any new ownership test should not apply to a REIT's first taxable year or the first half of subsequent taxable years. See I.R.C. §§ 542(a)(2) and 856(h)(2).
(17) I.R.C. § 857(b)(6).