Like other major enterprises in the United States in recent years, the real estate industry has evolved into a customer-oriented service business. Landlords that provide new services to their tenants only after such services have become "usual and customary" are at risk of losing their competitive edge in attracting and retaining top-quality tenants. But the laws under which REITs have operated have prohibited them from providing these services to their tenants, thus placing them at a competitive disadvantage.

Consequently, NAREIT strongly supported the passage of proposed legislation that culminated in the signing, on December 17, 1999, by President Clinton, of a bill that included the REIT Modernization Act (RMA). This legislation will, when it goes into effect in 2001, allow REITs to create subsidiaries that can provide the important, cutting edge services that tenants desire.

Services Benefit Shareholders and Tenants

Most businesses now know that providing ancillary services with good quality controls produces both customer loyalty and additional income. Under the prior law, a REIT is required to use independent contractors to provide non-customary services to its tenants. So REIT management has had little control over the quality of the services rendered to its tenants. Additionally, income from these new revenue-producing opportunities has accrued to the benefit of a third party, rather than to the benefit of REIT shareholders.

Allowing REITs to provide new services to tenants has three compelling benefits. First, the availability of a new service for tenants generates greater customer loyalty and allows the REIT landlord to remain competitive. Second, the REIT can maintain better quality controls over the services rendered to its tenants. Third, the new service (offered either by the landlord or by a third party licensed by the landlord) generates a new stream of income for the REIT shareholders.

A Little History

Since 1986, income that REITs derive from providing customary services to their tenants has been considered rents from real property that meets both the 95 percent and 75 percent gross income tests (for maintaining REIT status). The Taxpayer Relief Act of 1997 adopted a useful rule under which a small amount of non-customary services that a REIT provides to a tenant does not disqualify the underlying rents that the tenant pays the REIT. However, if a REIT provides non-customary or tenant-specific services, such as concierge services, to a tenant beyond a minimal amount, all payments from that tenant do not qualify under the relevant REIT tax tests.

The original REIT legislation had permitted a REIT to earn up to five percent of its income from sources other than rents, capital gains, dividends and interest. However, many REITs have had the opportunity to maximize shareholder value by earning more than five percent from managing joint ventures and from other third party service income.

President Clinton signed the Reit Modernization Act into law on December 17, 1999.

To capture this income flow, many REITs have invested in nonvoting securities of C corporations, called third party subsidiaries (TPSs), in which REIT officers or others own the voting common stock. These corporations provide to unrelated parties services already being delivered to a REIT's tenants—such as landscaping apartment complexes—or provide services not allowed to be offered by a REIT—such as managing a shopping mall in which the REIT owns a joint venture interest. Moreover, mortgage REITs have used TPSs to make mortgage loans, purchase mortgage loans from third parties or from the REIT, and to service mortgage loans. This arrangement has allowed REITs to supply services to non-tenants while continuing to comply with the applicable diversification tests, which are patterned loosely after the asset diversification rules that apply to mutual funds.

The Internal Revenue Service granted private letter rulings approving these investments starting in 1988, although it has chosen not to rule directly on this structure since 1994. Dividends to the REIT from the TPS qualify under the REIT 95 percent gross income test, but not the 75 percent gross income test. Also, a REIT's stock in the TPS does not qualify under the 75 percent asset test. Thus, a REIT continues to be principally devoted to real estate operations.

The TPS structure has allowed REITs to use their assets and expertise to provide real estate related services to non-tenants in a format that is fully taxable. However, the structure is awkward because the REIT is not allowed to control the subsidiary. The inability of a REIT to own all the stock of a TPS (under the diversification rules) means that REIT shareholders cannot be assured that the TPS always will act in their best interests. Also, part of the income earned by the TPS will accrue to the voting shareholders' benefit rather than the REIT shareholders. Last, the IRS contends that any non-customary service a TPS renders to the associated REIT's tenants disqualify the rents the REIT receives from the tenants.

Taxable REIT Subsidiaries

The recently signed RMA will allow a REIT to own up to 100 percent of the stock of a taxable REIT subsidiary (TRS) that can provide services to REIT tenants and others without disqualifying the rents that the REIT receives from its tenants. The RMA contains size limits on a TRS to ensure that a REIT remains focused on core real estate ownership and operations. To ensure that a TRS is subject to an appropriate level of corporate taxation, the amount of debt and rental payments from a TRS to its affiliated REIT will be limited. Also, a 100 percent excise tax will be imposed to the extent any transaction between a TRS and its affiliated REIT or that REIT's tenants is not conducted on an arms' length basis.

A TRS may not operate or manage lodging or health care facilities, but a TRS may lease lodging facilities from its affiliated REIT at market rates so long as an independent contractor operates and manages the lodging facilities. After the 2001 effective date, a REIT will not be able to own more than 10 percent of the vote or value of the securities of a non-REIT C corporation (other than securities of a TRS, certain debt securities, and securities of "grandfathered" entities described below).

The RMA restrictions on TRSs will not apply to arrangements in place (including third party subsidiaries) as of July 12, 1999, so long as the subsidiary does not engage in a new line of business, its existing business assets do not increase, and the REIT does not acquire any new securities in the subsidiary.

Some Key Provisions

Effective Date. Both the new 10 percent vote or value test and the rules applicable to TRSs will become effective for taxable years beginning after December 31, 2000. Accordingly, the new excise taxes and limits on a subsidiary's ability to deduct interest will not apply until 2001.
10 percent Vote or Value Test. The RMA will prohibit a REIT from owning (at the end of each quarter) more than 10 percent of the vote or value of the securities of a non-REIT corporation. However, there will be four important exceptions to this prohibition:

• The 10 percent test will not apply to any TRS securities. This will allow a REIT to own sufficient voting stock so as to control taxable subsidiaries that can both provide services to its tenants as well as third parties. Not only will TRSs allow a REIT to provide more efficient services to customers, a TRS will permit transparent reporting to shareholders because the financial statements of a TRS generally will be consolidated with its affiliated REIT. Further, adopting a TRS structure will make it easier to integrate TRS employees into the REIT's compensation plans. Existing TPSs will be able to convert tax-free into TRSs.
• The 10 percent test will not apply to "straight debt" securities a REIT owns in another corporation. This will allow a REIT to own more than 10 percent of an issuer's securities so long as the rate on the REIT's loan is fixed and the debt is not convertible into the issuer's stock.
• The 10 percent test will not apply to mortgage loans from a REIT to its TRS, since such mortgages (as under prior law) are considered "real estate assets" rather than securities.
• The 10 percent test will not apply to certain arrangements in place on July 12, 1999. The 10 percent rule will apply if the subsidiary engages in a "substantial" new line of business or acquires any "substantial" asset (other than through a binding contract, a like-kind transaction, a casualty replacement or a tax-free reorganization with another grandfathered entity), or the REIT acquires any new securities in the subsidiary (other than pursuant to a binding contract in effect on July 12, 1999, or in a tax-free reorganization with another grandfathered entity).

Size of a TRS. Under the RMA, no more than 20 percent of a REIT's gross assets may be securities (both equity and debt) of a TRS, which will be measured at fair market value.

Scope of a TRS' Activities. A TRS will be able to perform any third party activity that a TPS is allowed under prior law plus generally any type of service (other than operating lodging or health care facilities) to the associated REIT's tenants, including non-customary services. Thus, a TRS will be able to provide tennis lessons to an apartment REIT's tenants, offer concierge services to an office REIT's tenants, engage in land development, extend bulk purchasing discounts to tenants, and partner with other entities to provide a range of services such as renters' insurance. All such activities will be fully subject to a corporate level tax.

Distribution Requirement. The RMA will return the REIT distribution requirement from 95 percent to the 90 percent level currently applicable to mutual funds and that applied to REITs from 1960 to 1980.

Personal Property Rents. The RMA will change the measurement of the REIT 15 percent personal property rule from adjusted tax basis to fair market value.

Health Care REITs. The RMA will allow a REIT to hire an independent contractor to operate nursing homes, etc. without a lease for up to six years when the REIT takes back health care property at the end of a lease and cannot re-lease it. This rule will extend the "foreclosure property" rules, under which a REIT pays corporate taxes on the operating income from such property for a limited period until it can secure a new lease. In addition, pre-existing arrangements with respect to other properties will be disregarded in testing whether an entity qualifies as an independent contractor for health care properties using the foreclosure property rules.

Definition of Independent Contractor. In the case of a publicly traded corporation being tested as an independent contractor, the RMA only will examine shareholders owning more than five percent of the corporation's stock.

Earnings & Profits Rules. To prevent some traps for the unwary, the RMA will make some technical changes about how a company computes pre-REIT earnings and profits that it must distribute to its shareholders after electing REIT status or merging with a C corporation.

With a Little Help From Our Friends

The gist of all this is that REITs will, as of 2001, be in a better position to provide the ancillary services that will make them able to fundamentally improve the range of services they provide to their customers and maximize returns to their investors. Steve Wechsler, NAREIT's president, has noted that, "This is the latest in a series of significant and constructive changes to the REIT rules since the creation of real estate investment trusts by Congress forty years ago. The REIT industry looks forward to providing new services, generating new income and paying new taxes through the creation of taxable REIT subsidiaries."

NAREIT greatly appreciates the support that the Clinton Administration and many members of Congress offered this legislation.

Tony M. Edwards is NAREIT's senior vice president and general counsel. For extensive coverage and analysis of the RMA, see the Governmental Relations area of www.nareit.com.

"As tax policy makers we have the responsibility to make sure that tax laws governing REITs are updated to reflect the realities of a dynamic market and to maintain a proper competitive balance between real estate owned through the REIT structure and through more traditional corporate and partnership structures."
—Sen. Daniel Patrick Moynihan, D-NY