Taking Steps toward REIT Reform

Although the performance of real estate investment trusts (REITs) has been stellar in the past several years, the tax code governing REITs is long overdue for an overhaul. In fact, the last substantive change in the tax code involving REITs occurred in 1986. Since that time, burdensome tax code compliance problems have arisen.
But the Real Estate Investment Trust Simplification Act of 1997 (REITSA) should remedy these problems. On March 20, 1997, REITSA (H.R. 2121) was introduced by Republican Representative Clay Shaw of Florida, with cosponsorship from 17 additional House Ways and Means Committee members. This legislation proposes REIT tax reform in three areas: noncompliance issues, mutual fund parity, and technical corrections.

Noncompliance Issues
Technical noncompliance issues that potentially could disqualify REITs could trap unknowing investors.

Demand Letters. Under current law, REITs that do not send demand letters to shareholders within 30 days of the taxable year's close may lose their REIT status. Demand letters require shareholders to indicate the actual owners of the REIT stock. REITSA would replace the penalty of the loss of REIT status with a $25,000 administrative fine. This fine would increase to $50,000 for intentional violations.

De Minimus Rule. Under present law, REIT income from a project can be disqualified for REIT status if a REIT's employee performs even a nominal task that is deemed an impermissible service. For example, if a REIT employee helps a tenant move into an apartment space, that assistance potentially could disqualify the revenue from that apartment project. REITSA would permit REITs to provide services to projects with a value not exceeding 1 percent of gross revenue.

Attribution Rules. These rules are designed to protect REITs by preventing the owners of REIT stock from possessing undue control over rent-paying businesses. Under current law, no more than 10 percent of total rents can come from a related party that controls 10 percent or more of a REIT. However, the rule has been triggered when three REIT shareholders hold interests in tenants that contribute 5 percent each to a REIT's income. The attribution rules disqualify the rents paid by these tenants, even though the three parties are unrelated. REITSA will increase to 25 percent the gross revenue that can be contributed by businesses of REIT stockholders who collectively own 10 percent or more of a REIT.

Mutual Fund Parity
Mutual fund parity comprises reforms that would provide REITs with the same tax treatment as mutual funds.

Distribution Requirement. Under current law, REITs must disperse 95 percent of their net income to shareholders. However, mutual funds' disbursement requirement is only 90 percent. REITSA would equalize the treatment of mutual funds and REITs by requiring a 90 percent distribution for both. Investors and REIT managers argued for years that the 95 percent distribution requirement prevented REITs from accumulating reserves that could be used to pay for scheduled capital improvements.

Tax Credit. Under present law, retained capital gains on the sale of an asset are paid by the REIT. When this after-tax income is passed on to REIT shareholders, they also are subject to taxation on this capital gain. REITSA would eliminate this double taxation. Capital gains paid at the corporate level would be passed on to REIT investors in the form of a tax credit. Once again, this would level the playing field for REITs and mutual funds by equalizing the tax treatment.

Technical Corrections
Technical corrections address issues that have made REITs cumbersome to administer. Eight technical corrections to the tax code governing REITs are summarized as follows:

  • earnings and profit rules would be modified to determine if a REIT has earnings and profits from a non-REIT year;
  • the foreclosure election period would be increased from two to three years;
  • a REIT would not violate the independent contractor requirement if it receives rents from a lease to an independent contractor as a tenant at a second health-care facility;
  • any liability secured by a real property or used to acquire or improve real property could be treated as qualifying income under the variable interest hedging rule;
  • the excess noncash income exclusion would be expanded to include most forms of phantom income and make exclusions available for accrual-basis REITs;
  • involuntary conversions no longer would be counted against the permitted seven sales of property under safe harbor;
  • Under REIT ownership modifications, REIT lenders of shared appreciated mortgages would not be penalized if a borrower declared bankruptcy; and
  • an IRS private-letter ruling position would provide that REITs may treat wholly owned subsidiaries as qualified REIT subsidiaries even if they have been owned by non-REIT entities.

Buoying the prospects for the legislation's passage is an assessment by the Joint Committee on Taxation that the proposed changes would have a negligible tax collection impact. Companion legislation was expected to be introduced in the Senate by June 1997. As indicated by the large number of House Ways and Means Committee cosponsors, support for REITSA is solid in the House. Industry groups are working to gather support in the Senate. The prospect for REITSA's passage in the 105th Congress is cautiously optimistic. However, partisan wrangling over the budget and tax reform quickly could put REITSA on the back burner.

George Green

George Green is a policy representative/senior economist for investment real estate at the National Association of Realtors in Washington, D.C.