REIT Provisions in the Administration's
Proposed Fiscal Year 1999 Budget
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 1999 Budget
March 11, 1998
Submitted by Steven J. Guttman
Chairman and Chief Executive Officer, Federal Realty Investment Trust
As requested in Press Release No. FC-11 (February 18, 1998), the National Association of Real Estate Investment Trusts(r) ("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 1999 Budget.
NAREIT's comments will address the Administration proposals to (1) amend section 1374 of the Internal Revenue Code to treat an "S" election by a large C corporation as a taxable liquidation of that C corporation; (2) restrict real estate investment trusts ("REITs") from owning more than 10 percent of the value of so-called "subsidiary service corporations;" (3) modify treatment of closely held REITs; and (4) freeze the grandfather status of stapled (or paired-share) REITs. We appreciate the opportunity to present these comments.
NAREIT is the national trade association for real estate companies. Members are REITs and other public 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 250 REITs or other public real estate companies, as well as over 2,000 investment bankers, analysts, accountants, lawyers and other professionals who provide services to REITs.
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. Other 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) 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 must come 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 by 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 in two important ways. First, 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, real estate investment needed to be on a more economic and income-oriented footing.
In addition, as part of the 1986 Act, Congress took the handcuffs off REITs. The Act permitted REITs to operate and manage -- in addition to owning -- 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 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 astounding 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 $150 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. 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. Both over the past two years and the past twenty years, REIT market performance has been comparable to that of the S&P 500 and has greatly 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 1997, REITs paid out over $8 billion in dividends to their shareholders. Just as Congress intended, today through REITs small investors have access to large-scale, income producing real estate on a basis competitive with large institutions and wealthy individuals.
But REITs don't just benefit investors. The lower debt levels associated with REITs compared to real estate investment overall has a positive effect on the overall economy. Average debt levels for REITs are 35 percent of market capitalization, compared to leverage of 80 percent and higher used by privately owned real estate (which have the effect of minimizing 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 an acceleration in the 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 significant, unnecessary restrictions. NAREIT looks forward to working with Congress and the Administration to further 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. SECTION 1374
The Administration's Fiscal Year 1999 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 was also included in the Administration's Fiscal Year 1997 and 1998 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 subject to tax but for Congress' enactment of Internal Revenue Code section 13741. Under section 1374, a C corporation making an S corporation election can elect to have the S corporation pay any tax that otherwise would have been due on the "built-in gain" of the C corporation's assets, but only if those assets were 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, worked 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 Internal Revenue Service (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 permit the REIT or RIC to be subject to rules similar to the principles of section 1374. Thus, C corporations can elect REIT status and incur a corporate-level tax only if the REIT sells assets 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 was to continue to allow C corporations to make S corporation and REIT elections when those elections were 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 tax2 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, is required to have at least 100 shareholders, and 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 to be used primarily in the circumvention of 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 REIT's 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 a taxable distribution 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.
Last, but far from least, 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.
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.
II. SUBSIDIARY SERVICE CORPORATIONS
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). The shares of a wholly-owned "qualified REIT subsidiary" ("QRS") of the REIT are ignored for this test. The Administration's Fiscal Year 1999 Budget proposes 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 (other than a wholly owned QRS).
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).3 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.4
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 QRS). In addition, no more than 5 percent of a REIT's assets can be represented by securities of a single issuer (other than a QRS).
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. 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 service income.
Starting in 1988, the Internal Revenue Service issued private letter rulings to REITs approving a structure to facilitate a REIT providing a limited amount of services to third parties.5 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 Service Subsidiary" ("TPSS," also known as a "Preferred Stock Subsidiary"). The TPSS typically provides 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. The REIT receives dividends from the TPSS that are treated as qualifying income under the 95 percent income test, but not the 75 percent income test.6 Accordingly, a REIT continues to be principally devoted to real estate operations. In addition, while the IRS has approved using TPSSs 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.7
The Administration proposes to change the asset diversification tests to prevent a REIT from owning securities in a C corporation that represent either 10 percent of the corporation's vote or value. The proposal would apply 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 TPSS stock is grandfathered by virtue of the effective date, the grandfather status would terminate if the TPSS engages in a new trade or business or acquires substantial new assets on or after the date of first committee action. This proposal is only expected to raise $19 million over five years.
B. Statement Against Administration Proposal to Limit REIT Investments in Service Subsidiaries
The REIT industry has grown significantly during the 1990s, from an equity market capitalization under $10 billion to a level exceeding $150 billion. The TPSS 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. By halting the expansion of TPSSs, the Administration proposal would curtail REIT growth at a time when the industry is just realizing Congress' vision of making publicly owned, income-producing real estate accessible for small investors. Since the profits of the TPSS are taxable at the corporate level today, NAREIT sees no reason to restrain their future use and growth.
The REIT asset rules are patterned loosely after the asset diversification rules applicable to mutual funds, with the REIT rules being significantly more restrictive.8 In contrast to the REIT rules, a mutual fund can own 100 percent of any one issuer so long as not more than 25 percent of the value of the fund's total assets are invested in that issuer. The REIT provisions do not provide the same flexibility. A REIT cannot own more than 10% of the voting securities of a non-REIT corporation, and securities of a non-REIT corporation cannot be worth more than 5 percent of the REIT's assets. The Administration proposal would further restrict REIT investment, in contrast with the flexibility afforded to mutual funds.
Over the years, Congress has modified and refined the REIT rules several times to ensure that REITs can continue to effectively fulfill their mission to promote investment by individuals in income-producing real estate. These modifications helped shift the focus of real estate investment generally from the tax loss orientation of the 1970s and 1980s to the taxable, income-oriented REIT environment today. Most recently, Congress reviewed the REIT rules and enacted the constructive REIT Simplification Act of 1997.
NAREIT believes strongly that the Administration proposal limiting REIT investment in TPSSs is a noticeable step backwards in thinking at a time when policymakers should seriously consider additional forward-thinking steps to make income-based real estate investments easily and economically accessible to small investors everywhere. To ensure REITs remain competitive in the real estate marketplace, an important step forward in this area is to enable REITs in the future to provide more services to both tenants and customers under appropriate tax rules.
While NAREIT strongly disagrees with the Administration proposal, we do believe that the TPSS approach is not an ideal solution to making certain that REITs can provide competitive services in the real estate marketplace. NAREIT looks forward to working with the Administration and Congress to formulate appropriate rules to enable REITs to serve their tenants and customers and thereby effectively compete with other real estate companies.
C. Summary
NAREIT strongly opposes the Administration proposal as it will only further restrict REITs from fulfilling their mission of making investment in large-scale, income-producing real estate accessible to small investors. NAREIT encourages Congress and the Administration to work towards a solution that will enable REITs to better serve their tenants and customers, thereby maximizing returns to REIT shareholders. For REITs to compete effectively with other real estate investors, they must be able to manage and operate their properties, including providing a wide range of customer services. There is no reason why REITs should not be able to provide noncustomary services to tenants as well as services to non-tenant customers on a basis taxable at the corporate level.
III. 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.9 In applying this test, most entities owning REIT stock are "looked through" to determine the ultimate ownership by individuals of the stock. Second, at least 100 persons (including corporations and partnerships) must be REIT shareholders.10 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.11
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 it finds abusive. 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) 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.
B. 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 welcomes 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 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 needs to be made so that a REIT may own more than 50 percent of another REIT's stock. For example, in the course of an acquisition, a REIT may need to own more than 50 percent of another REIT's stock while conducting a tender offer for the target REIT's shares. Also, in structuring a joint venture a REIT may desire to own a majority, controlling interest in another REIT. Neither of these situations raises abuse concerns. After all, the "control" REIT must comply with the full panoply of REIT rules-- including any new ones--to ensure the private REIT is truly widely held.
Second, 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 "incubator REITs" sometimes are majority owned by its sponsor to allow the REIT to accumulate a track record that will allow it to go 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.
In addition, there is no reason why a partnership, mutual fund 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.
C. Summary
NAREIT supports a change in the REIT rules to prevent 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.
IV. PAIRED SHARE REITs
The Administration's Fiscal Year 1999 Budget proposes to freeze the "grandfathered" status of the existing paired share REITs.
A. Background and Current Law
In order to actively manage their properties within the strictures of the REIT rules, in the 1970s and early 1980s a handful of REITs sought and received permission from the IRS to establish a "paired" relationship with other companies that would manage the REIT-owned properties. A "paired-share" company is actually two companies the stock of which is "paired" or "stapled" such that they trade as a single unit. As a result, the two companies are owned by the same shareholders. One company, the REIT, owns real estate and, in some cases, may lease it to the second operating company. The operating company is typically organized as a C corporation with the accompanying corporate level tax. The operating company is unrestricted in the businesses it may operate, meaning it may operate those businesses, such as hotels or golf courses, which require a high level of services be provided to customers.
In 1984, Congress adopted section 269B in the Deficit Reduction Act of 1984 ("the Act") which requires that in applying the tests for REIT status, all stapled entities are treated as one entity.12 In connection with considering and restricting the use of "paired share" entities by non-REIT U.S. corporations operating overseas, Congress decided in 1984 to "grandfather," or apply prior law to, a very limited number of REITs that earlier had received IRS permission to adopt a "paired share" structure.13 Congress crafted this exception for the paired share REITs out of a concern for fairness to these companies and their shareholders who made their investments on the basis of existing law. No doubt the same fairness issues apply today.
The Administration proposes to limit the tax benefits of the existing paired share REITs that qualify under the 1984 Act's grandfather rules. Pursuant to the proposal, the general rules treating the REIT and the stapled C corporation as a single entity for purposes of the REIT qualification tests would be applied to properties acquired by grandfathered entities on or after the effective date and activities or services relating to such properties performed on or after the effective date.
B. Statement Concerning Freezing the Grandfathered Status of Stapled REITs
NAREIT does not support the Administration proposal out of concern for the shareholders who reasonably relied on existing law when investments were made.
If enacted, the Administration proposal would cause investors in some of these entities to experience adverse consequences. The shareholders reasonably relied on Congress' grandfathering of the stapled REITs and the previous IRS rulings approving of their status. This authority should not be reversed without careful consideration of the extent to which the REITs, their investors and others have made long-term financial commitments in reasonable reliance on such authority.
C. Summary
NAREIT does not support the Administration proposal out of concern for fairness to the stapled REITs and their shareholders who made their investments on the basis of existing law.
1 Hereinafter all references to "section" are to the Internal Revenue Code of 1986 (as amended).
2 I.R.C. Sec. 857(b)(6).
3 I.R.C. Sec. 856(c)(3).
4 I.R.C. Sec. 856(c)(2).
5 PLRs 9440026, 9436025, 9431005, 9428033, 9340056, 8825112. See also PLRs 9507007, 9510030, 9640007, 9733011, 9734011, 9801012.
6 The REIT does not qualify for a dividends received deduction with respect to TRSS dividends. I.R.C. Sec. 857(b)(2)(A).
7 But see PLR 9804022.
8 Compare I.R.C. Secs. 851(b)(3) and 856(c)(4).
9 I.R.C. Sec. 856(h)(1).
10 I.R.C. Sec. 856(a)(5).
11 I.R.C. Secs. 542(a)(2) and 856(h)(2).
12 I.R.C. Sec. 269B(a)(3).
13 Over 200 publicly traded REITs are active in today's real estate marketplace. Of these, four are so-called "paired share" REITs.