[Congressional Record Volume 141, Number 124 (Friday, July 28, 1995)]
[Extensions of Remarks]
[Pages E1548-E1550]
From the Congressional Record Online through the Government Publishing Office [www.gpo.gov]


      THE REAL ESTATE INVESTMENT TRUST SIMPLIFICATION ACT OF 1995

                                 ______


                         HON. E. CLAY SHAW, JR.

                               of florida

                    in the house of representatives

                         Friday, July 28, 1995

  Mr. SHAW. Mr. Speaker, I rise today to draw my colleagues' attention 
to an important piece of legislation, H.R. 2121, the Real Estate 
Investment Trust Simplification Act of 1995 [REITSA], a bill to amend 
portions of the Internal Revenue Code dealing with real estate 
investment trusts, or REIT's. The legislation responds to the need for 
simplification in the regulation of the day-to-day operation of REIT's. 
REITSA is cosponsored by Mr. Matsui, Mr. Crane, Mr. Thomas, Mrs. 
Johnson, of Connecticut, Mr. Zimmer, Mr. Portman, Mr. Stark, Mr. 
Jacobs, Mr. Levin, Mr. Cardin, Mr. Dunn, and Mr. Sam Johnson of Texas.
  In 1960, Congress created REIT's to function as the real estate 
equivalent of the regulated investment company, or mutual fund. As 
such, they permit small investors to participate in real estate 
projects that the investors could not undertake individually and with 
the assistance of experienced management. Over time, the REIT industry 
has matured into its intended role with the greatest stride made in 
this decade.
  This development of the REIT industry is a result of a number of 
factors. As important as any other were the changes Congress enacted in 
1986 to the REIT rules themselves and the tax landscape in general. 
With respect to the general provisions, throughout the 1980's limited 
partnerships used the offer of multiple dollars of tax paper losses for 
each invested dollar to attract investors away from solid investments 
like REITs, which seek to provide investors with consistent 
distributions from economically feasible real estate investments but 
provide no opportunity to receive a pass-through of tax motivated 
losses. Accordingly, the elimination of those tax loss loopholes led 
investors to look for income-producing investment opportunities.
  Also included in the 1986 tax legislation were important 
modifications to the REIT provisions of the Code. Among the changes 
made as part of that modernization of the REIT tax laws, the first in a 
decade and most recent comprehensive revision of the REIT laws, the 
most significant was the change allowing REIT's to directly provide to 
tenants those services customary in the leasing of real estate as had 
been permitted to pension plans and other tax-exempt entities engaged 
in the leasing of real property. Prior to that change, a REIT was 
required to use an independent contractor to provide those services.
  These legislative changes and the lack of credit to recapitalize 
America's real estate produced a suitable environment for the 
substantial growth in the REIT industry and the fulfillment of 
Congress' original hopes for the REIT vehicle.
  From 1990 to present, the industry has grown from a market 
capitalization of approximately $9 billion to nearly $50 billion. 
Fueling that growth has been the introduction of
 some of America's leading real estate companies to the family of long 
existing, viable REIT's. As a result, the majority of today's REIT's 
are owners of quality, income-producing real estate. Thus, hundreds of 
thousands of individuals that own REIT shares through direct 
investment, plus the many more who are interest holders in the growing 
number of mutual funds or pension funds investing in REIT's, have 
become participants in the recapitalization of tens of billions of 
dollars of America's best real estate investments. Likewise, investors 
in mortgage REIT's have the opportunity to participate in the ever 
growing market for securitized mortgages, further contributing to the 
recapitalization of quality real estate.

  The benefits of the growth in the REIT industry were addressed in a 
recent Urban Land Institute White Paper titled ``The REIT 
Renaissance.'' That white paper concluded that ``[f]rom an overall 
economic standpoint, the real estate industry and the economy should be 
well served by the expansion of the REIT industry--the broadening of 
participation in real estate ownership, the investment in market 
information and research that the public market will bring, and the 
more timely responsiveness to market signals that will result from 
better information and market analysis.''
  To assist the continued growth of this important industry, was 
developed to address areas in the existing tax regime that present 
significant, yet unnecessary, barriers to the use of the REIT vehicle. 
The proposals represent a modernization of the most complex parts of 
the regulatory structure under which REIT's operate, while leaving 
intact the basic underlying ownership, income, asset, and distribution 
tests introduced in the original REIT legislation.
                       Summary of Key Provisions

       A. Title I contains three proposals to remove unnecessary 
     ``traps for the unwary.'' These proposals would address 
     current requirements that are not necessary to satisfy 
     Congressional objectives, that carry a disproportionate 
     penalty for even unintentional oversights, or that are 
     impracticable in today's environment. Title I's overriding 
     intention is not to penalize a REIT's many small investors by 
     stripping the REIT of its tax status as a result of an act 
     that does not violate Congress' underlying intent in creating 
     the REIT vehicle.
       Section 101. Shareholder Demand Letter. The potential 
     disqualification for a REIT's failure to send shareholder 
     demand letters should be replaced with a reporting penalty. 
     Under present law, regulations require that a REIT send 
     letters to certain shareholders within 30 days of the close 
     of the REIT's taxable year. The letters demand from its 
     shareholders of record, a written statement identifying the 
     ``actual owner'' of the stock. A REIT's failure to comply 
     with the notification requirement may result in a loss of 
     REIT status.
       The failure to send-so-called demand letters may result in 
     the disqualification of a REIT with thousands of shareholders 
     that easily satisfies the substantive test because of a 
     purely technical violation. As a result of disqualification, 
     a REIT would be compelled to pay taxes for all
      open years, thereby depriving their shareholders of income 
     generated in compliance with all of the REIT rules. 
     Fortunately, the Internal Revenue Service has not enforced 
     any such technical disqualifications and instead has 
     entered into closing agreements with several REITs. The 
     proposal would alleviate the need to enter into such 
     closing agreements on a prospective basis.
       H.R. 2121 provides that a REIT's failure to comply with the 
     demand letter regulations would not, by itself, disqualify a 
     REIT if it otherwise establishes that it satisfies the 
     substantive ownership rules. But under these circumstances, a 
     $25,000 penalty ($50,000 for intentional violations) would be 
     imposed for any year in which the REIT did not comply with 
     the shareholder demand regulations and the REIT would be 
     required, when requested by the IRS, to send curative demand 
     letters or face an additional penalty equal to the amounts 
     related above. In addition, to protect a REIT that meets the 
     regulations, but is otherwise unable to discover the actual 
     ownership of its shares, the bill provides that a REIT would 
     be deemed to satisfy the share ownership rules if it complies 
     with the demand letter regulations and does not know, or have 
     reason to know, of an actual violation of the ownership 
     rules.
       Section 102. De Minimus Rule for Tenant Services Income. 
     The uncertainty related to qualifying services for a REIT 
     should be addressed by a reasonable de minimum test. In 1986, 
     Congress modernized the REITs' independent contractor rules 
     to allow them to directly furnish to tenants those services 
     customary in the management of rental property. However, 
     certain problems persist. Under existing law, a REIT's 
     receipt of any amount of revenue as a result of providing an 
     impermissible service to tenants with respect to a property 
     may disqualify all rents received with respect to that 
     property. For example, if a REIT's employee assists a tenant 
     in moving in or out of an apartment complex (a potentially 
     impermissible service), technically the IRS could contend 
     that all the income from the apartment complex is 
     disqualified, even though the REIT received no direct revenue 
     for the provided 

[[Page E 1549]]
     service. Similar concerns might arise if a REIT provided wheelchairs at 
     a mall on a no-cost basis. The disqualifications of a large 
     property's rent could seriously threaten, or even terminate, 
     the REIT's qualified status.
       Interestingly, at the same time a REIT could be severely 
     punished for providing services to tenants or their visitors, 
     the REIT rules properly provide that up to 5 percent of a 
     REIT's gross income may come from providing services to non-
     tenants. Thus, under present law a REIT is better off 
     providing services to nontenants than providing the same 
     services to tenants.
       In addition to the potential disqualification of rents, the 
     absence of a de minimus rule requires the REIT to spend 
     significant time and energy in monitoring every action of its 
     employees, and significant dollars in attorney fees to 
     determine whether each potential action is an impermissible 
     service. The uncertainty regarding the permissibility of 
     services also requires that the IRS to expend considerable 
     resources in responding to private ruling requests.
       To lessen the burden of monitoring each REIT employee's 
     every action and to eliminate unnecessary disqualification of 
     tenant rents, this bill provides for a de minimum exception. 
     The exception would treat small amounts of revenue resulting 
     from an impermissible service in a
      manner similar to revenue received from providing services 
     to non-tenants, and protect the classification of rents 
     from the affected property as qualifying REIT income. The 
     de minimus exception is equal to 1 percent of the gross 
     income from the affected property. The de minimus 
     exception is based on gross income to be consistent with 
     the REIT's income tests, and is set at 1 percent to 
     reflect an amount large enough to provide the requisite 
     safe harbor (note that it is 1 percent of the income from 
     an affected property, regardless how small, and not all 
     properties owned by the REIT), yet small enough not to 
     encourage disregard of the independent contractor rule. 
     Because many of the services in question will not result 
     in a direct receipt of gross income, the bill provides a 
     mechanism for establishing the gross income received 
     relative to an impermissible service. The gross income is 
     deemed at least equal to the direct costs of the service 
     (i.e. labor, cost of goods) multiplied by 150 percent.
       For example, in the case of a REIT providing wheelchairs at 
     a mall, the cost of the wheelchairs would be multiplied by 
     150 percent to achieve the gross income realized from the 
     impermissible service. If that and any other gross income 
     related to impermissible services provided to tenants of that 
     mall does not exceed 1 percent of the malls gross income for 
     the year, the impermissible service income would be 
     classified as non-qualifying income. However, rents received 
     from tenants of the mall would not be disqualified.
       A REIT's actions are still policed under this change. 
     First, if a REIT's gross income from impermissible services 
     exceed 1 percent of the gross income from the affected 
     property, that income and the rents from that property would 
     be disqualified as under current law. Second, as previously 
     noted, a REIT's gross income from non-qualifying sources is 
     limited to 5 percent of total gross income. Accordingly, 
     gross income from impermissible sources that does not exceed 
     the 1 percent threshold would be included in that small 
     basket, thereby placing a second check on the REIT's 
     activities.
       Section 103. Attribution Rules Applicable To Tenant 
     Ownership. Unintended double attribution under section 318 
     should be minimized, while preserving the intended purpose of 
     the attribution rule. The attribution rules of section 318 
     are interjected to ensure that a REIT does not receive rents 
     from a 10 percent or more related party, in which case the 
     rents are deemed disqualified income for the REIT gross 
     income tests. While the intention of that rule is proper, a 
     quirk in the application of section 318 to REITs as called 
     for under section 856(d)(2) may result in the 
     disqualification of a REIT's rent when no actual direct or 
     indirect relationship exists between the REIT and tenant.
       Under section 318(a)(3)(A), stock owned directly or 
     indirectly, by a partner is considered owned by the 
     partnership. In addition, under section 318(a)(3)(C), a 
     corporation is considered as owning stock that is owned, 
     directly or indirectly, by or for a person who also owns more 
     than 10 percent (in the case of REITs) of the stock in such 
     corporation. Those attribution rules may create an unintended 
     result when several persons who collectively own 10 percent 
     of a REIT's tenant, also own collectively 10 percent of the 
     REIT. So long as those persons are unrelated, because their 
     individual interests in both the REIT and tenant do not equal 
     10 percent the REIT is
      not deemed to own 10 percent of the tenant. However, if 
     those persons obtain interests, regardless of how small, 
     in the same partnership the REIT will be deemed to own 10 
     percent of the tenant. This results from the partnership's 
     deemed ownership of the partners' stock in both tenant and 
     the REIT. Further, because the partnership becomes a 
     deemed 10 percent owner of the REIT under section 
     318(a)(3)(A), REIT is deemed the 10 percent owner of 
     tenant under section 318(a)(3)(C).
       In essence, the REIT becomes the deemed 10 percent owner of 
     its tenant as a result of a variation of the partner-to-
     partner attribution that section 318(a)(5)(C) specifically 
     was enacted to prevent. It is only through the combination of 
     the partners' various interests in the REIT and tenant that a 
     disqualification of the rents occurs. This is true regardless 
     of the purpose for the partnership's existence. The partners 
     may have no knowledge of the other's existence and may be 
     partners in a huge limited partnership completely unrelated 
     to the REIT.
       H.R. 2121 addresses this problem by modifying the 
     application of section 318(a)(3)(A) (attribution to the 
     partnership) only for purposes of section 856(d)(2), so that 
     attribution would occur only when a partner holds a 25 
     percent or greater interest in the partnership. This 
     threshold presumes that such a partner will have knowledge of 
     the other persons holding interest in the partnership, and 
     will have an opportunity to determine if those persons hold 
     an interest in the REIT. By not suspending the double 
     attribution entirely, the bill prevents the potentially 
     abusive practice of placing a ``dummy'' partnership between 
     the REIT and those persons holding interests in the tenant.
       B. Title II of REITSA contains two proposals that would 
     assist in carrying out Congress' original intent to create a 
     real estate vehicle analogous to regulated investment 
     companies.
       Section 201. Credit For Tax Paid by REIT On Retained 
     Capital Gains. Current law taxes a REIT that retains capital 
     gains, and imposes a second level of tax on the REIT 
     shareholders when later they receive the capital gain 
     distribution. REITSA reform provides for the REIT rules to be 
     modified to correspond with the mutual fund rules governing 
     the taxation of retained capital gains by passing through a 
     credit to shareholders for capital gains taxes paid at the 
     corporate (REIT) level. This modification is necessary to 
     prevent the unintended depletion of a REIT's capital base 
     when it sells property at a taxable gain. Accordingly, the 
     REIT could acquire a replacement property without incurring 
     costly charges associated with a stock offering or debt.
       Section 202. Repeal of the 30 Percent Gross Income 
     Requirement. H.R. 2121 calls for the repeal of the 30 percent 
     gross income test because the effective management of a 
     REIT's portfolio and is not needed to ensure that a REIT 
     remains a long-term investor in real property. RICs have a 
     similar anti-churning provision known as the ``short-short'' 
     rule. The Tax Simplification and Technical Corrections Act of 
     1994 (H.R. 3419), as passed by the House of Representatives 
     on May 17, 1994, would have repealed that rule for RICs.
       Unlike RICs, REITs also face the imposition of a 100 
     percent tax on property held for sale in the ordinary course 
     of business (dealer property). Thus, repeal of the REIT 30 
     percent test would not open the playing field for REITs to 
     become speculators in real property. Instead, the repeal 
     helps to ensure that a REIT will not lose its status if a 
     REIT sells non-dealer property when market conditions are 
     most favorable.
       C. Title III of REITSA would simplify several technical 
     problems that REITs face in their organization and day-to-day 
     operations. Many of these proposals would build on 
     simplifications that Congress has adopted over the years.
       Section 301. Modification Of Earnings And Profits Rules For 
     Determining Whether REIT Has Earnings And Profits From Non-
     REIT Year. Only for purposes of the requirement that a REIT 
     distribute all pre-REIT earnings and profits (``E&P'') within 
     its first taxable year as a REIT, a REIT's distributions 
     should be deemed to carry out all pre-REIT earnings before 
     shareholders are considered to be receiving REIT E&P. Under 
     existing law, a REIT must not only distribute 95 percent of 
     its REIT taxable income to shareholders but it must in its 
     first year distribute all pre-REIT year E&P. If the company 
     mistakenly underestimates the amount of E&P generated while 
     operating as a REIT it may fail to satisfy those requirements 
     because the ordering rules controlling the distribution of 
     E&P currently provide that distributions first carry out the 
     most recently accumulated E&P. Thus, if a REIT distributes 
     the pre-REIT E&P and the expected REIT E&P in its first REIT 
     taxable year, the year-end receipt of any unanticipated 
     income would result in the reclassification of a portion of 
     the distribution intended to pass out the pre-REIT E&P.
       While REITs have methods available to make distributions 
     after the close of their taxable year that relate back to 
     assure satisfaction of the 95 percent income distribution 
     requirement, those methods can not be used to cure a failure 
     to distribute pre-REIT E&P after the close of the REIT's 
     taxable year. Accordingly, by allowing the REIT's 
     distributions to first carry out the pre-REIT E&P, the REIT 
     could satisfy both distribution requirements by using one of 
     the deferred distribution methods to distributed the 
     unanticipated income discussed in the example.
       Section 302. Treatment Of Foreclosure Property. Rules 
     related to foreclosure property should be modernized. For 
     property acquired through foreclosure on a loan or default on 
     a lease, under present law a REIT can elect foreclosure 
     property treatment. That election provides the REIT with 3 
     special conditions to assist it in taking over the property 
     and seeking its re-leasing or sale. First, a REIT is 
     permitted to conduct a trade or business using property 
     acquired through foreclosure for 90 days after it acquires 
     such property, provided the REIT makes a foreclosure property 
     election. After the 90-day period, the REIT must use an 
     independent contractor to conduct the trade or business 

[[Page E 1550]]
     (a party from whom the REIT does not receive income). Second, a REIT 
     may hold foreclosure property for resale to customers without 
     being subject to the 100 percent prohibited transaction tax 
     (although subject to the highest corporate taxes). Third, 
     non-qualifying income from foreclosure property (from 
     activities conducted by the REIT or independent contractor 
     after 90 days) is not considered for purposes of the REIT 
     gross income
      tests, but generally is subject to the highest corporate tax 
     rate. The foreclosure property election is valid for 2 
     years, but may be extended for 2 additional terms (a total 
     of 6 years) with IRS consent.
       Under H.R. 2121, the election procedure would be modified 
     in the following ways: (1) the initial election and one 
     renewal period would last for 3 years; (2) the initial 
     election would remain effective until the last day of the 
     third taxable year following the election (instead of exactly 
     two years from the date of election; and (3) a one-time 
     election out of foreclosure property status would be made 
     available to accommodate situations when a REIT desires to 
     discontinue foreclosure property status.
       In addition, the independent contractor rule under the 
     election would be modernized so that it worked in the same 
     manner as the general independent contractor rule. Currently 
     a REIT may provide to tenants of non-foreclosure property 
     services customary in the leasing of real property. However, 
     this previous modernization of the independent contractor 
     rule was not made to the rules governing the required use of 
     independent contractors for foreclosure property.
       Section 303. Special Foreclosure Rules For Health Care 
     Properties. In the case of health care REITs, H.R. 2121 
     provides that a REIT would not violate the independent 
     contractor requirement if the REIT receives rents from a 
     lease to that independent contractor as a tenant at a second 
     health care facility. This change recognizes the limited 
     number of health care providers available to serve as an 
     independent contractor on a property acquired by the REIT in 
     foreclosure, and the REIT's likely inability to simply close 
     the facility due to the nature of the facilities inhabitants. 
     In addition, the health care rules would extend the 
     foreclosure property rules to expirations or terminations of 
     health care REIT leases, since similar issues arise in those 
     circumstances.
       Section 304. Payments Under Hedging Instruments. H.R. 2121 
     would extend the REIT variable interest hedging rule to 
     permit a REIT to treat as qualifying any income from the 
     hedge of any REIT liability secured by real property or used 
     to acquire or improve real property. This provision would 
     apply to hedging a REIT's unsecured corporate debenture.
       Section 305. Excess Noncash Income. H.R. 2121 would expand 
     the use of the excess noncash income exclusion currently 
     provided under the REIT distribution rules. The bill would 
     (1) extend the exclusion to include most forms of phantom 
     income and (2) make the exclusion available accrual basis 
     REITs. Under the exclusion, listed forms of phantom income 
     would be excluded from the REIT 95 percent distribution 
     requirement. However, the income would be taxed at the REIT 
     level if the REIT did not make sufficient distributions.
       Section 306. Prohibited Transaction Safe Harbor. H.R. 2121 
     would correct a problem in the wording of Congress' past 
     liberalization of the safe harbor from the 100 percent excise 
     tax on prohibited transactions, i.e., sales of property in 
     the ordinary course of business. The adverse effect of 
     accumulated depreciation on the availability of the safe 
     harbor, which punishes REITs
      that hold their properties for longer terms, would be 
     mitigated, In addition, involuntary conversions of 
     property no longer would count against the permitted 7 
     sales of property under the safe harbor.
       Section 307. Shared Appreciation Mortgages (``SAM''). In 
     general, section 856(j) provides that a REIT may receive 
     income based on a borrower's sale of the underlying property. 
     However, the character of that income is determined by the 
     borrower's actions. The SAM provision would be modified and 
     clarified so that a REIT lender would not be penalized by a 
     borrower's bankruptcy (an event beyond its control) and would 
     clarify that a SAM could be based on appreciation in value as 
     well as gain.
       Section 308. Wholly Owned Subsidiaries. In 1986, Congress 
     realized the usefulness of a REIT holding properties in 
     subsidiaries to limit its liability exposure. H.R. 2121 would 
     codify a recent IRS private letter ruling position providing 
     that a REIT may treat a wholly-owned subsidiary as a 
     qualified REIT subsidiary even if the subsidiary previously 
     had been owned by a non-REIT entity. For example, this bill 
     would allow a REIT to treat a corporation as a qualified REIT 
     subsidiary when it purchases for cash and/or stock all the 
     stock of a non-REIT C corporation.
     

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