LEVELING THE PLAYING FIELD IN REAL ESTATE MARKETS

MICHAEL 'MAC' COLLINS (R-GA)

In March I introduced H.R. 3533, the Real Estate Investment Trust Tax Equity Act. This legislation is an important measure which levels the playing field among investors and businesses competing in similar real estate markets. It addresses the legislative change that occurred in the Deficit Reduction Act of 1984: paired-share REITs were provided a shotgun tax benefit in the 1984 legislation which has created a meaningful imbalance in certain industries.

REITs were first created in 1960 in order to give small investors access to the commercial real estate investment market. This market previously had been monopolized by large capital investors, and this new structure afforded a wider group of investors to share in the profit opportunities. A REIT is not required to pay a corporate level of tax, but must pass 95 percent of its taxable income through to its investors. Additionally, 95 percent of a REIT's income must come from passive sources, such as lease payments or interest on mortgage debt, etc. Also, 75 percent of a REIT's income must come from real estate. A REIT may not receive a significant portion of income from operating its real estate.

Over the years, there have been several legislative efforts to modify the REIT structure. While REITs have been generally prohibited from self-managing properties that they hold in trust, changes to the code were made in 1986 which allowed REITs that own specific types of real estate to provide customary services to their residents. However, under current law, REITs are still restricted from operating real estate that requires a high level of operation management services (usually associated with such entities as hotels, casinos, or similar properties). REITs that operate in these markets must lease the property to a third party, usually structured as a C corporation, which is tasked with providing the operation and direct management of the restricted real estate held by the REIT.

In the 1980s, certain REITs began pairing their shares of the REIT with those of the management company. For each share of the REIT received by the investor, they also received one share of the management company. Pairing these shares creates significant benefits because the same shareholders derive all of the profits from operations related to the real estate owned by the REIT.

Because of several concerns about the paired-share structure, including the fact that it could cause an artificial reduction in tax liabilities attributable to the income associated with the management of properties, Congress took action in 1984 to ensure that the two structures would be treated as one for purposes of applying the REIT gross income tests. However, in this legislation, Congress considered the impact on the companies that had already adopted the paired-share REIT structure. Consequently, these existing entities were grandfathered, with the acknowledgment that they would need additional time to 'unwind' in the effort to meet the standard gross income tests.

Although supporters of paired-share REITs argue they have no benefit over competitors within their industries, indications are to the contrary. Specifically, this structure provides significant benefit because it eliminates the sometimes adversarial relationship between the REIT and the management company. If both entities have the same group of shareholders, there is no friction over who should realize the benefit of profits. Second, the shifting of income between the two entities can have a significant impact on the tax liability attributable to profits. There are a number of ways this can be accomplished, whether through rent payments or shifting other overhead expenses. Third, the structure of pairedshare REITs enables these entities to avoid the double taxation of income from real estate, a benefit not realized by nonpaired-share REIT competitors in certain markets. Again, tax liabilities are minimized and profits are significantly increased for shareholders.

This unique business structure has made them particularly attractive to investors, thereby giving them more advantageous access to capital. Rather than making movements to 'unwind' or adjust their structure in anticipation of having to comply with standard REIT gross income tests, since 1995 a majority of the grandfathered entities have expanded aggressively.

Again, while today's paired-share REITs argue they have no real advantage over the traditionally structured corporations against whom they compete, their behavior indicates otherwise. Not only have some of the grandfathered REITS publicly discussed their advantage in an effort to attract investors, they have also stated in the past that they originally purchased the paired-share REIT not for the line of business that it was participating in, but because they wanted the paired-share structure, which provides unique, advantageous opportunities in certain markets.

Because the REIT market continues to expand aggressively, Congress must take action to ensure that the grandfathered REITs are not enjoying tax based advantages to the detriment of other businesses competing within the same industries. The legislation I introduced levels the playing field by further clarifying the intent of Congress expressed in the Deficit Reduction Act of 1984. My legislation simply states that paired-share REITs must comply with the standard gross income texts applicable to all REITs, contained in section 856 of the Internal Revenue Code. Federal tax policy must be consistent so that it does not favor one competitor over another within industries. This important legislation ensures equitable tax policy so that one group of investors does not have a significant benefit over their competitors.