NAREIT's "Talking Points" on Closely-Held REITs (March 9, 1998)
Congress created REITs in 1960 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. Second, at least 100 persons (including corporations and partnerships) must be REIT shareholders.
The Administration's proposed budget for Fiscal Year 1999 would create a new widely held test prohibiting any entity (including a corporation or partnership) from owning more than 50% of the vote or value of newly-created REIT's stock. The proposal is estimated to raise $94 million over five years.
NAREIT agrees that the widely held REIT tests are fundamental in carrying out Congress' intent to benefit the small investor. NAREIT recommends that this proposal be modified in three respects.
REITs Owning REITs. A REIT should be able to continue owning stock in another REIT without limitation. Since the original 1960 REIT legislation, REIT stock has been considered "real estate assets" rather than securities for purposes of the REIT asset tests. There are a number of situations under which a REIT may own a majority of another REIT's stock that are not within the scope of the perceived abuses targeted by the Administration's proposal. For example, in a tender offer one REIT might own for a period of time more than half of another REIT's stock. Since the "parent" REIT would need to satisfy the new widely held test, there could be no abuse if one REIT owned more than 50% of another REIT's stock.
Incubator REITs. The proposal should not apply to so-called "incubator REITs." A sponsor forms this type of private REIT to attract some venture capital from minority investors. The sponsor typically plans to use the funds to develop a track record by operating a real estate business for a few years with a view towards completing an initial public offering. These incubator REITs play an important role in allowing small investors to have access to commercial real estate.
The current "five or fewer" REIT rules recognize the necessity of providing a REIT an initial period to comply with the widely held rules. Under current law, the "five or fewer" rules (and the 100 person requirement) do not apply to a REIT's initial taxable year. In addition, the "five or fewer" rule only applies in the last half of all later taxable years. Accordingly, NAREIT suggests that the Administration's new widely held proposal adopt parallel rules.
However, the marketplace prefers evaluating a new company with several years' worth of economic performance. Thus, NAREIT recommends that the Administration's widely held proposal not apply to a private REIT that elects to be an incubator REIT. The electing REIT would have to furnish the IRS an offering document in which potential investors are advised that the REIT intends to list its shares on an established securities market within three years after its first taxable year. If the REIT does not so list its shares with an established securities market within this three-year period, the new widely held test would apply retroactively for all three years. Note that this would be a harsh penalty, as the purported incubator REIT presumably would have distributed 95 percent of its taxable income during the three years, but now would be subject to a corporate level tax (plus interest and penalties) for the previous three years if it failed the new widely held test.
Pass-through Entities. The Administration proposes to apply the new test to any entity owning more than 50% of the vote or value of a REIT. However, tax law usually views a partnership as an aggregation of its partners, rather than a single entity. It is not apparent what abuse would exist if, for example, an investment fund operating as an LLC with several hundred partners owns more than 50% of a REIT. Accordingly, NAREIT suggests that the widely held proposal be clarified to apply to any C corporation (rather than entity) that owns more than 50% of the vote or value of a REIT's stock.