REIT Provisions in the Administration's Proposed
Fiscal Year 1999 Budget (February 2, 1998)

On February 2, the Clinton Administration released its Fiscal Year 1999 budget plan. The proposed budget confirms rumors of provisions affecting REITs reported in The Wall Street Journal on January 29 and 30. It is important to realize that these proposals have been made at the very beginning of a long legislative process. Many items in past budgets were not enacted into law. A summary of the Administration's proposals affecting REITs follows:

Third Party Service Subsidiaries Would Be Restricted

The Administration proposes to prohibit REITs from owning more than 10 percent of the value of all classes of stock of a corporation. This requirement would prevent a REIT from owning more than 10 percent of the value of a so-called "third party service subsidiary" (also known as a "preferred stock subsidiary"). The Administration believes that the current rules, which only prohibit a REIT from owning more than 10 percent of the vote of any class of stock, permit REITs essentially to conduct an impermissible business through a subsidiary by holding a significant amount of nonvoting stock and debt in the subsidiary.


This proposal would be effective with respect to stock acquired on or after "the date of first committee action." It is not clear what this date refers to -- perhaps the date the bill is initially marked up by the Ways and Means Committee. In addition, the "grandfathered" status of an existing subsidiary would terminate if it engages in a new line of business or acquires substantial new assets (both tested on the date of first committee action).


While NAREIT strongly disagrees with this proposal, it does believe that the current restrictions on services to tenants and others need to be simplified and modernized. The current rules restrict even third party service subsidiaries from providing non-customary services to a REIT's tenants. In connection with Congressional consideration of this proposal, NAREIT will work to have Congress reconsider the asset tests to allow a REIT to own a taxable subsidiary with appropriate restrictions to limit any potential abuse.


Grandfathered Paired Share REITs Would Be Limited


The proposed budget would limit the grandfather status of the existing paired share REITs. In effect, the proposal would prevent paired share REITs from acquiring or operating new properties under the paired share structure. For purposes of determining whether any grandfathered entity is a REIT, the stapled entities would be treated as one with respect to (1) properties acquired on or after the effective date; and (2) activities or services relating to such properties performed by a stapled entity.


The effective date again would be the unclear "date of the first committee action."


Proposed Tax on Built-In Gains


As in its proposed budgets for the last two years, the Administration proposes taxing the built-in gains of C corporations electing REIT status or merging into REITs in tax-free reorganizations. The proposal would impede a C corporation's ability to defer taxes upon electing REIT status or merging into a REIT by using the 10-year election under Internal Revenue Code section 1374 available to REITs (as well as S corporations and mutual funds). As in previous budget proposals, this tax on built-in gains would apply only to REITs or corporations worth more than $5 million. Additionally, this proposal would apply to REIT elections that are first effective for a taxable year beginning after January 1, 1999 (which means the year 2000 and beyond for calendar year taxpayers), and to tax-free acquisitions of a C corporation made after December 31, 1998.


We expect that the same coalition of interested groups that successfully opposed this proposal in 1996 and 1997 will work together to defeat it again.


Closely Held REITs


To redress perceived abusive use of private REITs, the Administration proposes to change the "five or fewer" test by imposing an additional requirement. To ensure the REIT is truly "widely held" the proposed budget would prevent any "person" (i.e., a corporation, partnership or trust) from owning more than 50 percent of the voting power or value of all classes of stock. This proposal would be effective for companies electing REIT status for taxable years beginning on or after "the date of first committee action."


NAREIT will carefully monitor the details of this proposal to ensure that it does not ban legitimate private REITs.


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We will keep you advised of further developments in the budget legislation. We plan to fully review these proposals at the NAREIT CEO Conference (February 23-25 in Washington, D.C.) and to organize our legislative response and initiatives. Questions should be directed to the Legal Department at NAREIT, 1-800-3NAREIT or 202-785-8717.