REIT-related revenue proposals include steps in right direction.

The Clinton Administration's budget revives in modified form some of the Administration's prior tax proposals directed at Real Estate Investment Trusts (REITs). The proposals, if enacted, would greatly change the tax treatment of: third party service subsidiaries; closely-held REITs; and built-in gains on the conversion of a C corporation to a REIT or the merger of a C corporation into a REIT.

Past attempts by the Administration to make similar changes in the taxation of REITs were not successful and, as in the case of the corporate tax proposals discussed in our memorandum of February 1, 1999, it is uncertain whether the changes outlined in the proposals or any variation will be enacted.

While the Administration's REIT-related proposals do provide REITs some relief from the overly-restrictive REIT rules including, importantly, by providing opportunities for REITs to indirectly generate service income from their tenants and other sources that current law prohibits in varying degrees - the relief is limited and is coupled with new constraints.

The proposals miss an opportunity to promote migration of commercial real estate from private ownership to the publicly-traded markets and the attendant benefits to the economy and the investing public.

Third Party Service Subsidiaries

REITs currently use one or more taxable subsidiaries to generate income that could disqualify the REIT for tax purposes if earned directly by the REIT. By capitalizing each such subsidiary with non-voting preferred stock and debt, REITs have been able to retain most of the economic benefits of the subsidiary's business and convert the non-qualifying income of the subsidiary into interest and dividends.

The proposals, with two important exceptions, would make it more difficult for REITs to obtain the economic benefits of ownership of a taxable subsidiary by limiting the REIT's ownership to no more than 10 percent of the vote or value of the stock of such subsidiary. The proposals, however, contain exceptions for two new types of taxable subsidiaries: a "qualified business subsidiary" and a "qualified independent contractor subsidiary."

A qualified business subsidiary would be permitted to earn income by providing nontenant related services such as third party management services. A qualified independent contractor subsidiary, in addition to being permitted to earn income that could be earned by a qualified business subsidiary, would also be permitted to earn income by providing non-customary and other presently prohibited services to the REIT's tenants.

Under the proposals, all taxable subsidiaries owned by a REIT could not exceed 15 percent of the REIT's total assets, and of that total, no more than 5 percent could represent the value of qualified independent contractor subsidiaries. Such subsidiaries will be denied the ability to deduct interest on debt funded by the REIT.

The proposals also call for a new 100 percent excise tax to ensure: arm's length pricing for services provided to the REIT's tenants (to ensure that tenants are not paying the REIT higher rent in exchange for a discount on services that would be taxable income to the service subsidiary); and arm's length allocations for shared expenses between the REIT and its taxable Subsidiary.

Additional limitations as well as unspecified limitations on inter-company rentals between the REIT and its taxable subsidiary, will be proposed. These proposals would generally be effective on the date of the enactment, although a transition period would be provided for certain actions.

Closely-Held REITs

Under current law, a REIT must have at least 100 shareholders (who may own common or preferred stock) and not more than 50 percent of the value of its stock can be owned by five or fewer individuals during the last half of its taxable year. In response to the Administration's belief that certain closely-held structures are being used to facilitate corporate tax shelters, the proposals would add a new ownership requirement that would prohibit ownership of more than 50 percent of a REIT's stock by vote or value by any person (not only an individual) other than another REIT. In applying the ownership limitation, broad stock ownership attribution rules would apply. These proposals would generally apply on a prospective basis for entities electing REIT status on or after the first date of committee action.

Built-In Gain

Under current law, C corporations are subject to two levels of tax (once to the corporation on income earned and again to the shareholders when dividends are distributed). Similarly, a double tier tax applies on the liquidation of a C corporation or its conversion to a partnership, since the corporation is taxed on its built-in gains and the shareholders are taxed on their built-in gain on the stock. The tax law provides an exception to the double tax regime on the conversion of a C corporation to an S corporation (the "S corporation rule"). In such a conversion, the immediate corporate level tax is avoided and instead the S corporation is taxed on such built-in gain for an asset that is sold within 10 years of the conversion. The Internal Revenue Service permits C corporations that convert to REITs to avoid the immediate tax on built-in gains by electing to be subject to rules like those that apply to C corporations that convert to S corporations.

The proposals would repeal the S corporation rule for C corporations that have a value of $5 million or more at the time of conversion (or at the time of a merger into an existing S corporation), and subject such conversions to immediate tax on the built-in gains. As a result, the conversion of a C corporation that has a value of at least $5 million would result in the immediate recognition of the C corporation's built-in gain. The proposals would generally apply for taxable years beginning after December 31, 1999.