House Bill: H.R. 1616

As requested in Press Release No. FC-11 (June 9, 1999), the National Association of Real Estate Investment Trusts® ("NAREIT") respectfully submits these comments in connection with the Committee on Ways and Means' review of tax relief proposals to sustain a strong economy. NAREIT thanks the Chairman and the Committee for the opportunity to share its views on several important issues affecting REITs and publicly traded real estate companies.

NAREIT's comments address (1) H.R. 1616, the Real Estate Investment Trust Modernization Act of 1999; (2) the Administration proposals to modify the treatment of closely held real estate investment trusts ('REITs") and amend section 1374¹ to treat an "S" election by a large C corporation as a taxable liquidation of that C corporation; (3) H.R. 844; and (4) at risk rules applying to nonsecured public debt. We appreciate the opportunity to present these comments.

NAREIT is the national trade association for REITs and publicly traded real estate companies. Members are REITs and publicly traded businesses that own, operate and finance income-producing real estate, as well as those firms and individuals who advise, study and service these businesses. REITs are companies whose income and assets are mainly connected to income-producing real estate. By law, REITs regularly distribute most of their taxable income to shareholders as dividends. NAREIT represents over 200 REITs and publicly traded real estate companies, as well as over 1,600 industry professionals who provide a range of legal, investment, financial and accounting-related services to these companies.

Executive Summary

REIT Modernization Act. Congress created REITs in 1960 to make investment in income producing real estate easily and readily available to investors from all walks of life, yet current law prevents REITs from providing needed and emerging services to their tenants, putting them at a competitive disadvantage in the real estate marketplace. In addition, current law requires REITs to use indirect and inefficient methods in order to provide services to third parties. The Administration's Fiscal Year 2000 Proposed Budget contains a proposal to address these issues by authorizing REITs to own and operate taxable REIT subsidiaries. Because it is a better solution to the competitive limitations facing REITs today, NAREIT strongly supports H.R. 1616, the Real Estate Investment Trust Modernization Act of 1999 co-sponsored by Messrs. Thomas, Cardin and 31 other members of the House of Representatives.

H.R. 1616 would incorporate the principles of the Administration's Fiscal Year 2000 proposal to allow a REIT to own stock in taxable REIT subsidiaries, with four significant exceptions. First, H.R. 1616 would require taxable REIT subsidiaries to fit within the current, unified 25% asset test, rather than the complex and cumbersome 5% and 15% assets tests under the Administration proposal. Second, H.R. 1616 would limit interest deductions on debt between a REIT and its taxable subsidiary in accordance with the current earnings stripping rules of section 163(j), whereas the Administration would eliminate even a reasonable amount of intra-party interest deductions. Third, H.R. 1616 would prohibit a taxable REIT subsidiary from operating or managing hotels, while allowing a subsidiary to lease a hotel from its affiliated REIT so long as (a) the rents are set at market levels, (b) the rents are not tied to net profits, and (c) the hotel is operated or managed by an independent contractor. Fourth, H.R. 1616 would not apply the new rules on taxable REIT subsidiaries to current arrangements so long as a new trade or business is not engaged in and substantial new property is not acquired, unless the REIT affirmatively elects taxable REIT subsidiary status for its existing third party subsidiaries. Conversely, the Administration proposal would apply to current arrangements after an undefined period of time. H.R. 1616 also would make other beneficial and modernizing changes to the REIT tax rules, such as restoring the distribution requirement to 90% from 95%.

Closely Held REITs. The Administration proposes to prevent any entity from owning 50% or more of the vote or value of a REIT's stock. NAREIT supports the Administration's intention to craft a new ownership test intended to correspond to a REIT's primary mission: to make investment in income-producing real estate accessible to ordinary investors. However, we believe that the Administration's proposal is too broad, and therefore should be narrowed to prevent only non-REIT C corporations from owning 50% or more of a REIT's stock (by vote or value). In addition, the new rules should not apply to so-called "incubator REITs" that have proven to be a viable method by which small investors can access publicly traded real estate investments.

Built-in Gain Tax. The Administration proposes to deny S corporations, mutual funds and REITs worth more than $5 million from using the 10-year deferral rule under section 1374. Congress has rejected the Administration's call for a change in the section 1374 rules for three straight budgets. NAREIT recommends that Congress again reject this proposal. We also ask Congress to conduct oversight of the IRS to ensure that it does not do administratively what it has not been able to achieve by legislation.

Tenant Improvements. NAREIT strongly supports H.R. 844, which would change the depreciation period of certain tenant improvements to 10 years to better approximate their true economic lives.

At Risk Rules. NAREIT urges Congress to update the qualified nonrecourse financing rules to include publicly traded debt.

Background on REITs

A REIT is a corporation or business trust combining the capital of many investors to own, operate or finance income-producing real estate, such as apartments, shopping centers, offices and warehouses. REITs must comply with a number of requirements, some of which are discussed in detail in this statement, but the most fundamental of these are as follows: (1) REITs must pay at least 95% of their taxable income to shareholders; (2) most of a REIT's assets must be real estate; (3) REITs must derive most of their income from real estate held for the long term; and (4) REITs must be widely held.

In exchange for satisfying these requirements, REITs (like mutual funds) benefit from a dividends paid deduction so that most, if not all, of a REIT's earnings are taxed only at the shareholder level. On the other hand, REITs pay the price of not having retained earnings available to meet their business needs. Instead, capital for growth and significant capital expenditures largely comes from new money raised in the investment marketplace from investors who have confidence in the REIT's future prospects and business plan.

Congress created the REIT structure in 1960 to make investments in large-scale, significant income-producing real estate accessible to investors from all walks of life. Based in part on the rationale for mutual funds, Congress decided that the only way for the average investor to access investments in larger-scale commercial properties was through pooling arrangements. In much the same ways as shareholders benefit by owning a portfolio of securities in a mutual fund, the shareholders of REITs can unite their capital into a single economic pursuit geared to the production of income through commercial real estate ownership. REITs offer distinct advantages for smaller investors: greater diversification through investing in a portfolio of properties rather than a single building and expert management by experienced real estate professionals.

Despite the purpose of the REIT structure, the industry experienced very little growth for over 30 years mainly for two reasons. First, at the beginning REITs were seriously constrained by policy limitations. REITs were mandated to be passive portfolios of real estate. REITs were permitted only to own real estate, not to operate or manage it. This meant that REITs needed to use third party independent contractors, whose economic interests might diverge from those of the REIT's owners, to operate and manage the properties. This was an arrangement the investment marketplace did not accept readily or warmly.

Second, during these years the real estate investment landscape was colored by tax shelter-oriented characteristics. Through the use of high debt levels, which created artificial bases for depreciation, interest and depreciation deductions significantly reduced taxable income -- in many cases leading to so-called "paper losses" used to shelter a taxpayer's other income. Since a REIT is geared specifically to create "taxable" income on a regular basis and a REIT, unlike a partnership, is not permitted to pass "losses" through to its owners, the REIT industry could not compete effectively for capital against tax shelters.

In the Tax Reform Act of 1986 (the "1986 Act"), Congress changed the real estate investment landscape. On the one hand, by limiting the deductibility of interest, lengthening depreciation periods and restricting the use of "passive losses," the 1986 Act drastically reduced the potential for real estate investment to generate tax shelter opportunities. This meant, going forward, that real estate investment needed to be on a more economic and income-oriented footing.

On the other hand, as part of the 1986 Act, Congress modified a significant policy constraint that had been imposed on REITs at the beginning. The Act permitted REITs not merely to own, but also to operate and manage most types of income producing commercial properties by providing "customary" services associated with real estate ownership. Finally, for most types of real estate (other than hotels, health care facilities and some other activities that consist of a higher degree of personal services), the economic interests of the REIT's shareholders could be merged with those of the REIT's operators and managers.

Despite Congress' actions in 1986, significant REIT growth did not begin until 1992. One reason was the real estate recession in the early 1990s. Until the late 1980s banks and insurance companies kept up real estate lending at a significant pace. Foreign investment, particularly from Japan, also helped buoy the marketplace. But by 1990 the combined impact of the Savings and Loan crisis, the 1986 Act, overbuilding during the 1980s by non-REITs and regulatory pressures on bank and insurance lenders, led to a nationwide depression in the real estate economy. During the early 1990s commercial property values dropped between 30 and 50%. Credit and capital for commercial real estate became largely unavailable. As a result of this capital crunch, many borrowers defaulted on loans, resulting in losses by financial institutions and expense to the federal government.

Against this backdrop, starting in 1992, many private real estate companies realized that the best and most efficient way to access capital was from the public marketplace utilizing REITs. At the same time, many investors decided that it was a good time to invest in commercial real estate -- assuming recovering real estate markets were just over the horizon. They were right.

Since 1992, the REIT industry has attained impressive growth as new publicly traded REITs infused much needed equity capital into the over-leveraged real estate industry. Today there are over 200 publicly traded REITs with an equity market capitalization exceeding $150 billion. These REITs are owned primarily by individuals, with 49% of REIT shares owned directly by individual investors and 37% owned by mutual funds, which are owned mostly by individuals. But REITs certainly do not just benefit investors.

The lower debt levels associated with REITs compared to real estate investment overall have had a positive effect throughout the economy. Average debt levels for REITs are 40-50% of market capitalization, compared to leverage of 75% and often higher used when real estate is privately owned. The higher equity capital cushions REITs from the negative effects of fluctuations in the real estate market that have traditionally occurred. The ability of REITs better to withstand market downturns should have a stabilizing effect on the real estate industry and its lenders, resulting in fewer future bankruptcies and work-outs. Consequently, the general economy will benefit from reduced real estate losses by federally insured financial institutions.

Consistent with the policy underlying the REIT rules, many believe that, over time, the U.S. commercial real estate economy will move toward more and more ownership by REITs and publicly traded real estate companies. Yet, future growth may be significantly limited by the inability of REITs under current law to be able to provide more services to their tenants than they are currently allowed to perform. Although the 1986 Act largely married REIT management to REIT assets and the Taxpayer Relief Act of 1997 included additional helpful REIT reforms, REITs still must operate under limitations that increasingly will make them non-competitive in the emerging, customer-oriented real estate marketplace. NAREIT looks forward to working with Congress and the Administration further to modernize and improve the REIT rules so that REITs can continue to offer investors from all walks of life opportunities for rewarding investments in income-producing real estate.

I.     REIT MODERNIZATION ACT Of 1999

A.    Taxable REIT Subsidiaries

As part of the asset diversification tests applied to REITs, a REIT may not own more than 10% of the outstanding voting securities of a non-REIT corporation pursuant to section 856 (c)(5)(B).² The Administration's Fiscal Year 1999 Budget proposed to amend section 856(c)(5)(B) to prohibit REITs from holding stock possessing more than 10% of the vote or value of all classes of stock of a non-REIT corporation.³ The Administration's Fiscal Year 2000 Budget proposed an exception to this vote or value rule for taxable REIT subsidiaries.

1.   Background and Current Law. The activities of REITs are strictly limited by a number of requirements that are designed to ensure that REITs serve as a vehicle for public investment in real estate. First, a REIT must comply with several income tests. At least 75% of the REIT's gross income must be derived from real estate, such as rents from real property, mortgage interest and gains from sales of real property (not including dealer sales). In addition, at least 95% of a REIT's gross income must come from the above real estate sources, dividends, interest and sales of securities.

Second, a REIT must satisfy several asset tests. On the last day of each quarter, at least 75% of a REIT's assets must be real estate assets, cash and government securities. Real estate assets include interests in real property and mortgages on real property. As mentioned above, the asset diversification rules require that a REIT not own more than 10% of the outstanding voting securities of an issuer (other than a qualified REIT subsidiary under section 856(i)). In addition, no more than 5% of a REIT's assets can be represented by securities of a single issuer (other than a qualified REIT subsidiary).

REITs have been so successful in operating their properties and providing permissible services to their tenants that they have been asked to provide these services to non-tenants, utilizing expertise and capabilities associated with the REIT's real estate activities. In addition, mortgage REITs are presented with substantial opportunities to service the mortgages that they securitize. The asset and income tests, however, restrict how and to what extent REITs can engage in these activities. A REIT can earn only up to 5% of its income from sources other than rents, mortgage interest, capital gains, dividends and interest. However, many REITs have had the opportunity to maximize shareholder value by earning more than 5% from third party services.

Starting in 1988, the Internal Revenue Service ("IRS") issued private letter rulings to REITs approving a structure to facilitate a REIT providing a limited amount of services to third parties.⁴ These rulings sanctioned or permitted a structure under which a REIT owns no more than 10% of the voting stock and up to 99% of the value of a non-REIT corporation through nonvoting stock. Usually, managers or shareholders of the REIT own the voting stock of the "Third Party Subsidiary" ("TPS," also known as a "Preferred Stock Subsidiary"). The TPS typically either provides to unrelated parties services already being delivered to a REIT's tenants, such as landscaping and managing a shopping mall in which the REIT owns a joint venture interest, or engages in other real estate activities, such as development, which the REIT cannot undertake to the same extent. A TPS of a mortgage REIT typically services a pool of securitized mortgages and sells mortgages as part of the securitization process that has the effect of lowering homeowners' interest rates.

The REIT receives dividends from the TPS that are treated as qualifying income under the 95% income test, but not the 75% income test.⁵ Accordingly, a REIT continues to be principally devoted to real estate operations. While the IRS has approved using the TPS for services to third parties and "customary" services to tenants the REIT could otherwise provide, the IRS has not permitted the use of these subsidiaries to provide impermissible, non-customary real estate services to REIT tenants.⁶ 2.   Administration Proposal. In 1998, the Administration proposed changing the asset diversification tests to prevent a REIT from owning securities in a C corporation that represent 10% of either the corporation's vote or its value. The proposal would have applied with respect to stock acquired on or after the date of first committee action. In addition, to the extent that a REIT's ownership of TPS stock would have been grandfathered by virtue of the effective date, the grandfather status would have terminated if the TPS engaged in a new trade or business or acquired substantial new assets on or after the date of first committee action.

In its Fiscal Year 2000 Budget, the Administration again proposed to base the 10% asset test on either vote or value. However, it also proposes an exception for two types of taxable REIT subsidiaries ("TRS"). A qualified business subsidiary ("QBS") would be the successor to the current TPS and could engage in the same activities as can a TPS today. A REIT could not own more than 15% of its assets in QBSs. The second type of TRS would be a qualified independent contractor subsidiary ("QIKS"), which could provide non-customary services to the affiliated REIT's tenants. A REIT could not own more than 5% of its assets in QIKSs as part of its 15% TRS allocation.

Under the Administration's proposal, a TRS could not deduct any interest payments to its affiliated REIT, and 100% excise tax penalties would be imposed to the extent that any pricing between a TRS and either its affiliated REIT or that REIT's tenants was not set on an arms'-length basis. The new TRS rules would apply to all existing TPSs after a time period to be determined by Congress.

3.   Statement in Support of H.R. 1616. The REIT industry has grown significantly during the 1990s, from an equity market capitalization under $10 billion to over $150 billion. The TPS structure is used extensively by today's REITs and has been a small, but important, part of recent industry growth. These subsidiaries help ensure that the small investors who own REITs are able to maximize the return on their capital by taking full economic advantage of core business competencies developed by REITs in owning and operating the REIT's real estate or mortgages. The Administration appropriately recognized that it makes sense to allow a REIT to utilize these core competencies through taxable subsidiaries so long as the REIT remains focused on real estate and the subsidiary's operations are appropriately subject to a corporate level tax.

In addition, the Administration's proposal recognizes that the REIT rules need to be modernized to permit REITs to remain competitive. By virtue of the "customary" standard in defining permissible REIT rental activities, REITs must wait until their competitors have established new levels of service before providing that service to their customers. This "lag effect" assures that REITs are never leaders in their markets, but only followers, to the detriment of their shareholders. Under the Administration proposal, the REIT could render such services to its tenants through a subsidiary that is subject to corporate tax.

The Administration's TRS proposal is a serious and very significant step in the right direction, but NAREIT requests Congress instead to enact H.R. 1616. This bill parallels the Administration's subsidiary proposal, but improves and clarifies this concept in four major ways.

First, H.R. 1616 would require taxable REIT subsidiaries to fit within the current, unified 25% asset test, rather than the unnecessarily complex and cumbersome 5% and 15% assets tests under the Administration proposal described above. Requiring two types of TRSs would cause severe complexity and administrative burdens, such as allocating costs between a QBS and a QIKS without incurring a 100% excise tax. Further, the Code should encourage, rather than prohibit, the same TRS providing the same service to its affiliated REIT's tenants and to third parties to make it easier to ensure that the pricing of those services is set at market rates. Moreover, the 5% and 15% limits are unnecessarily restrictive given the fact that the subsidiary is subject to a corporate level tax on all of its activities. H.R. 1616 adopts the better approach of treating TRS stock as an asset that must fit within the current 25% basket of non-real estate assets a REIT that can own, along with other non-real estate assets such as personal property.

Second, H.R. 1616 would limit interest deductions on debt between a REIT and its taxable REIT subsidiary in accordance with the current earnings stripping rules of section 163(j), whereas the Administration would eliminate even a reasonable amount of intra-party interest deductions. Congress confronted very similar earnings stripping concerns in the 1980s with respect to foreign organizations and their U.S. subsidiaries and resolved those concerns by enacting section 163(j). This section permits interest deductions on objective, modest amounts of related party debt. Section 163(j) is easily implemented, and guidance has been provided by final regulations. H.R. 1616 would adopt even stricter rules for REITs and their subsidiaries by limiting the interest deductions to market rates, or else suffer a 100% excise tax. Clearly, REITs should not be forced to comply with an absolute denial of legitimate interest deductions when foreign organizations in similar circumstances are not so limited.

Third, the Administration's proposal does not address whether REITs could use a TRS to own or operate hotels or health care facilities. H.R. 1616 would prohibit a taxable REIT subsidiary from operating or managing hotels and health care facilities, while allowing a subsidiary to lease a hotel from its affiliated REIT so long as (a) the rents are set at market levels, (b) the rents are not tied to net profits, and (c) the hotel is operated or managed by an independent contractor.

Fourth, H.R. 1616 would not apply the new rules on subsidiaries to current arrangements so long as a new trade or business is not engaged in and substantial new property is not acquired, unless the REIT affirmatively elects, on a timely basis, taxable REIT subsidiary status for such TPS. Conversely, the Administration proposal would become effective after an undefined period of time. REITs have planned their operations based on IRS rulings starting in 1988 that have sanctioned or permitted TPSs and should not be penalized for following established policy. H.R. 1616 would adopt the approach to an effective date contained in last year's Administration's budget proposals that acknowledged the IRS' earlier acquiescence to the TPS structure.

B. Other Provisions in H.R. 1616

NAREIT strongly endorses the other important modernization provisions contained in H.R. 1616: (1) restoration of the distribution requirement to the 90% level that applied to REITs from 1960 to 1980 (and that has at all times applied to mutual funds); (2) providing more flexibility for a REIT to hire an independent contractor to operate nursing homes, etc. without a lease for up to six years when the REIT takes back a health care property at the end of a lease and cannot re-lease it; (3) in the case of a publicly traded corporation being tested as an independent contractor, H.R. 1616 only would examine shareholders owning more than 5% of the corporation's stock; and (4) to prevent some traps for the unwary, H.R. 1616 would make some technical changes about how a company computes pre-REIT earnings and profits that it must distribute to its shareholders after electing REIT status or having a C corporation merge into it.

II.     OTHER ADMINISTRATION PROPOSALS AFFECTING REITS

A.    Closely Held REITS

The Administration's Fiscal Year 2000 Budget proposes to add a new rule, creating a limit of less than 50% on the vote or value of stock any entity could own in any REIT.

1.   Background and Current Law. As discussed above, Congress created REITs to make real estate investments easily and economically accessible to the small investor. To carry out this purpose, Congress mandated two rules to ensure that REITs are widely held. First, five or fewer individuals cannot own more than 50% of a REIT's stock.⁷ In applying this test, most entities owning REIT stock are "looked through" to determine the ultimate ownership of the stock by individuals. Second, at least 100 persons (including corporations and partnerships) must be REIT shareholders. Both tests do not apply during a REIT's first taxable year, and the "five or fewer" test only applies in the last half of each subsequent taxable year of the REIT.

The Administration appears to be concerned about non-REITs establishing "captive REITs" and REITs doing "step-down preferred" transactions for various tax planning purposes, which the Administration finds abusive, such as the "liquidating REIT" structure curtailed by the 1998 budget legislation.⁸ The Administration proposes changing the "five or fewer" test by imposing an additional requirement. The proposed new rule would prevent any "person" (i.e., a corporation, partnership or trust, including a pension or profit sharing trust) from owning stock of a REIT possessing 50% or more of the total combined voting power of all classes of voting stock or 50% or more of the total value of shares of all classes of stock. Certain existing REIT attribution rules would apply in determining such ownership, and the proposal would be effective for entities electing REIT status for taxable years beginning on or after the date of first committee action.

2.   Statement Providing Limited Support for Administration Proposal on Closely Held REITs. NAREIT generally shares the Administration's views and concerns. We believe that the REIT structure is meant to be widely held and that it should not be used for abusive tax avoidance purposes. Therefore, NAREIT fully supports the intent of the proposal. But we are concerned that the Administration proposal casts too broad a net, prohibiting legitimate, temporary use of "closely held" REITs and fails to recognize that ownership by another pass-through entity is widely held. A limited number of exceptions are in order to allow certain "entities" to own a majority of a REIT's stock. For instance, NAREIT certainly agrees with the Administration's decision to exclude a REIT's ownership of another REIT's stock from the proposed new ownership limit.⁹ NAREIT would like to work with Congress and the Administration to ensure that any action to curb abuses does not disallow transactions necessary to foster the future REIT marketplace and to recognize the widely held nature of certain non-REIT entities.

First, an exception should be allowed to enable a REIT's organizers to have a single large investor for a temporary period, such as in preparation for a public offering of the REIT's shares. Such an "incubator REIT" sometimes is majority owned by its sponsor to allow the REIT to accumulate a track record that will facilitate its going public. The Administration proposal would prohibit this important approach which, in turn, could curb the emergence of new publicly traded REITs in which small investors may invest.

Second, there is no reason why a partnership, mutual fund, pension or profit-sharing trust or other pass-through entity should be counted as one entity in determining whether any "person" owns 50% of the vote or value of a REIT. A partnership, mutual fund or other pass-through entity is usually ignored for tax purposes. The partners in a partnership and the shareholders of a mutual fund or other pass-through entity should be considered the "persons" owning a REIT for purposes of any limits on investor ownership. Similarly, the Code already has rules preventing a "pension held" REIT from being used to avoid the unrelated business income tax rules, and therefore the new ownership test should not apply to pension or profit-sharing plans. Instead, NAREIT suggests that the new ownership test apply only to non-REIT C corporations that own more than 50% of a REIT's stock.¹⁰

III.     SECTION 1374

The Administration's Fiscal Year 2000 Budget proposes to amend section 1374 to treat an "S" election by a C corporation valued at $5 million or more as a taxable liquidation of that C corporation followed by a distribution to its shareholders. This proposal also was included in the Administration's Fiscal Year 1997, 1998 and 1999 proposed budgets.

A.    Background and Current Law

Prior to its repeal as part of the Tax Reform Act of 1986, the holding in a court case named General Utilities permitted a C corporation to elect S corporation, REIT or mutual fund status (or transfer assets to an S corporation, REIT or mutual fund in a carryover basis transaction) without incurring a corporate-level tax. With the repeal of the General Utilities doctrine in 1986, such transactions arguably would have been immediately subject to tax but for Congress' enactment of section 1374. Under section 1374, a C corporation making an S corporation election pays any tax that otherwise would have been due on the "built-in gain" of the C corporation's assets only if and when those assets are sold or otherwise disposed of during a 10-year "recognition period." The application of the tax upon the disposition of the assets, as opposed to the election of S status, works to distinguish legitimate conversions to S status from those made for purposes of tax avoidance.

In Notice 88-19, 1988-1 C.B. 486 (the "Notice"), the IRS announced that it intended to issue regulations under section 337(d)(1) that in part would address the avoidance of the repeal of General Utilities through the use of REITs and regulated investment companies ("RICs," i.e. mutual funds). In addition, the IRS noted that those regulations would enable the REIT or RIC to be subject to rules similar to the principles of section 1374. Thus, a C corporation can elect REIT status and incur a corporate-level tax only if the REIT sells assets in a recognition event during the 10-year "recognition period."

In a release issued February 18, 1998, the Treasury Department announced that it intends to revise Notice 88-19 to conform to the Administration's proposed amendment to limit section 1374 to corporations worth less than $5 million, with an effective date similar to the statutory proposal. This proposal would result in a double layer of tax: once to the shareholders of the C corporation in a deemed liquidation and again to the C corporation itself upon such deemed liquidation.

Because of the Treasury Department's intent to extend the proposed amendment of section 1374 to REITs, these comments address the proposed amendment as if it applied to both S corporations and REITs.

B.    Statement in Support of the Current Application of Section 1374 to REITs

As stated above, the Administration proposal would limit the use of the 10-year election to REITs valued at $5 million or less. NAREIT believes that this proposal would contravene Congress' original intent regarding the formation of REITs, would be both inappropriate and unnecessary in light of the statutory requirements governing REITs, would impede the recapitalization of commercial real estate, likely would result in lower tax revenues, and ignores the basic distinction between REITs and partnerships.

A fundamental reason for a continuation of the current rules regarding a C corporation's decision to elect REIT status is that the primary rationale for the creation of REITs was to permit small investors to make investments in real estate without incurring an entity level tax, and thereby placing those persons in a comparable position to larger investors. H.R. Rep. No. 2020, 86th Cong., 2d. Sess. 3-4 (1960).

By placing a toll charge on a C corporation's REIT election, the proposed amendment would directly contravene this Congressional intent, as C corporations with low tax bases in assets (and therefore a potential for a large built-in gains tax) would be practically precluded from making a REIT election. As previously noted, the purpose of the 10-year election is to allow C corporations to make S corporation and REIT elections when those elections are supported by non-tax business reasons (e.g., access to the public capital markets), while protecting the Treasury from the use of such entities for tax avoidance.

Additionally, REITs, unlike S corporations, have several characteristics that support a continuation of the current section 1374 principles. First, there are statutory requirements that make REITs long-term holders of real estate. The 100% prohibited transactions tax on REITs complements the 10-year election mechanism.

Second, while S corporations may have no more than 75 shareholders, a REIT faces no statutory limit on the number of shareholders it may have and is required to have at least 100 shareholders. In fact, some REITs have hundreds of thousands of beneficial shareholders. NAREIT believes that the large number of shareholders in a REIT and management's fiduciary responsibility to each of those shareholders preclude the use of a REIT as a vehicle primarily to circumvent the repeal of General Utilities. Any attempt to benefit a small number of investors in a C corporation through the conversion of that corporation to a REIT is impeded by the REIT widely-held ownership requirements.

The consequence of the Administration proposal would be to preclude C corporations in the business of managing and operating income-producing real estate from accessing the substantial capital markets' infrastructure, comprised of investment banking specialists, analysts, and investors, that has been established for REITs. In addition, other C corporations that are not primarily in the business of operating commercial real estate would be precluded from recognizing the value of those assets by placing them in a professionally managed REIT. In both such scenarios, the hundreds of thousands of shareholders owning REIT stock would be denied the opportunity to become owners of quality commercial real estate assets.

Furthermore, the $5 million dollar threshold that would limit the use of the current principles of section 1374 is unreasonable for REITs. While many S corporations are small or engaged in businesses that require minimal capitalization, REITs as owners of commercial real estate have significant capital requirements. As previously mentioned, it was Congress' recognition of the significant capital required to acquire and operate commercial real estate that led to the creation of the REIT as a vehicle for small investors to become owners of such properties. The capital intensive nature of REITs makes the $5 million threshold essentially meaningless for REITs.

It should be noted that this proposed amendment is unlikely to raise any substantial revenue with respect to REITs, and may in fact result in a loss of revenues. Due to the high cost that would be associated with making a REIT election if this amendment were to be enacted, it is unlikely that any C corporations would make the election and incur the associated double level of tax without the benefit of any cash to pay the taxes. In addition, by remaining C corporations, those entities would not be subject to the REIT requirement that they make taxable distributions of 95% of their income each tax year.

Moreover, the Administration justifies its de facto repeal of section 1374 by stating that "[t]he tax treatment of the conversion of a C corporation to an S corporation generally should be consistent with the treatment of its [sic] conversion of a C corporation to a partnership." Regardless of whether this stated reason for change is justifiable for S corporations, in any event it should not apply to REITs because of the material differences between REITs and partnerships.

Unlike partnerships, REITs cannot (and have never been able to) pass through losses to their investors. Further, REITs can and do pay corporate level income and excise taxes. Simply put, REITs are C corporations. Thus, REITs are not susceptible to the tax avoidance concerns raised by the 1986 repeal of the General Utilities doctrine.

We note that on March 9, 1999, the Treasury Department and the IRS released their 1999 Business Plan, in which it listed a project for "[r]egulations regarding conversion of C corporation to to [sic] RIC or REIT status." On February 22, 1996, the Treasury Department issued a release stating that "the IRS intends to revise Notice 88-19 to conform to the proposed amendment to section 1374, with an effective date similar to the statutory proposal." We urge the Congress to use its oversight authority to be certain that the Treasury Department does not by-pass Congress and enact the "built-in gain" tax on REITs and RICs administratively. Any such action would directly contravene Congress' repeated rejection of any statutory change in this area.

C.    Summary

The 10-year recognition period of section 1374 currently requires a REIT to pay a corporate-level tax on assets acquired from a C corporation with a built-in gain, if those assets are disposed of within a 10-year period. Combined with the statutory requirements that a REIT be widely held and a long-term holder of assets, current law assures that the REIT is not a vehicle for tax avoidance. The proposal's two level tax would frustrate Congress' intent to allow the REIT to permit small investors to benefit from the capital-intensive real estate industry in a tax efficient manner.

Accordingly, NAREIT believes that tax policy considerations are better served if the Administration's section 1374 proposal is not enacted. Further, the Administration should not contravene the Congress' clear intent in this area by attempting to impose this double level tax on REITs and RICs by administrative means.

IV.     TENANT IMPROVEMENTS

As an essential part of meeting customer demands, landlords routinely construct improvements to leased space to conform to a tenant's requirements. The average lease term (and therefore the usefulness of the "build out" for the tenant) ranges from five to ten years. However, since the Tax Reform Act of 1986, landlords must depreciate these "tenant improvements" over the tax life of the entire building: 39 years.

H.R. 844 and S. 879 would ameliorate this disconnect between the tenant improvement's economic life and its tax write-off period. For the purposes of simplicity, under H.R. 844 and S. 879 a lessor would depreciate its tenant improvements over ten years.

NAREIT joins the other national real estate trade associations in strongly urging the Committee to incorporate H.R. 844 in its mark-up of tax legislation this year. H.R. 844 would remove disincentives currently in place that discourage landlords from updating buildings, and would more closely conform the tax Code to economic realties.

V.     AT RISK RULES

In 1986, Congress extended the at risk rules for the first time to real estate. However, it created an exception for "qualified nonrecourse financing," since it recognized that loans made by an unrelated party in the lending business would not be used to create the "tax shelters" targeted by the underlying rules.

Congress modernized the REIT rules in the 1986 Act, and the REIT industry has blossomed from less than $10 billion in equity market capitalization to about $150 billion today. As REITs have matured into full-fledged public companies, they have used the financing techniques long traditional to public companies. More than two thirds of the publicly traded REITs now have investment grade rating from the credit agencies and routinely issue nonsecured corporate debt. The use of such debt benefits the economy because the rating agencies require a conservative level of debt.

However, as with the rest of the real estate sector, REITs routinely use partnerships to own and operate real estate holdings. Under the current at risk rules, a REIT's partners are penalized by the REIT's use of unsecured debt because the money is lent by the public markets rather than an entity engaged in the business of lending money.

Even though the Internal Revenue Service has issued some private letter rulings that provide some limited relief in these situations, NAREIT strongly recommends that Congress update the at risk rules to include a publicly traded debt as being eligible as qualified nonrecourse financing. Such debt should include a debt instrument which either is traded on an established securities market or is readily tradable on a secondary market (or the substantial equivalent thereof).

NAREIT thanks the Committee for the opportunity to comment on these important proposals.

¹For purposes of this Statement, "section" refers to the Internal Revenue Code of 1986, as amended.

²The shares of a wholly-owned "qualified REIT subsidiary" ("QRS") of the REIT are ignored for this test.

³Since it is a disregarded entity for tax purposes, a qualified REIT subsidiary would be excepted from the requirement that a REIT not own more than 10% of the vote or value of another corporation.

⁴PLRs 8825112, 9340056, 9428033, 9431005, 9436025 9440026. See also PLRs 9507007, 9510030, 9640007, 9733011, 9734011, 9801012, 9808011, 9835013.

⁵The REIT does not qualify for a dividends received deduction with respect to TPS dividends. I.R.C. § 857(b)(2)(A).

⁶But see PLR 9804022. In addition, the IRS has been flexible in allowing a TPS to engage in an "independent line of business" in which it provides a service to the public and a minority of the users are REIT tenants. See, e.g., PLRs 9627017, 9734011, 9835013.

⁷I.R.C. § 856(h)(1). There is no apparent reason why the proposed ownership test similarly should not be aimed at limiting more than 50% stock ownership, rather than 50% or more as now proposed.

⁸NAREIT supported the Administration's and Congress' move to limit the tax benefits of liquidating REITs.

⁹If the proposed test remains applicable to all persons owning more than 50% of a REIT's stock, then Congress should apply the exception for a REIT owning another REIT's stock by examining both direct and indirect ownership so as not to preclude an UPREIT owning more than 50% of another REIT's stock.

¹⁰As under the current "five or fewer" test, any new ownership test should not apply to a REIT's first taxable year or the first half of subsequent taxable years. See I.R.C. §§ 542(a)(2) and 856(h)(2).

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