(Sec. 5004 of the Bill)

Present Law

In General

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.

Stapled REITs

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 REITs.

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

Overview

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

In General

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 (Sec. 857(b)(5)).

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.

Mortgage rules

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 such refinancing.

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 exception.

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.

Other rules

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 provision.

Effective Date

The provision is effective for taxable years ending after March 26, 1998.