The REIT stuff.

Real estate investment trusts (REITs) have made a comeback as investment vehicles, fueled by changes originally made in the Tax Reform Act of 1986.

REITs may be set up as trusts, corporations or associations and must meet several specific and detailed requirements. If these are met, a REIT is treated as a conduit. Income earned can be passed through to the investors and taxed only at the individual investor level. To qualify as a REIT, an organization must satisfy both asset ownership and income requirements.

ASSET OWNERSHIP

Seventy-five percent of the value of the entity's total assets must be in real estate, cash and cash items (such as certificates of deposit or receivables) or government securities. Real estate includes land and buildings, mortgages on real estate, interests in mortgage pools and interests in other qualifying REITs.

In addition, there are limitations on the other 25% of the REIT's assets. The entity may not have more than 5% of the value of its assets in securities, and no more than 10% of the outstanding voting stock, of any one issuer.

A qualified REIT subsidiary is not treated as a separate corporation, and the subsidiary's assets, liabilities, income, deductions and credits are considered to be held by the REIT. To qualify, the REIT must own 100% of the stock of such a subsidiary at all times during its existence. If the REIT does not own all the subsidiary's stock, it is treated as a new corporation that acquired all its assets and liabilities in exchange for the stock.

INCOME

Specified sources also must provide specific percentages of the REIT's annual income.

1. At least 75% of the income must be derived from real estate transactions, gains on other REIT shares, real property tax refunds, gains from foreclosed property, rent from real property, interest on mortgages, gains from the sale or disposition of most real property or real property interests and qualified temporary investment interest. Rent from real property includes that attributable to incidental personal property (as long as it is no more than 15% of the total rent) and includes charges for services customarily furnished in connection with the rental of real property.

Note: If an independent contractor is not used to perform the services or manage the property, the attributable income is not rent from real property.

Qualified temporary investment interest includes any income from stock or debt attributable to the temporary investment of new capital received within one year after the REIT received the capital.

2. At least 95% of the REIT's income must be derived from these sources plus dividends, interest and capital gains from the sale of stock and securities. For purposes of this requirement, interest includes any amount qualifying as interest.

3. A REIT may not derive more than 30% of its gross income from the sale or other disposition of stock or securities held for less than six months, property in prohibited transactions or most real property held for less than four years.

USE OF NON-REIT SUBSIDIARIES

Because of these limitations, entities considering REIT status must examine carefully their own income and asset holdings. For organizations with income from a variety of nonqualifying sources, the use of a "non-REIT subsidiary" may be effective. Such a non-REIT subsidiary is a fully taxable subsidiary that assumes the ownership and operation of nonqualifying businesses. This subsidiary must not be wholly owned by the REIT; otherwise, it is considered a qualified REIT subsidiary.

Both the 10% and 5% asset tests must be followed carefully. The subsidiary must be structured so the REIT owns less than 10% of the subsidiary's voting stock, either through nonvoting common stock or a combination of nonvoting preferred stock and debt. The subsidiary's securities also may not be more than 5% of the REIT's total assets; if this may be a problem, placing the nonqualifying assets or business in two or more subsidiaries should provide a solution.

Caveat: The use of this strategy also involves many other issues, both general tax issues (such as the subsidiary's capitalization) and nontax business issues (such as control of the subsidiary). While this arrangement may provide economic opportunities, these other issues also must be resolved for the plan to be successful.

For a discussion of non-REIT subsidiaries and other developments, see the Tax Clinic, edited by Lawrence Portnoy, in the July 1993 issue of The Tax Adviser.