[Congressional Record Volume 143, Number 38 (Friday, March 21, 1997)]
[Extensions of Remarks]
[Pages E559-E561]
From the Congressional Record Online through the Government Publishing Office [www.gpo.gov]




[[Page E559]]



                         REITSA FLOOR STATEMENT

                                 ______
                                 

                         HON. E. CLAY SHAW, JR.

                               of florida

                    in the house of representatives

                        Thursday, March 20, 1997

  Mr. SHAW. Mr. Speaker, today I am introducing H.R. 1150, the Real 
Estate Investment Trust Simplification Act of 1997 [``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, Mr. Houghton, Mr. Herger, Mr. McCrery, Mr. Camp, Mr. Johnson, 
Ms. Dunn, Mr. Collins, Mr. English, Mr. Ensign, Mr. Weller, Mr. Stark, 
Mr. Levin, and Mr. Cardin. The Joint Committee on Taxation has 
determined that REITSA has a negligible effect on Federal fiscal year 
budget receipts.
  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 strides 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 REIT's, 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 the 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 $100 billion. 
Fueling that growth has been the introduction of some of American's 
leading real estate companies to the family of long existing, viable 
REITs. 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 recapitalizaton of 
quality real estate.
  The benefits of the growth in the REIT industry were addressed in a 
1995 Urban Land Institute White Paper title 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, H.R. 1150 
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. The proposals are 
supported by the National Association of Real Estate Investment Trusts, 
the National Realty Committee, the International Council of Shopping 
Centers, the National Multi-Housing Council, the Building Owners and 
Managers Association International, the National Association of 
Industrial & Office Properties, and other national organizations.


                 summary of key provisions of h.r. 1150

       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. 1150 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 ``five or fewer'' 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 ``five or fewer'' 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 minimus test. In 1986, 
     Congress modernized the REIT's 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 service. The disqualification 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% 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 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, H.R. 1150 provides for a de minimus 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% of the gross income from the affected property. The de 
     minimus exception is based on gross income to be consistent

[[Page E560]]

     with the REIT's income tests, and is set at 1% to reflect an 
     amount large enough to provide the requisite safe harbor 
     (note that it is 1% 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 would 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 would be deemed at least equal to the direct 
     costs of the service (i.e., labor, cost of goods) multiplied 
     by 150%.
       For example, if the IRS determined that a REIT's providing 
     wheelchairs at a mall is an impermissible service, the cost 
     of the wheelchairs would be multiplied by 150% 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% 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 
     exceeds 1% 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 source is 
     limited to 5% of total gross income. Accordingly, gross 
     income from impermissible sources that does not exceed the 
     1% 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% 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 rents 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% (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% of a 
     REIT's tenant, also own collectively 10% of the REIT. So long 
     as those persons are unrelated, because their individual 
     interests in both the REIT and tenant do not equal 10% the 
     REIT is not deemed to own 10% 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% 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% owner 
     of the REIT under section 318(a)(3)(A), REIT is deemed the 
     10% owner of tenant under section 318(a)(3)(C).
       In essence, the REIT becomes the deemed 10% 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. 1150 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% or 
     greater interest in the partnership. This threshold presumes 
     that such a partner would have knowledge of the other persons 
     holding interests in the partnership, and would 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 (``RICs'').
       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. H.R. 1150 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. Reduction in the 95% Distribution Requirement. 
     H.R. 1150 calls for reducing the REIT distribution 
     requirement of taxable ordinary income from 95% to 90%. RICs 
     have a similar distribution requirement, which is set at 90%. 
     The REIT distribution requirement was 90% from 1960 until 
     1976. As part of the Tax Reform Act of 1976, REITs were 
     granted a special ``deficiency dividend procedure'' designed 
     to protect their status in the face of a redetermination of 
     distributable income pursuant to an IRS audit. In exchange 
     for this decreased risk of inadvertent disqualification, 
     REITs were asked to distribute a higher percentage of their 
     income. However, when the deficiency dividend procedure was 
     extended to RICs in 1978, no corresponding change was made to 
     the RIC distribution requirement. Accordingly, H.R. 1150 
     calls for a reduction in the REIT distribution requirement to 
     restore conformity between REITs and RICs.
       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 
     distributen 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% of its REIT taxable income to shareholders, but it must 
     in its first year distribute all pre-REIT year E&P. In 
     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% income distribution 
     requirement (to be changed to 90% under REITSA), 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 distribute 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 (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% 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 test, 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. 1150, 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. 1150 
     provides that a REIT would not violate the independent 
     contractor requirement if the REIT receives rents

[[Page E561]]

     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 facility's 
     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 concerning a 
     limited number of operators arise in those circumstances. 
     However, foreclosure property treatment in these cases would 
     be limited to a two-year period, unless the Secretary grants 
     one or two possible two-year extensions.
       Section 304. Payments Under Hedging Instruments. H.R. 1150 
     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. For example, this 
     provision would apply to hedging a REIT's unsecured corporate 
     debenture or the currency risk of a debt offering denominated 
     in a foreign currency.
       Section 305. Excess Noncash Income. H.R. 1150 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 to accrual basis 
     REITs. Under the exclusion, listed forms of phantom income 
     would be excluded from the REIT 90% 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. 1150 
     would correct a problem in the wording of Congress' past 
     liberalization of the safe harbor from the 100% excise tax on 
     prohibited transactions, i.e., sales of property in the 
     ordinary course of business. 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. 1150 would 
     codify an 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. H.R. 1150 would allow a REIT to treat a 
     corporation as a qualified REIT subsidiary when it acquires 
     for cash and/or stock all the stock of a non-REIT C or S 
     corporation.
       The effective date would be for taxable years beginning 
     after the date of enactment.

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