Real Estate Investment Trust Simplification Act of 1997 ("REITSA")
REITS Simplified
By: Tony M. Edwards
NAREIT Vice President and General Counsel
REITs simplified? No, we're not kidding. NAREIT has labored for over five years on a package of REIT tax forms intended to modernize the REIT tax regime without altering the fundamental rules that allow the best of both worlds: a corporate vehicle without a corporate tax. Although essentially remaining the same over the years, the REIT tax proposals have changed both to recognize new issues and to address concerns raised by Congress and the Administration.
We are delighted that on August 5, President Clinton signed into law the Taxpayer Relief Act of 1997, which includes virtually all of the provisions contained in the Real Estate Investment Trust Simplification Act of 1997 ("REITSA").1 The remainder of this article describes these provisions, which apply to taxable years beginning after the date of enactment. Since most REITs are required to use the calendar year, this means that these provisions will apply starting in 1998.
1. TENNIS ANYONE?
Ancillary Services. One of the greatest strengths in the American economy today is that companies are focusing on delivering exceptional services to their customers. This transformation into a service economy is changing the real estate industry from one concerned about acquiring and operating buildings to one concentrating on meeting customer demands for space and related services.
The historic change that Congress made in 1986 allowing a REIT to provide customary services to its tenants provided the opportunity for fully integrated real estate concerns to become REITs. Before then, a REIT needed to use an independent contractor to perform the most basic services for its tenants, e.g., landscaping.
As well as the 1986 change has worked, a potential cause of concern has been lurking in the background. Under the 1986 change, if a REIT provides a non-customary service to a tenant, all monies received by the REIT from that tenant (even the underlying basic rent payments) are not qualifying income for purposes of the REIT tax tests. The IRS has extended this "tainting rule" to customary services provided to a particular tenant rather than all tenants for occupancy purposes. For example, the IRS concluded that the tainting rule would apply if a multifamily REIT arranged for independent contractors to provide tennis lessons and aerobic instructions to its tenants.
NAREIT has been successful in convincing the IRS to expand its scope of "good" services to include a greater array of opportunities for a REIT's customers, e.g., cable television.2 Also, the IRS has become more flexible in concluding that a particular service does not taint rents, especially when it is offered to members of the public, e.g., operating a golf course or truck rental services.3
Nevertheless, the process of waiting for the IRS to bless a new service is costly and time-consuming. In the interim, the REIT offers the service at its peril because of the potentially catastrophic consequences of tainting. This waiting period allows competitors not using the REIT structure to gain a competitive advantage. In addition, there is a real possibility that the IRS will not issue a positive ruling, and there is always the further threat that the tainting issue might arise because an employee goes out of his or her way to be helpful, e.g., moving a tenant into new space.
To alleviate these concerns, REITSA contains a useful rule allowing a REIT to perform a small amount of otherwise impermissible services to tenants. Rents are not "tainted" with respect to a property so long as the REIT does not perform impermissible services generating more than 1 percent of that property's gross income. For this purpose, impermissible services are considered as generating income at least equal to 150 percent of the REIT's direct costs in providing such services. Any income from such impermissible services is considered nonqualified income that fills up the 5% basket of nonqualified income that REITs are allowed to accumulate.
This exception allows a REIT to intentionally provide amenity services that might not be a big money-maker, but make a customer's service experience extraordinary. For example, an office REIT can offer concierge services to its tenants under which a REIT employee may pick up a tenant's dry cleaning, obtain theater tickets, or arrange transportation. The REIT probably does not care to earn much profit on these activities, but hopes that it can attract and retain high caliber customers (paying high rents) who appreciate these potential services.
Hopefully, this provision is a portent of things to come. REITs face tremendous competitive challenges and opportunities in using their customer base to provide services not directly related to real estate. NAREIT will explore ways to allow its member companies to further tap this potential.
2. CASTLE KEEPERS
REIT Retention of Capital Gains. REITs know all too well that retained earnings can be the cheapest source of capital. Especially during cycles of the market when it is difficult to raise new capital, retained earnings is an attractive source to fund the substantial capital expenditures needed to maintain the quality of a company's properties.
Prior law taxed a REIT that retained capital gains, and imposed a second level of the tax on the REIT shareholders when later they receive net proceeds.4 This double-tax result was a strong disincentive to retain capital gains proceeds.
REITSA mirrors the corresponding mutual fund rules governing taxation of retained capital gains by passing through a credit to shareholders for capital gains taxes paid at the corporate level. It allows a REIT to retain the after tax proceeds of a taxable capital gain while maintaining a single tax regime; under the credit mechanism, the tax is imposed at the entity level rather than at the shareholder level.
3. GROSS OUT
30 Percent Gross Income Test. One of the over-riding principles that has governed REITs since 1960 is that they should be long-term holders of real estate. There were two, largely duplicative rules intended to reach this result.
First, a REIT must pay a confiscatory 100 percent excise tax on any profit it earns from the sale of property sold in its ordinary course of business, colloquially known as "dealer property." An example is converting an apartment complex and selling condominiums. Second, a company lost its REIT status if in any year at least 30 percent of its gross income was derived from sales of dealer property, real estate held for less than four years (even if not dealer property), or securities held for less than one year.
The 30 percent test prevented REITs (often smaller companies) from capitalizing on an opportunity to make a large profit when it received an offer to buy a property or a package of properties held for less than four years. There also was confusion whether this rule included sales of mortgages held for less than one year. Last, it represented a significant barrier to a REIT wanting to buy a package of properties or securities with a view of selling a significant amount within four years.
REITSA repeals the 30 percent gross income test for REITs, while leaving the 100 percent excise tax on sales of dealer property largely intact.
4. POST HASTE
Shareholder Demand Letter. Another overriding axiom of the REIT regime is that REITs should be widely held so that the small investor can participate in top quality real estate opportunities not otherwise available. The rule preventing five or fewer individuals owning more than one-half of a REIT ("the 5/50 rule") carries out this mandate.
The REIT rules attempt to create a paper trail for the IRS to use to ensure compliance with this "5/50 rule." Within 30 days after the close of its taxable year, a REIT is required to mail a letter to certain of its shareholders of record asking the record shareholder to advise the REIT who is the beneficial shareholder. IRS regulations suggest that a REIT may lose its REIT status if it fails to meet this 30-day deadline, even if the company satisfies the substantive 5/50 tests.5 This requirement presented an unnecessary potential cause for disqualification.6
REITSA replaces the potential disqualification with a reporting penalty (usually $25,000) imposed on a REIT's failure to follow IRS notification rules. In addition, a REIT that sends out timely shareholder letters and does not know (or have reason to know) of a 5/50 violation is deemed to satisfy this ownership test. Thus, a REIT complying with these rules will not be penalized if a marriage, merger or other event not known to the REIT somehow causes a 5/50 breach.7
5. HEDGED BETS
Interest Rate Protection. Even though modern REITs use conservative levels of leverage, they still need to maintain significant levels of secured or unsecured debt. With this leverage comes interest rate risk and the need to manage a company's exposure.
In 1986, Congress resolved a narrow tax issue concerning REITs' exposure to variable rate debt. The Code was changed to provide that a REIT's income from a hedge of a variable rate position qualifies under the 95 percent income test.
Since then, a host of opportunities have opened up to REIT management to protect the exposure to interest rate risk. REITSA updates the prior REIT hedging rule to include income from all hedges (e.g., caps and collars) of all types of REIT liabilities as qualifying income for purposes of the 95 percent income test.
6. RUBE GOLDBERG REIT RULES
Attribution Rules. Possibly the most intricate "bells and whistles" contained in the REIT tax rules address deemed rules governing hypothetical ownership. These arise in two contexts.
First, Congress wants to be certain that one investor cannot manipulate rent payments between a REIT and another entity controlled by that investor. Erring on the side of caution, Congress disqualifies as rents any payments from an entity more than 10 percent owned by a person also owning 10 percent of the REIT. 8
Second, a REIT is not allowed to profit from offering any impermissible services (other than the 1 percent REITSA rule described above). Instead, a REIT must use an independent contractor, defined as an entity not more than 35 percent owned by the REIT and from which the REIT does not earn income.
To make matters more interesting, the Internal Revenue Code attributes stock ownership to various persons for both tests. For example, in determining the 10 percent thresholds, a person is deemed to own his or her spouse's stock. These attribution rules reach unmanageable proportions when it comes to determining when one partner is deemed to own the interests of another partner. Tax practitioners found it difficult to render unqualified opinions because they could not trace the attribution relationships required by the Code.
REITSA corrects this technical "glitch." Although the actual workings of this deemed ownership rule are beyond the scope of this article, suffice it to say that REITSA limits the prior partnership attribution rules only to 25 percent or greater partners.
7. REIT DROPPINGS
Distribution of Pre-REIT Earnings. Since 1986, a new REIT must distribute within its first REIT taxable year all earnings and profits ("E&P") generated before its REIT election In addition, IRS regulations require similar distributions when a C corporation merges into a REIT in a tax-free reorganization.9 A REIT can lose its REIT status if it does not distribute the correct amount.
However, if a REIT has unexpected year-end earnings, the normal ordering rules governing E&P distributions create a substantial risk that a new REIT may fail to distribute all of its pre-REIT E&P, notwithstanding its good faith efforts to comply with the distribution requirement.
For example, assume a C corporation elects REIT status for 1997 with $100x in pre-1997 earnings. In December of 1997, the company calculates that it will have $30x of earnings for the year, and therefore declares and distributes $130x as dividends before year-end. However, it learns in January that its retail tenants had better-than-expected holiday sales, so that the REIT actually earned $40x in 1997. Under prior law, the first $40x distributed was traceable to 1997 earnings, with the balance of $90x attributable to pre-REIT E&P. Since the Code requires a distribution of the entire $100x in 1997, the company would face the loss of its REIT status.10
For these purposes only, REITSA reverses the ordering rules for accumulated E&P distributions to make it easier for a new REIT (or, according to IRS regulations, a REIT that absorbs a non-REIT corporation in a tax-free reorganization) to comply with the distribution requirement. In the above example, the $100x of pre-REIT earnings would be deemed distributed first, and therefore REIT status would not be jeopardized.
8. THE PHANTOM KNOWS
Excess Noncash Income. In meeting its distribution requirements, an accrual basis REIT must take into account "phantom income", or income that a taxpayer recognizes without receiving cash. In 1986, Congress permitted cash basis REITs to ignore certain items of phantom income in determining their distribution requirements.
REITSA (1) extends this rule to include most forms of phantom income, e.g., income from the discharge of indebtedness; and (2) makes the rule available to the vast majority of companies that are on the accrual basis of tax accounting. Note that this could create some tax exposure.
For example, if a mortgage REIT received $100x in interest payments and also recognized $30x from original issue discount, to retain its REIT status it now only must distribute 95% of the $100x rather than the $130x of total income. However, if it only distributed $95x of cash, it would receive a $95x dividends paid deduction, leaving $35x in taxable income. The REIT now has the choice of paying tax on the $35x or to take steps as under prior law to alleviate this tax exposure, e.g., distributing all of its current cash flow of $100x plus $30x raised from borrowing.
9. THE ABCs OF QRSs
Qualified REIT Subsidiaries. In 1986, Congress recognized the usefulness of a REIT holding properties in subsidiaries to limit its liability exposure. However, the Code required that the REIT own the subsidiary's stock for the subsidiary's entire existence. Codifying a recent IRS position, REITSA allows a REIT to use a wholly-owned subsidiary to hold property even if the subsidiary previously had been owned by a non-REIT.
The legislative history indicates that the acquired corporation will be deemed to have been liquidated and those assets re-contributed to a new subsidiary.12 Thus, any pre-REIT earnings will need to be distributed by year-end, and any of the subsidiary's "built-in gain" (i.e., the excess of the assets' value over their tax bases) will be taxed at the corporate level unless the REIT elects to defer the gain.13
10. PORT IN A STORM
Prohibited Transactions Safe Harbor. As stated above, the Code imposes a 100% excise tax on prohibited transactions, i.e., sales of property in the ordinary course of business. However, because it can be difficult to decide whether a taxpayer acts as a dealer with respect to a particular transaction, Congress provides a safe harbor under which a REIT can be assured that the excise tax will not apply.
One of the requirements for the safe harbor is that the REIT not make more than seven sales of property in a year or does not sell properties comprising 10 percent of its cumulative tax basis. A REIT carefully planning its seven sales could have been blindsided if a government agency compels the company to sell a property by virtue of eminent domain. REITSA clarifies that involuntarily converted property is ignored in determining whether a REIT has met its seven-sale threshold.
11. TAKE-BACK TOOLS
Foreclosure Property. Two provisions simplify the administration of the REIT foreclosure property rules. First, when a REIT treats an asset as foreclosure property, it needs to get permission from the IRS to continue this treatment after two years and then again after another two years. REITSA extends the time period for the foreclosure election from two to three years, thereby allowing a REIT another year to attempt to rework a foreclosed property before needing to go to the IRS.
Second, the foreclosure rules require a REIT to use an independent contractor to operate the foreclosure properties after 90 days. However, these rules were not revised in 1986 to allow the REIT to directly perform customary services without the use of an independent contractor. REITSA coordinates the foreclosure property independent contractor rule with the primary independent contractor rule for REITs.
12. SAM, I AM
Shared Appreciation Mortgages. In 1986, Congress created a regime under which the actions of a borrower under a shared appreciation mortgage ("SAM") are imputed to a REIT lender. Thus, assume that a REIT lent money to a borrower to acquire an apartment building, the borrower went bankrupt after a year, and the bankruptcy court ordered the building to be sold as a condominium project. Under prior law, the profits from the condo sales attributable to the REIT under the SAM would be subject to the 100% excise tax on prohibited transaction and would count towards the 30 percent gross income test.
REITSA creates a safe harbor to the shared appreciation mortgage ("SAM") rules that would not penalize a REIT lender for an event beyond its control, i.e., the borrower's bankruptcy. The provision also clarifies that SAMs could be based on appreciation in value as well as gain.
13. WHAT GOT AWAY.
Largely because of procedural issues, two provisions contained in the stand-alone REITSA bills were not included in the bill signed by the President on August 5.
a. BACK TO THE FUTURE
90 Percent Distribution Requirement. From 1960 through 1976, REITs had to distribute 90 percent of their taxable income. Congress bumped up this requirement to 95 percent when it enacted the deficiency dividend rules, which it believed lessened the need to retain income. However, mutual funds retained their 90 percent distribution requirement even after they were given access to the same deficiency dividend procedures in 1978.
NAREIT continues to believe that a REIT should be required once again to distribute only 90 percent of taxable income. The net after tax proceeds of the undistributed amounts would be a healthy source of funds for the capitalized expenditures needed to maintain real estate. Since a REIT would be taxed on undistributed amounts, this provision should be at worst revenue neutral.
b. HEALTHY REITS
Maintenance of Health Care Properties. REITSA would have provided a health care REIT with needed flexibility when it takes control of a qualified health care facility upon a default or expiration of a tenant's lease or mortgage. The proposal would have allowed a REIT to use a health care provider to operate such a facility as an independent contractor, even though the REIT may receive income from the provider in the form of rent from other properties. REITSA also would have allowed a health care REIT to make a foreclosure property election when its lease terminates or expires.
This provision also was estimated to produce a negligible revenue effect, and we hope that Congress will enact both provisions in the near future.
14. ACKNOWLEDGEMENTS.
Laws do not become reality without a lot of hard work in communicating the message to legislators and their staff. Over the past five years, many dozens of REIT industry leaders have met with key policy-makers to educate them and seek their support. Also, a large number of tax professionals have devoted extraordinary amounts of time in helping to prepare, analyze and negotiate the details of REITSA.
NAREIT cannot possibly thank all those who contributed to this important success for the REIT industry (you know who you are), but we would like to single out the following individuals: Stanford Alexander with Weingarten Realty Investors, Mark Decker with Friedman, Billings, Ramsey, Lou Garday (formerly with Burnham Pacific), Art Greenberg with Equity Group Investments, Morris Kramer with Roberts & Holland, Bob Lowenfish with Corporate Property Investors, Thayne Needles with Coopers & Lybrand, Ken Roath of Health Care Property Investors, and Tom Robinson with Legg, Mason, Wood, Walker.
1. H.R. 1150 and S. 898. See also 143 Cong. Rec. E559 (Daily Ed. March 21, 1997) (remarks of the Honorable E. Clay Shaw, Jr.); 143 Cong. Rec. S. 5611 (Daily Ed. June 12, 1997) (remarks of the Honorable Orrin G. Hatch).
2.See, e.g., PLR 9701028.
3. See, e.g., PLR 9627017.
4. Many REITs avoid this taxable conundrum by engaging in like-kind deferred transactions.
5. Treas. Reg. ¤ 1.857-8(e).
6. In 1993 an IRS agent attempted to disqualify two REITs for not timely mailing their shareholder demand letters. Fortunately, the IRS appellate division dismissed the case after it learned that the REITs satisfied the substantive ownership test. Since then, the IRS has adopted a commendable position under which it does not disqualify a REIT the first time it fails to send out the letters. The IRS internally refers to this as the "one bite of the apple" theory.
7. In any event, most REITs adopt "Excess Share" provisions in its organizational documents to avoid an unforeseen problem in this area. See, e.g., PLR 9627017.
8. Congress ignores the fact the other 90 percent of shareholders of the REIT's tenant would object and prevent any inflated rent payments to the REIT.
9. Treas. Reg. ¤ 1.857-11. Many practitioners have concluded that these regulations exceed the scope of the underlying statutory authority.
10. It is possible that the REIT could use the deficiency dividend provisions of Code section 858 to avoid loss of REIT status in this scenario.
11. PLRs 9717036, 9718006.
12. H.R. Rep. No. 220, 105th Cong., 1st Sess. 698 (1997).
13. See Notice 88-19, 1988-1 C.B. 486. 0,