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NAREIT National Policy Bulletin

REIT Modernization Act Launched in Congress
April 29, 1999

Introduction

Yesterday, Representatives Bill Thomas (R-Calif.), Ben Cardin (D-Md.) and 30 other Representatives introduced in the House of Representatives H.R. 1616, the Real Estate Investment Trust Modernization Act of 1999 (the "RMA"). (The statutory language will be accessible in the Government Relations section of www.nareit.com.) The bill's central feature, which would allow a REIT to own up to 100% of the stock of taxable REIT subsidiaries, is similar to an initiative contained in the Administration's Fiscal Year 2000 budget proposal. The original co-sponsors include two-thirds of the members of the Committee on Ways and Means, which is the House committee responsible for originating tax legislation. A companion Senate bill is expected to be introduced soon.

We urge all NAREIT members to: (1) write the RMA co-sponsors to thank them for their leadership in this important legislation (the co-sponsors are listed at the beginning of the statutory language posted on our web site); and (2) call Representatives who are not original co-sponsors of the RMA and request that they contact Representatives Thomas or Cardin to become an RMA co-sponsor. Please call Tony Edwards, Marty DePoy, or Joe Quigley at NAREIT for further details.

NAREIT applauds these co-sponsors for their leadership in endorsing legislation that would permit REITs to provide more competitive services to their customers and to operate more efficiently. NAREIT also welcomes the support of the following leading real estate organizations that have endorsed the RMA: the American Resort Development Association, the American Seniors Housing Association, the International Council of Shopping Centers, the Mortgage Bankers Association of America, the National Apartment Association, the National Association of Industrial and Office Properties, the National Association of Realtors, the National Multi Housing Council, and the National Realty Committee.

NAREIT looks forward to working with Congress and the Administration to enact the RMA this year. Although the outlook for passage is reasonably good, it is by no means certain that Congress will adopt the RMA this year. Among other factors, it is likely that the RMA will have to be made part of a larger tax bill such as budget reconciliation. Under the budget plan adopted by Congress on April 15, the tax-writing committees are scheduled to complete their work on a tax bill by late July. However, it will not be clear until the bill is drafted whether the Administration will agree to sign such tax legislation.

Executive Summary

Taxable REIT Subsidiaries. The RMA would allow a REIT to own up to 100% of the stock of a taxable REIT subsidiary ("TRS") that could provide services to REIT tenants and others without disqualifying the rents that a REIT receives from its tenants. The RMA contains size limits on TRSs to ensure that a REIT remains focused on core real estate ownership and operations. To ensure that a TRS is subject to an appropriate level of corporate taxation, the amount of debt and rental payments from a TRS to its affiliated REIT would be limited. Further, 100% excise taxes would be imposed to the extent the transactions between a TRS and its affiliated REIT or that REIT's tenants are not conducted on an arms' length basis. A TRS could not operate or manage lodging or health care facilities, but a TRS could lease lodging facilities from its affiliated REIT at market rates so long as an independent contractor operates and manages the lodging facilities.

The RMA restrictions on TRSs would not apply to arrangements in place (including third party subsidiaries) as of the date of introduction so long as the subsidiary does not engage in a new line of business and its existing business does not increase.

Health Care REITs. The RMA would allow a REIT to hire an independent contractor to operate nursing homes, etc. without a lease for up to six years when the REIT takes back a health care property at the end of a lease and cannot re-lease it. This rule would extend the "foreclosure property" rules, under which a REIT pays corporate taxes on the operating income from such property for a limited period until it can secure a new lease. In addition, pre-existing arrangements with respect to other properties would be disregarded in testing whether an entity qualifies as an independent contractor for health care properties using the foreclosure property rules.

Distribution Requirement. The RMA would return the distribution requirement from 95% to the 90% level currently applicable to mutual funds and that applied to REITs from 1960 to 1980.

Definition of Independent Contractor. In the case of a publicly traded corporation being tested as an independent contractor, the RMA only would examine shareholders owning more than 5% of the corporation's stock.

Earnings & Profits Rules. To prevent some traps for the unwary, the RMA would make some technical changes about how a company computes pre-REIT earnings and profits that it must distribute to its shareholders after electing REIT status or having a C corporation merge into it.

TAXABLE REIT SUBSIDIARIES

Background

Additional Services to Tenants. Since 1986, income that REITs derive from providing customary services to their tenants is considered rents from real property that meets both the 95% and 75% gross income tests. The Taxpayer Relief Act of 1997 adopted a useful rule under which a small amount of non-customary services that a REIT provides to a tenant does not disqualify the underlying rents that the tenant pays the REIT. However, if a REIT provides non-customary or tenant-specific services (e.g., concierge services) to a tenant beyond a de minimus amount, the IRS contends that all payments from that tenant do not qualify under the relevant REIT tax tests. The IRS generally takes the position that this "tainting" effect also applies if the services are rendered by a REIT's third party subsidiary.

Like other major businesses in the United States in the 1990s, the real estate industry is rapidly evolving into a customer-oriented service business. Landlords that provide new services to their tenants only after such services have become usual and customary risk losing their competitive edge in attracting and retaining top-quality tenants. Further, as REITs grow larger they automatically affect what services are considered customary in a geographic locale. Paradoxically under the current rules, some services might never be considered customary because REITs are prevented from providing "leading edge" services.

In addition, all businesses have discovered that providing ancillary services with good quality controls produces customer loyalty. Under the current law, a REIT must use independent contractors to provide non-customary services to its tenants, so REIT management has little control over the quality of the services rendered by the independent contractor to the REIT's tenants. Income from these new revenue-producing opportunities must accrue to the benefit of a third party, to the REIT shareholders' detriment.

Thus, providing new services to tenants has three equally compelling benefits. First, the availability of the new service to the tenant generates greater customer loyalty and allows the REIT landlord to remain competitive. Second, the new service (offered either by the landlord or by a third party licensed by the landlord) generates a new stream of income for the REIT shareholders. Third, the REIT can maintain better quality controls over the services rendered to its tenants.

Services to Third Parties. Modern REITs have performed services for their tenants so well that third parties retain REITs to provide the same service. The original REIT legislation contemplated that a REIT could earn up to 5% of its income from sources other than rents, capital gains, dividends and interest. However, many REITs have had the opportunity to maximize shareholder value by earning more than 5% from managing joint ventures and from other third party service income.

To capture part of this income flow, many REITs have invested in non-REIT C corporations (sometimes using some key REIT employees). These corporations provide to unrelated parties services already being delivered to a REIT's tenants (such as landscaping services and managing a shopping mall in which the REIT owns a joint venture interest), or provide services not allowed to be offered by a REIT. Moreover, mortgage REITs have used non-REIT C corporations to make mortgage loans, purchase mortgage loans from third parties or from the REIT, and to service mortgage loans.

The REIT asset rules are patterned loosely after the asset diversification rules applicable to mutual funds. Under these rules, a REIT may not own more than 10% of the voting securities of another company (other than a "qualified REIT subsidiary" or another REIT), and the securities of another company may not exceed 5% of the value of a REIT's total assets.

To comply with the diversification tests, REITs have invested in nonvoting securities of C corporations, the voting stock of which is controlled by other persons ("Third Party Subsidiary," or "TPS"). The Internal Revenue Service granted private letter rulings approving these investments starting in 1988, although it has chosen not to rule directly on this structure since 1994. Any dividends to the REIT from the TPS qualify under the REIT 95% gross income test, but not the 75% gross income test. Accordingly, a REIT continues to be principally devoted to real estate operations.

The TPS structure is economically important because it has allowed REITs to use their assets and expertise to provide real estate related services to non-tenants in a format that is fully taxable. However, the structure is awkward because the REIT is not allowed to control the subsidiary. To satisfy the diversification tests, 90% or more of its voting stock must be owned by parties other than the REIT, and the TPS stock cannot be worth more than 5% of the REIT's assets. The inability of a REIT to own all the stock of a TPS means that REIT shareholders cannot be assured that the TPS always will act in their best interests. Also, part of the income earned by the TPS will accrue to the voting shareholders' benefit rather than the REIT shareholders.

Administration Proposals

Last Year's Proposal. In its proposed budget for Fiscal Year 1999, the Administration proposed changing the 10% asset test described above to prohibit a REIT from owning more than 10% of the vote or value of a non-REIT corporation. In deference to all the IRS rulings issued since 1988 concerning third party service subsidiaries, the Treasury Department proposed to apply this repeal of the subsidiary structure only to new subsidiaries created after the "date of first committee action" and to any expansion (after such date) of business activities of existing third party subsidiaries.

In the past year, NAREIT conducted a dialogue with the Administration and the Congress on ways in which the Treasury Department's stated concerns could be addressed while allowing the REIT industry to meet competitive demands from the marketplace.

This Year's Proposal. In the proposed Fiscal Year 2000 Budget released in February, the Administration again recommended changing the 10% asset test to prohibit a REIT from owning more than 10% of the vote or value of a non-REIT C corporation. However, in a significant departure, the Administration called for an exception to the new 10% asset test for TRSs. There would be two types of TRSs under the proposal.

A qualified business subsidiary ("QBS") would be the successor to TPSs. A QBS would be able to provide management and other services to non-tenants of the REIT or otherwise conduct any business for parties other than the affiliated REIT's tenants.

A qualified independent contractor subsidiary ("QIKS") would be allowed to perform non-customary and other currently prohibited services to REIT tenants as well as activities that could be performed by a QBS.

The Administration proposed two size limitations for TRSs. First, all TRSs owned by a REIT could not represent more than 15% of the value of the REIT's total assets. Second, the value of all QIKSs could not represent more than 5% of the value of the REIT's assets.

The Administration proposed to totally disallow a TRS' interest payments (directly or indirectly) on debt to a REIT that owns stock in the TRS. Note also that any rents paid by a TRS to a REIT owning more than 10% of the TRS' stock would not be considered qualified rental income under existing REIT tax tests.

A 100% 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 TRS through increased rents to the REIT); and (2) allocation of shared expenses between the REIT and the TRS.

The Treasury Department proposed that this provision would be effective after the date of enactment. However, REITs would be allowed to combine and convert TPSs into TRSs tax-free "prior to a certain date." Treasury contemplated "a transition period" to allow for conversion of existing subsidiaries before the 10% vote or value test would become effective. Note that there is no transition rule for the non-deductibility of interest payments by a TPS to its affiliated REIT.

RMA Proposal

The RMA builds on the Administration's current TRS proposals but makes several important improvements.

First, the RMA would require TRSs to fit within the current, unified 25% asset test, rather than the unnecessarily complex and cumbersome 5% and 15% 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% limits are unnecessarily restrictive given the fact that the subsidiary is subject to a corporate level tax on all of its activities. The RMA 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 RMA 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). (Note, however, that the RMA would not disallow a TRS' interest deductions on debt to third party lenders that is guaranteed by its affiliated REIT, as such guarantees reduce a TRS' interest rate and thereby increases its taxable income). 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 RMA 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 and their U.S. affiliates in similar circumstances are not so limited.

Third, the Administration's proposal does not address whether REITs could use a TRS to operate and manage hotels or health care facilities. Given Congress' decision in 1998 to curtail the activities of so-called paired share REITs, the bill's sponsors believe it appropriate to ensure that taxable REIT subsidiaries cannot replicate the activities of these entities. The RMA would prohibit a taxable REIT subsidiary from operating or managing hotels or health care facilities, 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; (c) the hotel is operated by an independent contractor; and (d) no organized gambling occurs at the hotel. Further, a TRS could not be a franchiser of any brand name under which a lodging or health care facility is operated.

Fourth, the RMA would allow payments from a TRS for space rented from a REIT to be considered qualified rents under the REIT income tests if (1) the TRS rents no more than 10% of the leased space of a property; and (2) the TRS pays substantially the same rents for similar space as the non-related parties at the same property.

Fifth, the RMA contains some safe harbors that REITs could use to objectively satisfy arms' length requirements necessary to avoid the 100% excise tax penalties. For example, the excise tax would not apply if a TRS provides a substantial amount of services to third parties at the same prices offered to tenants of its affiliated REIT. Considering the confiscatory nature of the excise tax, these safe harbors are needed to ensure that REITs would not be penalized for legitimate business transactions.

Sixth, the RMA 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. 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 RMA would adopt the concepts of the effective date in last year's Administration budget proposal that acknowledged the IRS' acquiescence to the TPS structure.

HEALTH CARE REITS

Background

A REIT is permitted to conduct a trade or business using property acquired through foreclosure for 90 days after it acquires such property, provided the REIT makes a foreclosure property election. After the 90-day period, the REIT may no longer conduct such trade or business, except through an independent contractor from whom the REIT does not derive or receive any income. Property is eligible for a foreclosure election if the REIT acquired it through foreclosure on a loan or default on a lease, but not if the REIT acquired it because a lease expired. If it makes the foreclosure property election, a REIT may hold foreclosure property for resale to customers without being subject to the 100% penalty tax under the prohibited transaction rules. Non-qualifying income from foreclosure property generally is subject to the highest corporate tax rate (now 35%).

Under the Code, foreclosure property status is lost if, at some time after 90 days from the date such property is acquired, the property is used in a trade or business conducted by the REIT (other than through an independent contractor from whom the REIT does not derive any income).

Health care REITs face unique problems under the foreclosure property rules when the lessee/operator of a health care facility terminates its lease, either through expiration or default. Unlike most other forms of rental properties, if a health care property lease terminates, it is extremely difficult to close the facility because medical services to patients must be maintained. A variety of government regulations mandate measures to protect patients' welfare, which greatly restrict the ability simply to close the facility. In addition, because of the limited number of qualified health care providers, it can be very difficult to find a substitute provider that also will lease the property.

Therefore, in order to keep a health care facility operational after the 90-day period has expired under the foreclosure property rules, a REIT must be able to hire a licensed health care provider that also qualifies as an independent contractor from whom the REIT does not derive or receive any income or profits. The limited pool of licensed providers that could qualify as independent contractors may be dramatically reduced, since many of these providers already lease other health care properties owned by the REIT. As existing lessees of the REIT, these providers generate income to the REIT, and may be viewed by the IRS as disqualified from serving as independent contractors.

RMA Proposal

The RMA provides that, in the case of qualified health care properties, a health care provider would not be disqualified as an independent contractor for purposes of the foreclosure property rules solely because a REIT receives rental income from the provider with respect to one or more other properties. In addition, the proposal would provide that a REIT could make a foreclosure property election with respect to lease expiration of a qualified health care property. The proposal would not extend the 90-day grace period in which the REIT could directly operate the property after the foreclosure event.

This proposal would help ensure that important health care facilities are not forced to close because of a technical requirement in the Code. As with any properties that are subject to a foreclosure election, non-rental income realized by the REIT under this proposal would be subject to the highest corporate tax rate. This proposal was included as part of H.R. 1150, the Real Estate Investment Trust Simplification Act of 1997, but was not included in the REIT-related provisions Congress adopted as part of the Taxpayer Relief Act of 1997 for procedural reasons. When H.R. 1150 was introduced in 1997, the Joint Committee on Taxation estimated that these changes would produce negligible revenue effects.

DISTRIBUTION REQUIREMENTS

Background

In developing the REIT, Congress looked substantially to the rules then governing regulated investment companies ("RICs"), otherwise known as mutual funds. Accordingly, REITs and RICs face similar qualification requirements. Among those requirements are limitations on the type of income each entity may generate and a mandated distribution of taxable income (with the exception of capital gains). At their inception in 1960, REITs and RICs both were subject to a 90% income distribution test.

In 1976, Congress passed several amendments to the REIT rules. One change was to provide a "deficiency dividend procedure" ("DDP") that protected a REIT under the required distribution test when the REIT's taxable income for a prior year was redetermined pursuant to an IRS audit in a subsequent year. Accompanying the introduction of the DDP was an increase in the required distribution of taxable ordinary income to 95% (effective on January 1, 1980).

In 1978, the DDP concept was extended to RICs. However, Congress did not seek to impose the higher income distribution requirement to RICs that accompanied the DDP when introduced for REITs in 1976, nor did it address why the REIT distribution requirement should stay at 95%.

RMA Proposal

The RMA would return the 95% annual distribution requirement to the original 90% threshold. A 90% distribution requirement is supported by the historical comparability of the REIT and RIC provisions, as well as the capital needs of REITs.

The original 90% taxable income distribution requirement represented Congress' intention to mirror the REIT after the RIC and an understanding that such entities could have legitimate business reasons for choosing to pay a corporate level tax in order to retain a small portion of their income. This flexibility is especially important in the capital-intensive commercial real estate leasing business under which REITs must pay for capital expenditures to maintain the quality of their properties. In addition, a 90% distribution requirement would provide a valuable source of after-tax revenues to make principal payments on outstanding debt.

This proposal also was included as part of H.R. 1150, the Real Estate Investment Trust Simplification Act of 1997, but was not included in the REIT-related provisions Congress adopted as part of the Taxpayer Relief Act of 1997 for procedural reasons. When H.R. 1150 was introduced in 1997, the Joint Committee on Taxation estimated that these changes would produce negligible revenue effects.

INDEPENDENT CONTRACTOR DEFINITION

Background

When Congress first enacted REITs in 1960, virtually all operations had to be carried out by independent contractors from which the REIT could not receive any income. An independent contractor is defined as an entity that does not own (directly or indirectly) more than 35% of a REIT's stock or an entity not more than 35% owned (directly or indirectly) by persons who own more than 35% of the REIT's stock. In 1986, Congress allowed REIT employees to directly provide customary services to REIT tenants. However certain, REITs still must use independent contractors to provide to their tenants more than a de mimimis amount of non-customary services even if Congress enacts the RMA.

It is difficult, if not impossible, to determine if a publicly traded corporation meets these tests because public stock is fungible and the SEC only requires persons owning more than 5% of a SEC-registered company to disclose their ownership.

RMA Proposal

In the case of a publicly traded corporation being tested as an independent contractor, the RMA would examine only shareholders owning more than 5% of the corporation's or the REIT's stock. The rule would parallel the test contained in Code section 382(g)(4).

EARNINGS & PROFITS

Background

When a non-REIT C corporation elects REIT status or merges into a REIT, the Code requires that all pre-REIT earnings and profits ("E&P") must be distributed to its shareholders by the close of the REIT's first taxable year. The Real Estate Investment Trust Simplification Act of 1997 made an ordering change intended to prevent a company from losing its REIT status merely because it underestimated its pre-REIT E&P.

RMA Proposal

The RMA would make additional technical ordering rule changes and would allow a REIT to use the deficiency dividend procedure when a company's pre-REIT E&P increases as a result of an IRS audit of its pre-REIT tax years.