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Clinton proposals could affect REITs.

As anticipated, President Clinton has asked Congress to eliminate a number of tax loopholes as part of his 1999 revenue proposals. One proposal is aimed at paired-shared REITs and three additional proposals affect all REITs.

The main Clinton proposal is aimed exclusively at paired-share REITs. The proposal would limit the grand-fathered status of a paired-share REIT to properties currently owned. "Stapled" entities would be treated as one entity with respect to properties acquired (whether by merger or purchase) on or after the first day of any committee action (the Effective Date) and with respect to any activities or services relating to such newly acquired properties that are undertaken or performed by one of the stapled entities on or after the Effective Date.

Except with respect to built-in gain for certain large C Corporations, as discussed more fully below, this proposal does not limit the ability of REITs (other than paired-share REIT) to expand their portfolios through mergers or acquisitions.

The first proposal by the administration which affects all REITs would prohibit REITs from holding or possessing stock which is more than 10 percent of the vote or value of all classes of stock of such corporation on or after the Effective Date. Any stock of any corporation owned on or before the Effective Date will be grand-fathered however, such grand-fathered status would terminate if the subsidiary corporation engages in a trade or business that it is not engaged in on the Effective Date or if it acquires substantial new assets on or after the Effective Date.

This proposal is aimed at REITs which generate significant income from impermissible businesses (i.e. third-party development or management business) through the use of "non-qualified REIT subsidiaries." A non-qualified REIT subsidiary is generally a subsidiary subject to corporate tax in which the REIT owns non-voting stock and less than 10 percent of the voting stock.

We recommend that existing REITs consider forming a non-qualified REIT subsidiary to conduct third party management or non-customary services (and, perhaps, form a separate non-qualified REIT subsidiary for each service) to take advantage of the grandfather provision.

As you may be aware, NAREIT may propose legislation to enable a REIT to own a taxable subsidiary to conduct or perform taxable non-customary services with appropriate restrictions to limit abuse (e.g., limiting payments of interest or rent to the REIT).

The second proposal by the administration affecting REITs would require that no person can own stock of a REIT possessing more than 50 percent of the total combined voting power of all classes of its voting stock or more than 50 percent of the total value of shares of all classes of its stock. For this purpose, the stock attribution rules in Section 856(d)(5) of the Code would apply. This proposal, which is aimed at closely held REITs (i.e.. situations in which 100 percent of the common stock of the REIT is issued to a single shareholder and the issuance of the REIT's preferred stock to 99 "friendly" shareholders) would be effective for entities electing REIT status for taxable years on or after the Effective Date. It is uncertain whether this proposal would affect captive Down-REITs (i.e., a private REIT organized as a subsidiary of a public REIT).

The third proposal by the administration which would have an impact on REITs deals with the conversion of large C Corporations (corporations with a value of $5 million or more) to an S Corporation, a RIC or a REIT. The proposal would require the immediate recognition by the large C Corporation of the net built-in gain in its assets through the repeal of Section 1374 of the Code and revisions to IRS Notice 98-19 (affecting conversions of C Corporations to RICs or REITs) to conform it thereto.

Currently, a large C Corporation can convert into an S Corporation or merge into a RIC or a REIT tax-free as long as the built-in gain assets are held for a period of 10 years. The proposal would be effective for all subchapter S elections effective for the taxable year beginning January 1, 1999 and would apply to all mergers or acquisitions of large C Corporations into an S Corporation, a RIC or a REIT after December 31. 1998. The proposal does not affect the formation of REITs (in particular those utilizing the UP-REIT structure) and does not affect the mergers of REITs with S Corporations, partnerships or limited liability companies.

It should be noted that a similar proposal to repeal Code Section 1374 was made by the administration in connection with the 1997 Tax Act. The 1997 proposal was dropped in committee before enactment, and hopefully, once again, the same groups that successfully opposed the legislation in 1997 will prevail in 1998.
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Title Annotation:Focus on: Banking & Finance
Publication:Real Estate Weekly
Date:Feb 18, 1998
Previous Article:The mortgage opportunity of a lifetime.
Next Article:Budget proposal unlikely to slow REIT growth or real estate consolidation.

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