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REITs: opportunities with 'non-REIT subsidiaries.' (real estate investment trusts)

In recent months, Wall Street has rediscovered the real estate investment trust (REIT). In contrast to the traditional passive investment vehicle of the 1970s, the REIT of the 1990s often manages, leases and develops its own properties. The Tax Reform Act of 1986 made this change possible by substantially modifying the requirement that an independent contractor manage the REIT's properties in order for the rental income to qualify for the 95% income test.

The current wave of REIT offerings includes the conversion of many fully integrated real estate companies to REIT status. Today's REIT candidate typically earns income from a variety of nonqualifying sources, including related-party and third-party fees. Property held primarily for sale produces income from prohibited transactions subject to a 100% penalty tax. A prospective REIT usually does not want to relinquish this source of income. However, even if it desired to dispose of those assets or businesses, finding a buyer within a short time frame and at an attractive price could prove to be difficult.

One solution that allows effective retention of the nonqualifying businesses and assets involves using a so-called "non-REIT subsidiary." is a fully taxable subsidiary of the REIT that assumes the ownership and operation of nonqualifying businesses. The non-REIT subsidiary must not be wholly owned by the REIT; if it is, it would usually be a "qualified REIT subsidiary" under Sec. 856(i), it would be disregarded for Federal income tax purposes, and all of its assets and income would be attributed to the REIT parent. The "lookthrough" provisions of Sec. 856(i) would throw the nonqualifying income back into the REIT, defeating the purpose of the subsidiary's existence.

It is not sufficient merely to reduce the REIT's ownership below 100%. The asset tests of Sec. 856(c)(5) must also be met, i.e., a REIT cannot own more than 10% of the voting securities of any one issuer. A REIT may want to retain most of the subsidiary's appreciation potential, or may have difficulty finding a third party to make the required investment to purchase a substantial interest in the subsidiary. In either case, the subsidiary could be structured by issuing voting and nonvoting common stock so that the REIT would own less than 10 % of the voting stock. The voting common stock could represent perhaps 5 % of the common equity, and the nonvoting common stock the remaining 95%. The REIT would own 10% or less of the voting common stock and 100% of the nonvoting common stock. If there is significant current equity in the assets, the REIT could take back a combination of nonvoting preferred stock and debt.

The asset tests of Sec. 856(c)(5) include another limitation: The REIT cannot hold securities of the nonqualifying subsidiary representing over 5% of the REIT's total assets. Since this test is based on the assets' gross value, many REITs will be able to satisfy the test with ease. If the 5% test creates a problem, placing the nonqualifying assets or business in two or more subsidiaries provides a solution, since the 5% and 10% tests are applied on an individual issuer basis.

Since the subsidiary will be taxable, the usual "debt versus equity" issues must be considered, including deductibility of interest and thin capitalization. In planning the structure, the effects on the REIT income tests also must be carefully examined; if a taxable gain is to be recognized after the REIT election is effective, the gain may affect the REIT's ability to satisfy the income tests. The possibility of income from a prohibited transaction must also be carefully considered.

Finally, the REIT must have 75 % of its assets invested in qualifying "real estate assets," cash and government securities, at the end of each quarter. The subsidiary would not be a qualifying asset, and using multiple subsidiaries would not help. However, since third-party debt reduces the value of a non-REIT subsidiary, the net value owned by the REIT may not present a problem when compared to 75% of its gross assets.

One major business issue remains: The REIT will be concerned about control of the subsidiary. An executive of the subsidiary may be an appropriate person to own the subsidiary's voting common stock, and the REIT can enter into an agreement with the executive restricting the transfer of the stock to appropriate persons.

A non-REIT subsidiary offers many planning opportunities for a REIT to benefit economically from related sources of nonqualifying income while still satisfying the numerous REIT restrictions. This benefit comes at the cost of a tax on the nonqualifying income. Therefore, the arrangement should not be viewed as being per se abusive. Where abuse exists, the IRS has other weapons in its arsenal, such as Sec. 482, to attack the arrangement.
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Author:Cutson, Gary A.
Publication:The Tax Adviser
Date:Jul 1, 1993
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