REIT Modernization Act of 1999

Remarks on S. 1057 by Senator Connie Mack

Congressional Record
HON. CONNIE MACK in the Senate
FRIDAY, MAY 14, 1999

Mr. MACK. Mr. President, today Senator Bob Graham and I, along with 17 of our colleagues, are introducing legislation to modernize the tax rules that apply to real estate investment trusts (`REITs').

This legislation is designed to remove barriers in the tax laws that impose unnecessary administrative burdens and make it more difficult for REITs to compete in an evolving marketplace. Our bill is similar to a proposal included in the President's Fiscal Year 2000 budget that permits REITs to establish a new type of subsidiary called a `taxable REIT subsidiary' (`TRS'). As with the President's proposal, the legislation we introduce today would permit REITs to establish a TRS to provide non-customary services to their tenants and to provide services to third parties. In return for these new rules, the TRS would be subject to a number of rules designed to prevent any income from being shifted out of the taxable subsidiary to the REIT.

Congress created REITs in 1960 to enable small investors to invest in real estate. The REIT provisions were modeled after the rules that applied to mutual funds. If a number of requirements are met, a corporation electing to be a REIT may deduct all dividends paid to its shareholders. One of the major requirements for REIT status is that REITs must distribute virtually all of their taxable income to their shareholders. Thus, unlike other C corporations that tend to retain most of their earnings, the income tax burden for REITs is shifted to the shareholder level. Unlike partnerships, REITs cannot pass losses through to their investors.

REITs are subject to a number of rules to ensure their primary focus is real estate activities. For example, at least 75% of a REIT's assets must be comprised of rental real estate, mortgages, cash items and government securities. A REIT also must satisfy two income tests. First, at least 75% of a REIT's annual gross income must consist of real property rents, mortgage interest, gain from the sale of a real estate asset and certain other real estate-related sources. Second, at least 95% of a REIT's annual gross income must be derived from the income items from the above 75% test plus other `passive income' sources such as dividends and any type of interest. In addition, a REIT cannot own more than 10% of the voting securities of a non-REIT corporation, and the securities of a singlenon-REIT corporation cannot be worth more than 5% of the REIT's assets.

Although REITs were created in 1960, they did not really become a significant part of the real estate marketplace until the 1990s--partly because the original legislation did not permit REITs to manage their own property. The Tax Reform Act of 1986 changed this, by permitting REITs to manage their own properties through the provision of `customary services' to tenants.

The market capitalization of REITs grew from about $13 billion at the end of 1991 to over $140 billion today. The taxes generated from REITs similarly have increased, with dividends from public REITs increasing from about $1 billion in 1991 to more than $8 billion today. While REITs remain a small portion of the entire real estate sector--in the range of 10% nationally--they account for as much as half of some sectors that require immense amounts of capital, such as shopping centers.

While the REIT industry has come a long way in recent years, it continues to fulfill its original mission: permitting small investors access to attractive real estate investments. Almost 90% of REIT shareholders are individuals either investing directly or through mutual funds.

Although REITs have seen remarkable growth in the 1990s, their ability to meet new competitive pressures in the real estate sector is in question as a result of tax law limitations on their activities. These rules limit the ability of REITs to provide full services to their tenants and to third parties. In general, REITs may only provide services to their tenants which the IRS has determined to be `customary' in the business, meaning services already provided by the typical real estate company in the market. REITs may only provide real estate-related services to third parties through preferred stock subsidiaries which they can own but not control. REITs are thus prohibited from offering leading edge, full service options to their tenants and limited in the use of their expertise to serve third parties. This presents competitive problems for REITs as the real estate marketplace has evolved and property owners have sought to provide a range of services to their tenants and other customers