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SUMMARY OF REIT MODERNIZATION PROPOSAL

SUMMARY OF REIT MODERNIZATION PROPOSAL


     Current Law Treasury Proposal H.R. 1616 & S. 1057
Asset and Income Tests At least 75% of a REIT's assets must be comprised of rental real estate, mortgages, cash or Government Securities. At least 75% of a REIT's annual income must consist of real property rents, mortgage interest, gain from the sale of real estate assets and certain other real estate related sources. At least 95% of the REIT's annual income must be derived from the real estate income sources in the 75% asset test plus "passive income" sources such as dividends and interest. In addition, a REIT cannot own more than 10% of the voting securities of any non-REIT corporation, and the securities of any single non-REIT corporation cannot exceed 5% of the REIT's assets. The 75% and 95% income tests and the 75% asset test would be the same as current law. The 5% asset test would remain, but the 10% limit on ownership of voting securities of a non-REIT corporation would be changed to a 10% limit on either the vote or value of securities of a non-REIT corporation. There would be an exception to both the 5% and 10% asset tests in the case of "taxable REIT subsidiaries". Same as the Treasury Proposal.
Non-customary Tenant Services Only "customary services" to tenants are considered rents from real property for purposes of meeting the 75% and 95% gross income tests. Through published rulings, the IRS decides on a case-by-case basis what is a "customary service" according to a determination whether the service is customarily provided by real estate companies in the particular market. REITs would be permitted to establish "taxable REIT subsidiaries" to provide a limited amount of non-customary services to tenants (5% of the REIT's assets) because, according to Treasury, "the prohibition of a REIT performing either directly or indirectly, non-customary services can put REITs at a competitive disadvantage in relation to others in the same market." Similar to the Treasury proposal, REITs would be permitted to establish "taxable REIT subsidiaries" to provide a limited amount of non-customary services to the REIT's tenants (25% of a REIT's assets).
Third Party Subsidiaries and Transitional Rules REITs can provide services to third parties (i.e. non-tenants) by establishing "third party subsidiaries" ("TPS"). These entities, sometimes referred to as preferred stock subsidiaries, are taxable corporations that have been established pursuant to private letter ruling guidance provided by the IRS since 1988. The IRS rulings also allow a TPS to provide services to the REIT's tenants if most of the TPS' services are provided to third parties. The REIT may not own more than 10% of the voting securities of the TPS but typically owns in excess of 95% of its value. Each TPS cannot be worth more than 5% of the REIT's total assets. After an undetermined transitional period, the Treasury proposal would prohibit REITs from owning more than 10% of the vote or the value in another corporation but would permit REITs to establish "taxable REIT subsidiaries" to provide both non-customary tenant services and services to third parties. REITs would be permitted to combine and convert their third party subsidiaries to taxable REIT subsidiaries tax-free. As under Treasury's FY 1999 Budget, existing third party subsidiaries would continue to be governed by current law, except that they could not expand their business activities or assets after the date of first committee action. As under the current Treasury proposal, REITs would be permitted to establish "taxable REIT subsidiaries" to provide both non-customary tenant services and services to others, and third party subsidiaries could convert tax-free into taxable REIT subsidiaries.
Taxable REIT Subsidiaries There is no provision in current law that permits "taxable REIT subsidiaries," although REITs are permitted to have "third party subsidiaries" subject to the 10% limit on ownership of the subsidiaries' voting securities and a 5% limit on the value of the subsidiary relative to the REIT's total assets. REITs would be permitted to own up to 100% of the stock of "taxable REIT subsidiaries" ("TRS"). The TRS could be either a "qualified independent contractor subsidiary" ("QICS") or a "qualified business subsidiary" ("QBS"). A QICS would be permitted to provide non-customary and other currently prohibited services with respect to REIT tenants, as well as services that could be performed by a QBS. A QBS would be permitted to provide services to third parties. The value of all TRSs owned by a REIT could not exceed 15% of the total value of the REIT's assets, and within that limit a QICS could not exceed 5% of the value of the REIT's assets. As under the Treasury proposal, REITs would be permitted to own up to 100% of the stock of "taxable REIT subsidiaries" ("TRS"). Unlike the Treasury proposal, there would be no distinction between subsidiaries based on whether services are provided to tenants or third parties. REITs would continue to be subject to the 75% asset test so the value of the TRS, together with the value of other non-real estate assets such as personal property, could not exceed 25% of the total value of a REIT's assets. Unlike the Treasury proposal, a TRS could not operate hotels or health care facilities and could not be a hotel franchiser.
Limitation on Earnings Stripping Any amounts a REIT receives as rental payments from an entity that is 10% or more owned by the REIT counts as nonqualified income. REITs are subject to the transfer pricing rules of section 482 that are designed to allocate the appropriate income and expenses between related corporations and to assess interest and penalties against the corporations for not using arms' length pricing. A number of constraints would be imposed to limit the ability of a TRS to shift income to the REIT.

1. Debt. A TRS would not be permitted to deduct any interest incurred on debt funded directly or indirectly by the REIT.
A number of constraints would be imposed to limit the ability of a TRS to shift income to the REIT.

1. Debt. The section 163(j) "earnings stripping" rules applicable to subsidiaries of tax-exempt organizations and non-U.S. entities would apply. Under these rules, a TRS could deduct interest payments to its affiliated REIT only if: (a) the ratio of its debt to its equity is less than 1.5 to 1; or, (b) half of its net income is greater than its net interest expense. In addition, another limitation not found in section 163(j) would apply: imposition of a 100% excise tax penalty on any interest payments above a commercially reasonable interest rate.
          2. Arms' Length Pricing. A 100% excise tax would be imposed on excess payments when: (a) a REIT receives higher rents as compensation for services provided by the TRS, and (b) shared overhead costs are over-allocated to the TRS. 2. Arms' Length Pricing. As under the Treasury proposal, a 100% excise tax would be imposed on a REIT to the extent it receives rents from tenants receiving services from the TRS that are above the amount that would be charged to tenants not receiving the services. Three safe harbors would be provided when: (a) the TRS provides a significant amount of services to third parties at prices equivalent to those charged the REIT's tenant; (b) rents for comparable space at the same property are the same regardless of whether the tenant is provided services from the TRS; and (c) the TRS charges the tenant at least 150% of its cost of providing the service. As under the Treasury proposal, a 100% excise tax also would be imposed on the REIT when shared overhead costs are over-allocated to the TRS.
          3. There would be "significant limits" placed upon intercompany rentals between a REIT and its TRS. 3. Inter-party Rentals. As under the Treasury proposal, payments from a TRS to its affiliated REIT generally would not be considered qualified rental income under the existing related party rules. Exceptions would apply only (1) if such payments by the TRS are substantially equivalent to the rents paid by unrelated tenants at an individual property and such tenants account for at least 90% of the property's leased space; or (2) for qualified lodging facilities that are operated and managed by an independent contractor. Rental payments from the TRS exceeding fair market rent would be subject to a 100% excise tax on the amount of the excess.
Foreclosure Rules for Health Care REITs REITs can operate a business through an independent contractor and pay a full corporate level tax on "foreclosure property" upon a breach of a mortgage or lease. No proposal. REITs could elect foreclosure property treatment for health care facilities upon a lease's termination. In addition, the definition of an independent contractor for this purpose would be based on the economics of the foreclosed property.
Distribution Requirement From 1960 to 1980, REITs were required to distribute at least 90% of their taxable income. Since 1980, REITs must distribute at least 95% of their taxable income. No proposal. Return distribution requirement to 90% (to match the distribution requirement of mutual funds).
Independent Contractor Definition Defined as a person who does not own, directly or indirectly, more than 35% of the shares of a REIT. No proposal. In the case of a publicly traded corporation being tested as an independent contractor, apply rules similar to section 382(g)(4) by examining only shareholders owning more than 5% of the corporation's or the REIT's stock.
Distribution of pre-REIT Earnings and Profits ("E&P") Law changed in 1997 to reorder current and accumulated E&P to prevent inadvertent disqualification. Law is silent on use of deficiency dividend procedure when an IRS audit increases pre-REIT E&P. No proposal. Modify 1997 change to better reflect reordering policy. Also, clarify that the deficiency dividend procedure would be available for IRS determinations of greater pre-REIT E&P.