IRS Restructuring Bill Enacted:
Grandfathered Paired Share REITs Limited

August 1, 1998


Since fall 1997, Congress worked on legislation IRS Restructuring and Reform Act of 1998, Pub. L. No. 105 - 206, or the "IRS Bill" overhauling how the Internal Revenue Service conducts its operations. Although its focus is on issues such as burden of proof and outside oversight of the IRS, as signed into law on July 22, the IRS Bill made changes affecting paired share REITs, REITs that participate in tax-free mergers with non-REIT C corporations, and long-term capital gains.

The IRS Bill does not contain three other Administration tax proposals affecting third party service subsidiaries, closely held REITs, and built-in gains arising from the conversion or merger of a C corporation into a REIT. It also omits the proposed legislation affecting private "liquidating REITs" (H.R. 3947 and S. 2122) described in detail in the National Policy Bulletin dated May 26, 1998 that can be viewed in the Legal/Legislative area of NAREIT's home page at


The IRS Bill generally adopted the provisions limiting the benefits of the grandfathered paired share REITs that were introduced by Chairmen Archer (R-TX) and Roth (R-DE) and Sen. Moynihan (D-NY) as H.R. 3558 and S. 1871 on March 26, 1998 and included in the Senate version of H.R. 2676.

As background, the 1984 tax bill treated any REIT and non-REIT C corporation as a single "stapled" or "paired share" company for purposes of the REIT tax rules if more than half of the stock of both entities must be transferred as a package. However, Congress did not apply these provisions to six stapled REITs that were operating as of June 30, 1983. These "grandfathered" stapled REITs could continue to operate as separate entities, e.g., the REIT could own hotels and lease them to its affiliated non-REIT C corporation.

For purposes of determining whether any grandfathered stapled REIT meets the REIT income tests, under the IRS Bill the stapled entities are treated as one entity with respect to property acquisitions, or "substantial" improvements of existing assets by the REIT, its stapled C corporation, or a subsidiary or partnership in which the REIT or stapled entity owns 10% of the vote or value.

The bill provides an exception for grandfathered properties -- properties acquired on or before March 26, 1998, and also properties later acquired pursuant to a written agreement binding on or before March 26 or the acquisition of which was described in a public announcement or SEC filing on or before March 26. A grandfathered property loses its status if the property is expanded beyond its original boundaries or if any improvement completed after December 31, 1999 changes the use of the property and costs more than 200% of the property's cost.

Special rules apply when the REIT or stapled entity acquires a mortgage interest after March 26, 1998 and the stapled entity performs services with respect to the property secured by the mortgage. All interest on the mortgage and all income received by the stapled entity is treated as income of the REIT that does not qualify for the 75% or 95% tests if the interest exceeds an arm's length rate.

The IRS Bill contains several clarifications that some grandfathered paired share companies requested (relating to intra-group transfers, binding contracts relief and certain UPREIT transactions). However, it does not contain more substantive changes intended to allow the operating companies to expand their operations without losing their grandfathered status or to delay the effective date.

In addition, the IRS Bill does not adopt a "technical correction" found in the House-passed bill that would have clarified that paired companies could have qualified under the grandfather rules even if the REIT status of one of the companies had lapsed. This provision had been included in the House bill at the request of Hollywood Park, Inc.


The IRS Bill includes a favorable clarification provision to the earnings and profits ("E&P") distribution rule for REITs contained in the Taxpayer Relief Act of 1997 ("TRA 97"). The provision's effective date is retroactive to TRA 97's enactment date of August 5, 1997.


I.R.C. Sec. 857(a)(3) requires newly electing REITs to distribute, during their first REIT taxable year, E&P that was accumulated in non-REIT years. Regulations extend this rule to REITs that absorb a non-REIT C corporation in a tax-free reorganization. However, the ordering rule in section 316 treats all distributions as being made from the current year's E&P. Most REITs cannot determine precisely the amount of their income before the end of the year. Thus, the ordering rules in section 316 complicated the E&P distribution requirement and created tax traps for unwary companies electing REIT status or REITs participating in a tax-free merger with a C corporation.

With the enactment of TRA 97 last summer, the potential trap was ameliorated by reversing the order of E&P deemed distributed. Thus, a REIT's distributions are deemed to carry out all pre-REIT E&P before shareholders are considered to receive REIT E&P.

Clarification For Tax-Free Mergers

Despite the simplification of the ordering rules for REIT E&P, some confusion still remained regarding distribution of a REIT's pre-merger E&P. Some REITs have accumulated E&P because of the different rules used to compute net income and E&P. The technical correction in the IRS Bill removes the confusion. It states that a REIT that has a C corporation merge into it would not have to distribute its own E&P first, but only the non-REIT E&P accumulated from the C corporation.

Please note that this clarification does not remove or affect the rule that the REIT must distribute 95% of its taxable income to its shareholders.


In a surprise move, the conferees added a capital gains provision to the IRS Bill that was not in either the House or Senate versions.

In TRA 97, Congress imposed a new 18-month holding period for individual taxpayers to qualify for the new maximum capital gains tax rate (20% for most individuals). The prior 28% rate applied to capital gains for assets held before disposition between 12 months and 18 months. This two-tiered structure created a high degree of complexity for taxpayers, especially for the growing number of mutual fund investors. The structure also led to significant complexity for REITs making capital gains distributions.

To achieve simplification, the conferees eliminated the 18-month holding period requirement, effective for sales of assets after December 31, 1997. Accordingly, the lower capital gains rates available to individual investors apply to sales of capital assets held for at least one year.

If you want to discuss any of these issues in further detail, please call the Government Relations Department at (202)785-8717 or (800)3NAREIT.