by Tony M. Edwards

Each of the four items NAREIT raised with the Internal Revenue Service (IRS) has been included in the official "Business Plan" for 2001. The plan is a combined priority list of regulatory items on which the IRS and the Treasury Department would like to provide guidance by June 2002. The list determines which areas of tax law will receive the dedicated resources and personnel of the agencies in the coming year.

The four items that NAREIT raised are:

1. Taxable REIT Subsidiaries. On October 31, 2000, NAREIT submitted a letter setting forth several issues that would benefit from IRS regulatory clarification. Most of the issues raised in the letter arise because it is not clear whether a partnership should be viewed as a separate entity or as an aggregate of the separate partners.

For example, the tax code provides that a REIT may own up to 100 percent of a taxable REIT subsidiary (TRS). Since most REITs use Operating Partnerships in an UPREIT or DownREIT structure, in reality most TRSs will be owned not directly by a REIT, but instead by the Operating Partnership of which the REIT is a substantial (usually the majority) partner. Similarly, the Code allows a TRS to provide non-customary services to a REIT's tenants.

Is it okay for a partnership between a TRS and an entity qualifying as an independent contractor to provide such services to the REIT's tenants? NAREIT asked the IRS to clarify that for this purpose a partnership should be ignored and the REIT treated as the owner of its proportional interests in a TRS.

NAREIT maintains a continuing dialogue with the IRS on several issues under the REIT Modernization Act of 1999, including ways in which it can interpret the "safe harbor debt" exception to the 10 percent vote or value test to be more user-friendly.

2. Tax-free Reorganizations. The Business Plan lists two proposed regulations on which NAREIT submitted comments and testified in 2000. The first set involves a merger of a target corporation into a qualified REIT subsidiary (QRS). The regulations proposed changing the conclusion in prior private letter rulings holding that such reorgan i zations should be tested as straight "A" reorganizations. Instead, the regulations proposed treating such mergers under another subsection of the Code that would make it almost impossible for the merger to be tax-free when the acquiror uses any cash as part of its consideration. NAREIT hopes that the IRS will revert back to its prior favorable position, especially when the merger of the target corporation into the acquiring REIT could qualify as a statutory merger under state law.

The second set of regulations concerns a C-corporation merging or electing into a REIT. The proposed regulations contained rules that were traps for the unwary, and even would affect accomplished transactions on a retroactive basis. NAREIT hopes that the final regulations will eliminate these potential traps.

3. Tax-free Spin-offs. In 1973, the IRS issued a revenue ruling concluding that a C-corporation could not distribute to its shareholders on a tax-free basis (a spin-off) the stock of a company that would elect REIT status. The IRS based its 1973 ruling on its conclusion that a REIT could not engage in an active trade or business. Obviously, this ruling has been outdated since Congress allowed REITs to be active managers of real estate in 1986, and hopefully the new item on the Business Plan will allow the IRS to modify the 1973 ruling to reflect this significant change.

4. Foreign Interests in Real Property Tax Act (FIRPTA). This legislation added to the tax Code provisions that impose tax and withholding obligations upon a non-U.S. person's sale of U.S. real estate. Under these provisions, a REIT must withhold and pay to the IRS 35 percent of its capital gains distributions to non-U.S. shareholders. Technically, such non-U.S. shareholders must file U.S. tax returns even if they otherwise do not operate any business in the United States (failure to file incurs a potential $100 penalty).

In January 2001, NAREIT asked the IRS to consider regulatory guidance that would relieve a non-U.S. investor from filing a U.S. tax return if the investor has no "effectively connected" U.S. income other than receiving REIT capital gains. The Business Plan lists FIRPTA, and NAREIT anticipates that the tax return issue will become part of the IRS' FIRPTA guidance.

NAREIT is very grateful to the many members of the Government Relations Committee who helped prepare the submissions to the IRS.