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Budget proposal unlikely to slow REIT growth or real estate consolidation.

The President's Budget Proposal includes provisions intended to clip a feather or two from the wings of REITs, apparently in an effort to limit them to their traditional role as widely held vehicles for passive real estate investment.

While the Proposal might, if enacted, constrain REITs somewhat, it is unlikely to have a meaningful effect on the burgeoning growth of REITs and other publicly-traded real estate operating companies.

The fundamental reasons for the consolidation, securitization and corporatization waves in the real estate markets - liquidity, transparency, predictability, accountability and security - are likely to result in a continuing rapid migration of real estate assets from private and institutional hands into public companies.

The Proposal is already facing stiff opposition and has an uncertain future. Regardless of the outcome, however, the Proposal provides a sobering reminder of the need for vigilance in monitoring and informing the legislative agenda, lest the maturation of the real estate markets (with its concomitant long term stability, security and other advantages) be inadvertently jeopardized.

The Proposal, if enacted, would preclude paired-share REITs from continuing to utilize their unique structure for newly acquired properties, and would prevent all REITs from engaging indirectly in active businesses through now-common "de-controlled subsidiaries." The Proposal would also tighten the REIT rules designed to ensure that REITs not be closely held in a manner which could raise significant issues for private or semi-private REITs. Finally, the Proposal would tax conversions of C Corporations into REITs.

Paired-Share REITs

Prior to 1984, the shares of certain REITs were paired with the shares of regular taxable corporations (C Corporations) and traded together as a single unit. In 1984, amendments to the tax law effectively prohibited such arrangements but indefinitely grandfathered the existing paired-share REITs. The few grandfathered REIT-C Corporation pairs, unlike unpaired REITs, can engage in active businesses through their C Corporations and have, of late, been growing at an impressive pace. The Proposal would limit utilization of the paired structure as a vehicle for future growth. Under the Proposal, in order to determine whether a previously grandfathered paired-share REIT continues to qualify as a REIT, the paired REIT and C Corporation would be treated as a single entity with respect to newly acquired properties. As a result, the paired entities would not be able to engage in active businesses relating to newly acquired properties to a greater extent than any unpaired REIT.

So called "paper-clipped" REIT-C Corporation combinations have not been directly addressed in the current Proposal, but the increased scrutiny of paired arrangements could result in statutory or regulatory changes affecting these entities.

Indirect Business Activity

REITs frequently use "de-controlled subsidiaries" to conduct business activities that cannot be conducted directly by the REIT. The voting stock of the typical decontrolled subsidiary is owned by management and the non-voting stock, which usually represents 90-95 percent of the subsidiary's value, is owned by the REIT. The President's Proposal would prohibit a REIT from holding stock representing 10 percent or more of the vote or value of all classes of stock of a corporation, thereby eliminating the use of such subsidiaries.

Closely Held Determination

The Proposal would also modify the application of the current requirement that a REIT not be closely held. Currently, beneficial ownership of a REIT must be held by at least 100 persons, and no more than 50 percent of the value of a REIT's stock can be owned by five or fewer individuals at any time during the last half of the taxable year. The Proposal would add an additional requirement that no person (not limited to individuals, and including corporations, partnerships and other entities) can own more than 50 percent of the vote or value of a REIT's shares. Although the provision does not target merger and acquisition activity, if loosely drafted it could negatively affect such activity. For the sake of clarity, appropriate exceptions should be included permitting, for example, more than 50 percent ownership by another REIT and an "incubation" period for private REITs pending a public offering.

Built-in Gains

Under this part of the Proposal (carried over from last year's budget proposals) conversions of "large" C Corporations (worth more than $5 million) into REITs would be treated as a taxable liquidation by the C Corporation and its shareholders. Under current law, there is generally no shareholder tax or corporate tax on such conversions, but certain built-in gains are realized on dispositions within 10 years after conversion.

Legislative and regulatory attention to REITs and related vehicles is certain to increase as the portion of the nation's real estate held through publicly traded vehicles increases. The industry must remain attentive to these important trends to ensure that the political and legislative spheres are fully informed of the complexities involved, lest the benefits in efficiency, stability and growth that stand to be gained be lost.
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Title Annotation:Focus on: Banking & Finance
Author:Einhorn, David M.
Publication:Real Estate Weekly
Date:Feb 18, 1998
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