(Sec. 5004 of the Bill)
A real estate investment trust ("REIT") is an entity that receives most of its income from
passive real estate related investments and that essentially receives pass-through treatment for
income that is distributed to shareholders. If an electing entity meets the qualifications for REIT
status, the portion of its income that is distributed to the investors each year generally is taxed to
the investors without being subjected to a tax at the REIT level. In general, a REIT must derive its
income from passive sources and not engage in any active trade or business.
Requirements for REIT status
A REIT must satisfy a number of tests on a year-by-year basis that relate to the entity's (1)
organizational structure, (2) source of income, (3) nature of assets, and (4) distribution of income.
These tests are intended to allow pass-through treatment only if there is a pooling of investment
arrangement, if the entity's investments are basically in real estate assets, and its income is passive
income from real estate investment, as contrasted with income from the operation of a business
involving real estate. In addition, substantially all of the entity's income must be passed through to
its shareholders on a current basis.
Under the organizational structure tests, except for the first taxable year for which an entity
elects to be a REIT, the beneficial ownership of the entity must be held by 100 or more persons.
Generally, no more than 50 percent of the value of the REIT's stock can be owned by five or fewer
individuals during the last half of the taxable year.
Under the source-of-income tests, at least 95 percent of its gross income generally must be
derived from rents, dividends, interest and certain other passive sources (the "95-percent test").
In addition, at least 75 percent of its income generally must be from real estate sources, including
rents from real property and interest on mortgages secured by real property (the "75-percent test").
For purposes of these tests, rents from real property generally include charges for services
customarily rendered in connection with the rental of real property, whether or not such charges are
separately stated. Where a REIT furnishes non-customary services to tenants, amounts received
generally are not treated as qualifying rents unless the services are furnished through an
independent contractor from whom the REIT does not derive any income. In general, an
independent contractor is a person who does not own more than a 35-percent interest in the REIT,
and in which no more than a 35-percent interest is held by persons with a 35-percent or greater
interest in the REIT.
To satisfy the REIT asset requirements, at the close of each quarter of its taxable year, an
entity must have at least 75 percent of the value of its assets invested in real estate assets, cash and
cash items, and government securities. Not more than 25 percent of the value of the REIT's assets
can be invested in securities (other than government securities and other securities described in the
preceding sentence). The securities of any one issuer may not comprise more than five percent of
the value of a REIT's assets. Moreover, the REIT may not own more than 10 percent of the
outstanding securities of any one issuer, determined by voting power.
A REIT is permitted to have a wholly-owned subsidiary subject to certain restrictions. A
REIT's subsidiary is treated as one with the REIT.
The income distribution requirement provides generally that at least 95 percent of a REIT's
income (with certain minor exceptions) must be distributed to shareholders as dividends.
In a stapled REIT structure, both the shares of a REIT and a C corporation may be traded,
but are subject to a provision that they may not be sold separately. Thus, the REIT and the C
corporation have identical ownership at all times.
In the Deficit Reduction Act of 1984 (the "1984 Act"), Congress required that, in applying
the tests for REIT status, all stapled entities are treated as one entity (Sec. 269B(a)(3)). The 1984
Act included grandfather rules, one of which provided that certain then-existing stapled REITs
were not subject to the new provision (Sec. 136(c)(3) of the 1984 Act). That grandfather rule
provided that the new provision did not apply to a REIT that was a part of a group of stapled
entities if the group of entities was stapled on June 30, 1983, and included a REIT on that date.
Reasons for Change
In the 1984 Act, Congress eliminated the tax benefits of the stapled REIT structure out of
concern that it could effectively result in one level of tax on active corporate business income that
would otherwise be subject to two levels of tax. Congress also believed that allowing a corporate
business to be stapled to a REIT was inconsistent with the policy that led Congress to create
As part of the 1984 Act provision, Congress provided grandfather relief to the small
number of stapled REITs that were already in existence. Since 1984, however, many of the
grandfathered stapled REITs have been acquired by new owners. Some have entered into new
lines of businesses, and most of the grandfathered REITs have used the stapled structure to engage
in large-scale acquisitions of assets. The Committee believes that such unlimited relief from a
general tax provision by a handful of taxpayers raises new questions not only of fairness, but of
unfair competition, because the stapled REITs are in direct competition with other companies that
cannot use the benefits of the stapled structure.
The Committee believes that it would be unfair to remove the benefit of the stapled REIT
structure with respect to real estate interests that have already been acquired. On the other hand,
the Committee believes that future acquisitions of interests in real property by these grandfathered
entities, or improvements of property that are tantamount to new acquisitions, should not be
accorded the benefits of the stapled REIT structure. Accordingly, the rules of the Committee bill
generally apply with respect to real property interests acquired by the REIT or a stapled entity after
March 26, 1998, pursuant to transactions not in progress on that date. Further, the Committee is
concerned that the some of the benefit of the stapled REIT structure can be derived through
mortgages and interests in subsidiaries and partnerships. Accordingly, the Committee bill provides
rules for mortgages acquired after March 26, 1998, and indirect acquisitions of real property
interests through entities after such date (with transition relief similar to that for direct acquisitions).
Explanation of Provision
Under the provision, rules similar to the rules of present law treating a REIT and all stapled
entities as a single entity for purposes of determining REIT status (Sec. 269B) apply to real
property interests acquired after March 26, 1998, by an existing stapled REIT, a stapled entity, or a
subsidiary or partnership in which a 10-percent or greater interest is owned by an existing stapled
REIT or stapled entity (together referred to as the "stapled REIT group"), unless the real property
interest is grandfathered as described below. Special rules apply to certain mortgages acquired by
the stapled REIT group after March 26, 1998, where a member of the stapled REIT group
performs services with respect to the property secured by the mortgage.
Rules for real property interests
The provision generally applies to real property interests acquired by a member of the
stapled REIT group after March 26, 1998. Real property interests that are acquired by a member
of the REIT group after such date, and which are not grandfathered under the rules described
below, are referred to as "nonqualified real property interests".
The provision treats activities and gross income of a stapled REIT group with respect to
nonqualified real property interests held by any member of the stapled REIT group as activities and
income of the REIT for certain purposes in the same manner as if the stapled REIT group were a
single entity. This treatment applies for purposes of the following provisions that depend on a
REIT's gross income: (1) the 95-percent test (Sec. 856(c)(2)); (2) the 75-percent test (Sec.
856(c)(3)); (3) the "reasonable cause" exception for failure to meet either test (Sec. 856(c)(6)); and
(4) the special tax on excess gross income for REITs with net income from prohibited transactions
Thus, for example, where a stapled entity leases nonqualified real property from the REIT
and earns gross income from operating the property, such gross income will be subject to the
provision. The REIT and the stapled entity will be treated as a single entity, with the result that the
lease payments from the stapled entity to the REIT would be ignored. The gross income earned by
the stapled entity from operating the property will be treated as gross income of the REIT, with the
result that either the 75-percent or 95-percent test might not be met and REIT status might be lost.
Similarly, where a stapled entity leases property from a third party after March 26, 1998, and uses
that property in a business, the gross income it derives will be treated as income of the REIT
because the lease would be a nonqualified real property interest.
Grandfathered real property interests
Under the provision, all real property interests acquired by a member of the stapled REIT
group after March 26, 1998, are treated as nonqualified real property interests subject to the general
rules described above, unless they qualify under one of the grandfather rules. An option to acquire
real property is generally treated as a real property interest for purposes of the provision.
However, a real property interest acquired by exercise of an option after March 26, 1998, is treated
as a nonqualified real property interest, even though the option was acquired before such date.
Under the provision, grandfathered real property interests include properties acquired by a
member of the stapled REIT group after March 26, 1998, pursuant to a written agreement which
was binding on March 26, 1998, and all times thereafter. Grandfathered properties also include
certain properties, the acquisition of which were described in a public announcement or in a filing
with the Securities and Exchange Commission on or before March 26, 1998.
A real property interest does not generally lose its status as a grandfathered interest by
reason of a repair to, an improvement of, or a lease of, the real property. Thus, if a REIT leases a
grandfathered real property to a stapled entity, a renewal of the lease does not cause the property to
lose its grandfathered status, whether the renewal is pursuant to the terms of the lease or otherwise.
Similarly, if a REIT owns a grandfathered real property interest that is leased to a third party and,
at the expiration of that lease, the REIT leases the property to a stapled entity, the interest would
remain a grandfathered interest. Finally, if a stapled entity leases a grandfathered property interest
from a third party and the property is repaired or improved, the interest would remain a
grandfathered interest except as described below.
An improvement of a grandfathered real property interest will cause loss of grandfathered
status and become a nonqualified real property interest in certain circumstances. Any expansion
beyond the boundaries of the land of the otherwise grandfathered interest occurring after March 26,
1998, will be treated as a non-qualified real property interest to the extent of such expansion.
Moreover, any improvement of an otherwise grandfathered real property interest (within its land
boundaries) that is placed in service after December 31, 1999, is treated as a separate nonqualified
real property interest in certain circumstances. Such treatment applies where (1) the improvement
changes the use of the property and (2) its cost is greater than (a) 200 percent of the undepreciated
cost of the property (prior to the improvement) or (b) in the case of property acquired where there
is a substituted basis, the fair market value of the property on the date that the property was
acquired by the stapled entity or the REIT. There is an exception for improvements placed in
service before January 1, 2004, pursuant to a binding contract in effect on December 31, 1999,
and at all times thereafter. The rule treating improvements as nonqualified real property interests
could apply, for example, if a member of the stapled REIT group constructs a building after
December 31, 1999, on previously undeveloped raw land that had been acquired on or before
March 26, 1998.
Ownership through entities
If a REIT or stapled entity owns, directly or indirectly, a 10-percent-or-greater interest in a
corporate subsidiary or partnership (or other entity described below) that owns a real property
interest, the above rules apply with respect to a proportionate part of the entity's real property
interest, activities and gross income. Thus, any real property interest acquired by such a
subsidiary or partnership that is not grandfathered under the rules described above is treated as a
nonqualified real property interest held by the REIT or stapled entity in the same proportion as its
ownership interest in the entity. The same proportion of the subsidiary's or partnership's gross
income from any nonqualified real property interest owned by it or another member of the stapled
REIT group will be treated as income of the REIT under the rules described above. However, an
interest in real property acquired by a grandfathered 10-percent-or-greater partnership or subsidiary
is treated as grandfathered if such interest would be a grandfathered interest if held directly by the
REIT or stapled entity. Thus, for example, if a REIT contributes a grandfathered real property
interest to a partnership 10 percent or more of which is owned on March 26, 1998, the interest will
not cease to be a grandfathered interest.
Similar rules attributing the proportionate part of the subsidiary's or partnership's real
property interests and gross income will apply when a REIT or stapled entity acquires a 10
percent-or-greater interest (or in the case of a previously-owned entity, acquires an additional
interest) after March 26, 1998, with exceptions for interests acquired pursuant to binding written
agreements or public announcements described above. Transition relief can apply to both an
entity's assets and the interest in the entity under the above rules. Thus, if on March 26, 1998, and
at all times thereafter, a stapled entity has a binding written contract to buy 10-percent or more of
the stock of a corporation and the corporation also has a binding written contract to buy real
property, no portion of the property will be treated as a nonqualified real property interest as a
result of the transaction.
Under the above rules, gross income of a REIT or stapled entity with respect to a
nonqualified real property interest held by a 10-percent-or-greater partnership or subsidiary is
subject to the rules for nonqualified real property interests only in proportion to the interest held in
the partnership or subsidiary. For example, assume that a stapled entity has a contract to manage a
nonqualified real property interest held by a partnership in which the stapled entity owns an 85
percent interest. Under the above rules, for purposes of applying the gross income tests, 85
percent of the partnership's activities and gross income from the property are attributed to the
REIT. As a result, 85 percent of the stapled entity's income from the management contract is
ignored under the single-entity analysis described above. The remaining 15 percent of the
management fee is not treated as gross income of the REIT because it is not income from a
nonqualified real property interest held or deemed held by the REIT or a stapled entity.
Grandfathered real property interests that are deemed owned by a REIT or a stapled entity
under the rules for 10-percent-or-greater interests will not be treated as acquired after March 26,
1998, if the REIT or a stapled entity subsequently becomes the actual owner. For example,
assume a REIT has a 50-percent interest in a partnership that distributes a grandfathered real
property interest to the REIT in complete liquidation of its interest. The 50-percent interest that
was previously deemed owned by the REIT will continue to be grandfathered; the remaining 50
percent interest will be a nonqualified real property interest because it was acquired by the REIT
after March 26, 1998.
Under the provision, special rules apply where a member of the stapled REIT group holds
a mortgage (that is not an existing obligation under the rules described below) that is secured by an
interest in real property, and a member of the stapled REIT group engages in certain activities with
respect to that property. The activities that have this effect under the provision are activities that
would result in impermissible tenant service income (as defined in Sec.856(d)(7)) if performed by
the REIT with respect to property it held. In such a case, all interest on the mortgage that is
allocable to that property and all gross income received by a member of the stapled REIT group
from the activity will be treated as impermissible tenant service income of the REIT, which is not
qualifying income under either the 75-percent or 95-percent tests. For example, assume that the
REIT makes a mortgage loan on a hotel owned by a third party which is operated by a stapled
entity under a management contract. Unless an exception applies, both the management fees
earned by the stapled entity and the interest earned by the REIT will be treated as impermissible
tenant services income of the REIT.
An exception to the above rules is provided for mortgages the interest on which does not
exceed an arm's-length rate and which would be treated as interest for purposes of the REIT rules.
An exception also is available for mortgages that are held by a member of the stapled REIT group
on March 26, 1998, and at all times thereafter, and which are secured by an interest in real property
on that date, and at all times thereafter (the "existing mortgage exception"). The existing mortgage
exception ceases to apply if the mortgage is refinanced and the principal amount is increased in
In the case of a partnership or subsidiary in which the REIT or a stapled entity owns a 10
percent-or-greater interest, a proportionate part of the entity's mortgages, interest and gross income
from activities would be attributed to the REIT or the stapled entity, subject to rules similar to those
for nonqualified real property interests. Thus, if a REIT or a stapled entity acquires a 10-percent
or-greater interest in a partnership or corporation after March 26, 1998, no mortgage held by the
partnership or subsidiary at such time would qualify for the existing mortgage exception.
Similarly, if a REIT or stapled entity owns a 10-percent-or-greater interest in a partnership or
subsidiary on March 26, 1998, and the REIT or the stapled entity subsequently acquires a greater
interest, a portion of each of the partnership's or subsidiary's mortgages that is the same as the
proportionate increase in the ownership interest would fail to qualify for the existing mortgage
Under the provision's priority rules, the mortgage rules do not apply to any part of a real
property interest that is owned or deemed owned by the REIT or a stapled entity under the rules for
real property interests described above. Thus, for example, if the REIT makes a mortgage loan on
real property owned by a stapled entity, the mortgage rules would not apply. If the property is a
nonqualified real property interest, the interest on the mortgage would be ignored under the single
entity analysis described above, and the gross income of the stapled entity from the property would
be treated as income of the REIT. Similarly, assume that a stapled entity owns 75 percent of the
stock of a subsidiary and has a management contract to operate a hotel owned by the subsidiary.
Assume also that the REIT makes a mortgage loan for the hotel. Under the real property interest
rules, 75 percent of the hotel is treated as owned by the stapled entity. Thus, if the hotel is a
nonqualified real property interest, 75 percent of the subsidiary's gross income from the hotel is
treated as income of the REIT and 75 percent of the income on the management contract is ignored
under the single-entity analysis. With respect to the remaining 25-percent interest in the
subsidiary, the real property interest rules do not apply, but the mortgage rules would treat 25
percent of the mortgage interest and 25 percent of management contract income as impermissible
tenant services income of the REIT.
For purposes of both the real property interest and mortgage rules, if a stapled REIT is not
stapled as of March 26, 1998, and at all times thereafter, or if it fails to qualify as a REIT as of
such date or any time thereafter, no assets of any member of the stapled REIT group would qualify
under the grandfather rules. Thus, all of the real property interests held by the group would be
nonqualified real property interests and none of the mortgages held by the group would qualify for
the existing mortgage exception.
For a corporate subsidiary owned by a stapled entity, the 10-percent ownership test would
be met if a stapled entity owns, directly or indirectly, 10 percent or more of the corporation's
stock, by either vote or value. For this purpose, any change in proportionate ownership that is
attributable solely to fluctuations in the relative fair market values of different classes of stock is not
taken into account. For interests in partnerships, the ownership test would be met if either the
REIT or a stapled entity owns, directly or indirectly, a 10-percent or greater interest in the
partnership's assets or net profits. Interests in other entities, such as trusts, are treated in the same
manner as 10-percent-or-greater interests in partnerships or corporations if the REIT or a stapled
entity owns, directly or indirectly, 10 percent or more of the beneficial interests in the entity.
Under the provision, terms used that are also used in the stapled stock rules (Sec. 269B) or
the REIT rules (Sec. 856) have the same meanings as under those rules.
The Secretary of the Treasury is given authority to prescribe such guidance as may be
necessary or appropriate to carry out the purposes of the provision, including guidance to prevent
the double counting of income and to prevent transactions that would avoid the purposes of the
The provision is effective for taxable years ending after March 26, 1998.