NAREIT's "Talking Points" on Permissible REIT Investments (March 9, 1998)

Current law

To focus the business of a real estate investment trust ("REIT") on income producing real estate, Congress requires REITs to meet specific asset and income tests. One test precludes a REIT from owning more than 10% of the voting securities of a non-REIT corporation.

Since 1988, the IRS has interpreted these rules to allow a REIT to own 90% or more of a non-REIT corporation through an investment in non-voting stock, with REIT shareholders or managers owning the controlling voting stock. This arrangement has allowed REITs and their shareholders to earn modest sources of income through these "preferred stock subsidiaries," which provide services to third parties.

The Administration's Fiscal Year 1999 Budget proposes to prohibit a REIT from owning more than 10% of the vote or value of a non-REIT's securities, effective for new preferred stock subsidiaries or for substantial new assets or new trades or businesses in existing subsidiaries. The proposal is estimated to raise $19 million over five years.

NAREIT strenuously opposes the Administration's proposal and believes it would have an unfair and unnecessarily disruptive effect on the REIT industry.

• The preferred stock subsidiaries are taxable corporations offering services to third party customers that are real estate related, since they typically are of the same type that a REIT may provide to their tenants. This is in keeping with REITs' real estate focus.

• The IRS has approved this arrangement for a decade, the industry has relied on these rulings, and Congress should not take any action in this area without subjecting it to the normal process of hearings and comments.

• Preferred stock subsidiaries typically provide services only to third parties. Thus, "transfer pricing" issues do not arise.

• No preferred stock subsidiary can be worth more than 5% of a REIT's assets, and therefore cannot significantly change the REIT's real estate purpose.

• As with any taxable corporation, a preferred stock subsidiary may use debt to finance its activities. However, these subsidiaries are service-oriented and typically do not need large amounts of capital. Thus, their ability to leverage is limited. Further, any interest income paid to a REIT becomes subject to the REIT's 95% distribution requirement and therefore is subject to a shareholder-level tax.

• As the IRS has ruled, a REIT should be able invest in stock of corporations that are subject to corporate tax, so long as most of the REIT's assets and income relate to real estate. NAREIT looks forward to working with the Congress and Administration as they review this area.

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