Julie D. Walpole SEPTEMBER Signature of Author:. Department of Urban Studies and Planning July 31, 1998

Transcription

1 EXPLORING THE PAIRED SHARE REIT and QUANTIFYING ITS TAX ADVANTAGE By Julie D. Walpole B.S. Mechanical Engineering Case Western Reserve University, 1988 SUBMITTED TO THE DEPARTMENT OF URBAN STUDIES AND PLANNING IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF SCIENCE IN REAL ESTATE DEVELOPMENT AT THE MASSACHUSETTS INSTITUTE OF TECHNOLOGY SEPTEMBER 1998 D 1998 Julie D. Walpole. All rights reserved. The author hereby grants to MIT permission to reproduce and to distribute publicly paper and electronic copies of this thesis document in whole or part Signature of Author:. Department of Urban Studies and Planning July 31, 1998 Certified by: W. Tod McGrath Lecturer, Department of Urban Studies and Planning Thesis Supervisor Accepted by: I ~-'--- - William C. Wheaton Chairman, Interdepartmental Degree Program in Real Estate Development MASSACHUSETTS INSTITUTE OF TECHNOLOGY OCT ROTCH LIBRARIES

2 EXPLORING THE PAIRED SHARE REIT and QUANTIFYING ITS TAX ADVANTAGE By Julie D. Walpole Submitted to the Department of Urban Studies and Planning On July 31, 1998 in Partial Fulfillment of Master of Science in Real Estate Development ABSTRACT Real Estate Investment Trusts (REITs) were established in 196 by Congress to open real estate investing to the small investor, in the same way that mutual funds have allowed small investors access to a diversified portfolio of stocks. As is the case with mutual funds, REITs enjoy a conduit status, allowing them to avoid corporate level taxation as long as they meet certain requirements. These requirements have been designed and legislated to ensure that REITs remains passive owners of real estate. As a passive owner of real estate, the traditional REIT vehicle is not ideally suited for an operationally intensive business, even those with a large real estate component (notably hotels, casinos, health care centers, and parking garages). Accordingly, variations of the REIT structure have emerged over time in an effort to benefit from the active business income generated through the operations of real estate holdings. One such variation is the Paired Share REIT. Conceived in 1977, and later banned from further formation in 1984, the structure has once again come under fire. Citing tax avoidance business practices that result in unfair competitive advantage, the Clinton Administration proposes to curb the use of the Paired Share structure on any new acquisitions by the five grandfathered Paired Share REITs that today still exist today. This thesis examines the Paired Share REIT structure and its perceived tax advantage. It concludes that while the Paired Share REIT structure can enjoy a tax advantage relative to a subchapter "C" corporation legislated REIT restrictions limit its financial flexibility. In addition, there are financial tactics available to the "C" corporation that can do much to mitigate these advantages. Two notable tactics are the use of the tax-shielding value of debt and the ability to retain earnings to fund growth. Further, it is concluded that the combined tax expense of the business entity and its shareholders does not differ significantly from the Paired Share REIT and the "C" corporation. Thesis Supervisor: W. Tod McGrath Title: Lecturer, Department of Urban Studies and Planning Center for Real Estate

3 Table of Contents ABSTRACT CHAPTER 1 Introduction... 5 CHAPTER 2 REIT Legislature... 9 The Emergence of the REIT... 1 The Real Estate Investment Trust Act of The Tax Reform Act of The Tax Reform Act of The R evenue A ct of The Deficit Reduction Act of The Tax Reform Act of The Technical and Miscellaneous Act of The Revenue Reconciliation Act of The Real Estate Investment Simplification Act of The 1999 Budget Proposal CHAPTER 3 The Paired Share REIT... 2 Tax Shelter Advantages Shareholder Benefits T he H otel Industry Banning the Paired Share REIT C urrent T rends CHAPTER 4 The Paper-Clip REIT L eak ag e Alignment of Interest Tax Efficiencies Legislative Risk CHAPTER 5 The Paired Share REIT Tax Advantage Towards Modeling the Tax Advantage The Typical "C" Corporation The Paired Share REIT C apital Structure Calculating Shareholder Value Determining Risk Adjusted Returns on Equity Shareholder V alue Total Tax R evenue APPENDIX A APPENDIX B APPENDIX C... 99

4 Acknowledgements The author would like to thank Tod McGrath for his patience, advice and direction especially during the final stages. I would also like to thank my husband, Jim, for understanding how important this research was to me and for his knowledge of the principles of finance which he graciously shared with me. Special thanks to the CREW. I do not know what I would have done with out your support.

5 CHAPTER 1 Introduction As the hotel sector rebounded in recent years from the overbuilding in the late 8's and the economic downturn of the early 9's, the acquisitive activities of Real Estate Investment Trusts (REITs) have allowed them to grow their asset base while taking full advantage of the public capital market. In particular, the Paired Share REIT has generated the attention not only of investors but competitors and legislators as well. The reason for this attention is twofold. This structure, but for several notable exceptions, was legislated out of existence in As it happens, these several Paired Share REITs have acquired half of the total hotel assets sold in the past three years.' This is due at least in part to the fact that this variation of the REIT vehicle is well suited to owning and operating hotel property. The Paired Share format allows two entities, one which owns the property (REIT) and one that operates the property, effectively to join themselves as one. As such, this structural link enjoys unique tax advantages and operational efficiencies by aligning the interest of ownership, operations, and shareholders. While these advantages have led to outstanding shareholder returns, outpacing most REIT indices through the last quarter of 1997 (See Exhibit 1.1), they have also caused competitors to cry foul and to lobby legislators to pare back this advantage. It has been alleged that the Paired Share REITs enjoy an unfair tax advantage thus enabling them to create more value from acquisitions and therefore outbid their non-paired Share REIT competitors. This work is intended to examine the Paired Share REIT structure and explore the tax avoidance practices allegedly available to those who exploit this unique conduit status. Given the recent proposals by the Clinton Administration to limit the use of the Paired Share format, the reader will benefit from a heightened awareness of the structure's benefits and tax advantages. Chapter 2 contains a retrospective of the history and legislative intent underlying the REIT vehicle. It details the evolution of the REIT provisions with discussion of the lobbying efforts and economic forces that impacted them. With an understanding of REIT legislation and the intent behind it, the reader can better judge the alleged improprieties inherent in some of the variations of the REIT structure. This chapter also highlights some of the motives behind the 1 Michelle Celarier, "The Trouble with REITs" CFO, Feb. 1998, pp

6 constraints the Internal Revenue Service places on the type of services a REIT can provide in operating its properties. The chapter concludes by presenting the current REIT proposals included in Clinton's 1999 Budget. Chapter three presents a thorough examination of the Paired Share REIT. This chapter will educate the reader as to the motivating force behind the creation of the Paired Share structure, elimination of ownership and operational conflict, and discuss the need for such an alignment of interests. This chapter also reports on the initial legislative ban on the Paired Share structure, in the Deficit Reduction Act of 1984, and the current issues surrounding the Clinton Administration's proposal to eliminate further expansion of the Paired Share REITs that remain in existence today. In light of the Administration's proposals, Chapter 4 explores a recent organizational phenomena designed to mimic the benefits of the Paired Share REIT structure outside of the proposed legislated boundaries. This form, the Paper-Clip REIT, has been employed by several prominent REITs to date. Should the proposed REIT legislation be enacted, the popularity and implementation of the Paper-Clip REIT is certain to hasten, as Paired Share REITs seek to maintain their ability to both own and operate real property. This chapter examines how well the Paper-Clip structure meets the same objectives as the Paired Share and discusses where it is shortcomings. Lastly, Chapter 5 is intended to support or mitigate concerns over the tax advantage a Paired Share REIT enjoys over its counterpart, the taxable "C" corporation. At the root of these concerns is the notion that a Paired Share REIT is able to manipulate operating revenue, nonqualifying REIT income, and avoid the corporate taxation it would be subject to as operating income of a "C" corporation. With this tax avoidance mechanism at a REITs disposal, many contend the Paired Share REIT is able to create more value from acquisitions than its competitors, most notably the typical "C" corporation. This research contends that without a proper examination of the capital structure and tax shielding benefits of corporate debt, in conjunction with the restrictive dividend policy of a Paired Share REIT, an educated judgement as to the size and importance of the Paired Share tax advantage can not be developed. The

7 stylized model presented in this research was constructed in an effort to account for the effects of leverage, dividend payout, and risk adjusted return on shareholder returns of a "C" corporation and Paired Share REIT holding and operating an identical asset.

8 C'e) Paired Share REIT Returns Through Last Quarter J x C Z (N -+- Patriot American Hospitality + Starwood Hotels & Resorts -a-first Union Real Estate Equity +Morgan Stanley REIT Index EXHIBIT 1.1

9 CHAPTER 2 REIT Legislature: Perfecting the REIT Vehicle The emergence of REITs has arguably benefited the real estate sector by providing disciplined access to capital. In recent years this access to capital along with the improving health of the economy has allowed for the widespread establishment and growth of REITs. As the accretive investments most REITs relied on to maintain growth and increased shareholder value begin to become scare, REIT management faces a daunting task: how to sustain the growth expectations within a structure more conducive to income investing? Though legislative provisions, since the inception of the REIT, have evolved in an effort to perfect the REIT vehicle, they struggle with addressing the benefits and abuses of this unique tax conduit structure. Historically, real estate investing has been predicated on a two-pronged investment strategy: tax advantaged cash flows and capital appreciation. Typically, bound by the restrictions of the Internal Revenue Code, real estate entity formation and capital structure choices have become a creative process, generating well-devised allocations of cash flow and "paper" losses for income tax reporting purposes. It would seem only fitting that the REIT vehicle, conceptualized and legislated to allow the average person to benefit from real estate investing, would also be granted certain tax breaks by Congress. As a consequence, Congress has found itself mandating amendments to the REIT statutes in a continuing effort to limit the abuse of this unique conduit structure while maintaining its intended purpose: to serve as a passive investment vehicle. The industry, responding to market forces, has countered with variations of the structure. Though careful to remain within the parameters allowed by law, the boundaries occasionally cross into territory not intended for the REIT format. These variations, in turn, force investigations into and reforms of the REIT structure. The focus of this chapter is to explore the marketplace forces that have led to a number of lobbying efforts, to the variations of the REIT structure, and ultimately to the basic legislative provisions that have evolved and which now govern the qualifications for REIT eligibility.

10 The Emergence of the REIT Prior to the Real Estate Investment Trust Act of 196, legislation that dealt primarily with real estate investment trusts (REITs) had not been enacted. In the absence of a legislated business structure, the pooling of ownership in real estate generally took the form of a business trust. At that time, true business trusts were granted "conduit" tax treatment and, therefore, avoided corporate tax at the entity level. The challenge to this favorable tax treatment for real estate holding was then, and is now, at the core of legislative provisions underlying the congressional intent of the REIT vehicle. The uncertainty regarding the tax status of realty trusts began with the creation of the Corporate Tax in the Tariff Act of 199. The Tariff Act established "a special excise tax with respect to the carrying on or doing business by such corporations, joint stock company or association or insurance company." What followed was a number of Supreme Court rulings dealing specifically with the applicability of the law to realty trusts, the last of which was Morrisssey v. Commissioner in This ruling became the precedent for determining the "corporate" nature of a business trust as defined by the following tests: 1) Title to property owned by the enterprise is held by trustees, as a continuing body, during the existence of trust; 2) centralized management by trustees, as representatives of beneficial owners, whether selected by or with the advise of beneficiaries or designated in the trust instrument with the power to select successors; 3) continuity, uninterrupted by deaths among beneficial owners 4) means for transfer of beneficial interests and introducing new participants with out affecting continuity; 5) limitation of personal liability of participants to property invested and contributed in the undertaking; These tests clearly defined realty trusts as corporations, thus subjecting them to double taxation. Remarkably, the disallowance of the conduit tax treatment for realty trusts was not fought with an organized lobbying effort until the early 195s. It is believed that after many trusts were forced to liquidate due to Morrisssey v. Commissioner, those that remained were not reeling from the new income tax burden because they were generally operating at a loss. Once a concerted lobbying effort was initiated, the goal became a legislative provision that would reinstate the conduit tax relief these

11 trusts had previously enjoyed. The proponents of this legislation fostered the notion that its passage would increase property beckoning new buyers and attracting private capital to assist in the urban renewal just beginning at the time. Understandably, Congressional opposition centered on the applicability of the law. Even then, hotel chains were brought to the attention of lawmakers as potential abusers of this structure. Lobbyists responded by insuring the intent of the law and amended the bill each time nonrealty trust issues concerned Congress. These amendments led to the passage of the bill (HR 4392) by both houses of Congress in 1956, but President Eisenhower still doubted its intent and initially vetoed the bill. "... It is by no means clear how far a new provision of this sort might by applied. Though intended to be applicable only to a small number of trusts, it could, and might well, become available to many real estate companies which were originally organized and have always carried on their activities as fully taxable corporations." The Real Estate Investment Trust Act of 196 In 196, the REIT bill (HR 196) was reintroduced and passed again by both houses of the Congress and subsequently signed by President Eisenhower. This legislation was the first to outline the requirements an entity must meet to be considered a passive vehicle for real estate investments (see appendix). Moreover, these requirements had to be met on an annual basis. Noncompliance meant "sudden death", the permanent loss of REIT status and the imposition of corporate tax at the entity level. One requirement that threatened the life of a REIT, due to its ambiguity, was the income source test. "Qualified income" was defined as rents received for the "bare right to occupy rental realty". This stricture did not cover much of what the industry felt should be considered real estate income, such as commitment fees to lease or buy properties. Further, mitigating concern over the reach of such a law, it also required REITs to organize as an unincorporated trust or association. This was viewed as an attempt to curb the wide use of the REIT vehicle, as business trusts are a creation of common law and therefore generally result in a greater degree of liability for the trustees. The Tax Reform Act of A Response to Economic Recession In the late 196's the REIT industry grew substantially with the creation of the mortgage REIT. The economic environment at that time allowed banking institutions with mortgage lending operations to set up REITs that would benefit from low interest rates and increased construction. By leveraging

12 their own equity capital, borrowing short term through commercial credit and bank loans (at 6%), and funding development at a much higher lending rate (13% to 16%), mortgage REITs prospered. Unfortunately, the economic recession in the early 197's proved the flaws in this lending REIT business model. The recession caused short-term interest rates to climb and the spreads between a REITs cost of funds and earnings to become negative. More importantly, these REITs faced longstanding concerns regarding the treatment of property they acquired in foreclosure. The disposition, acquisition and holding of such properties could trigger "sudden death." The statute at that time disallowed any REIT from holding property primarily for sale to customers in the ordinary course of its trade or business. In other words, the REIT structure prohibited some REITs from properly managing their assets without infringing on the statute. Once again, a lobbying effort ensued. The need for legislated relief with regard to foreclosed property was granted in 1975 with an amendment to the REIT law. This amendment protected a REIT from disqualification due to noncompliance of the income-source and asset tests on the activities connected with the foreclosed property. In summary, a REIT could now actively manage, temporarily, or arrange to sell a foreclosed property. The income from these activities that was not considered qualified income would not threaten a REIT's status but rather be subjected to taxation at the corporate rate. While this amendment granted REIT management the flexibility it needed to effectively handle problem loans and leases, the ambiguity of the REIT restrictions still tied the hands of REIT management with respect to their performing properties. The Tax Reform Act of A Response to Real Estate Business Realities The TRA of 1975 provided the REIT limited flexibility in the management of their properties. It did not, however, accomplish what many in the REIT industry had lobbied Congress for in the previous four years. Their effort focused on elucidating the provisions, making them more sensitive to the real estate marketplace and more effective with the business practices of the real estate industry. Due largely to lobbying efforts, Congress included in The Tax Reform Act of 1976 legislation that altered the inflexible REIT qualification requirements and granted relief from disqualification of REIT status for failure to meet income, asset, and distribution requirements. The TRA of 1976 extended the same relief granted in the TRA of 1975 for income from foreclosed property to all income a REIT generated that failed to meet the income-source and/or asset tests. More importantly,

13 the TRA of 1976 clarified the income source test immeasurably by including in rental income amounts received for customary and ancillary services provided for the benefit of the tenant as well a minimum allowance for rents from personal property in conjunction with the rents of real property. This minimum allowance was set low enough to continue the exclusion of all hotel income from qualifying as "good" income. The Act included changes, which enable the REIT to correct a distribution deficiency and to carry over net operating losses (NOLs) to subsequent tax years. Traditionally, the carry over of NOL was a right reserved for corporations. As this act also granted REITs the right to incorporate, it was fitting to allow NOL carry-forwards. The loosening of earlier restrictions did not come without a cost. The TRA of 1976 also raised the income distribution requirements from 9 percent to 95 percent of their otherwise taxable income. Although the TRA of 1976 did much to clarify REIT provisions allowing for additional flexibility in REIT management, it was careful to ensure the REIT's role as a passive investor. No changes were made to the requirement that all property owned by a REIT must be managed and operated by an independent contractor or third party. REIT management was still forced to remain removed from the operation of their properties. The Revenue Act of A Response to Investment Portfolio Management As stated previously, the restrictions set forth in REIT legislation were imposed to ensure that REITs remained a passive investment vehicle and did not engage in active business management. While some of the restrictions were meant to prevent traditional real estate activities such as development or brokerage, they also infringed upon a REIT's ability to modify its investment portfolio without bearing the cost of the tax burden. In 1978, one such restriction was changed in an effort to correct this shortcoming. The Revenue Act of 1978 created a "safe harbor" rule as an aid in determining whether a sale by the REIT of one of its assets would be considered a prohibited transaction and thus subjected to corporate taxation. If the asset sale met certain requirements, it would be considered a sale for the benefit of the investment portfolio, and therefore the proceeds from the sale would qualify as passive income. It would not be considered a result of the REITs participation in active real estate sales activities.

14 With greater legislative latitude, REIT management took on more of a defining role. Some senior management teams began looking at creative ways to add value to their entity while still remaining in the confines of the REIT provisions. REIT management formulated alternatives or enhancements to the REIT structure, which allowed them to invest in otherwise restricted assets. One area of concentration became the value associated with service income generated from a real estate operating company. Emerging from this strategy was the Paired-Share, or Stapled REIT entity. Certain REITs sought and received permission from the IRS to staple an operating or management company (run as a C-Corporation) to themselves and not lose their conduit tax status. Deficit Reduction Act of A Ban on the Stapled Entities The Deficit Reduction Act of 1984 (DEFRA) was legislated to increase the efficiency of the tax system in an effort to increase tax revenue. The bill proposed a small tax increase, and provisions that would limit unwarranted tax benefits and curb tax shelter abuses. The latter motivated a provision in the bill, which effectively banned any further formation of a stapled REIT entity. (For further discussion of the Paired Share REIT, refer to chapter 3.) The Tax Reform Act of The REIT Relief Act of 1986 No other piece of legislation, since The Real Estate Investment Trust Act of 196, has contributed more favorable to the growth and performance of REITs then The Tax Reform Act of 1986 (TRA 1986). The reason its impact was so broad is twofold. Firstly, TRA 1986 considerably diminished the private real estate investment market by eliminating many of the tax shelter provisions associated with investment in income producing properties. Secondly, it notably revised the REIT provisions themselves. The REIT provisions that where included in the TRA of 1986 were the culmination of a four year lobbying effort by the National Association of Real Estate Investment Trusts (NAREIT). NAREIT, once again, sought to update the REIT laws making them more attuned to the realities and practices of the real estate industry. The aim of the REIT modernization bill, which ultimately was accepted by the Conference Committee on Taxation and included as part of the TRA of 1976 tax reform package, was best expressed by a supporter of the bill, Congressman Guy,.

15 "There is at the present time an urgent need for comprehensive revisions in order to update the REIT tax rules to reconcile them with real estate taxation generally so that REITS and their shareholders will be able to compete more effectively and to continue their important function of enhancing the flow of capital to economically viable, incomeoriented real estate projects." The TRA of 1986 was a major overhaul of the tax system; as such it included major changes to the REIT tax provisions. Remarkably, The TRA of 1986 would result in a lower REIT tax burden on non-qualifying income even though its intent was to offset the tax rate reduction it legislated to both individuals and corporations 2 by broadening the corporate tax base. A number of the REIT provisions in the TRA of 1986 did provide substantial tax relief for REITs, which in turn reduce d corporate tax revenue, but more notably, they impacted the effectiveness of the REIT vehicle within the common practices of the real estate industry. One such provision was the amendment to the independent contractor rule, which required REITs to contract out property management and customary tenant services to a third party. The TRA of 1986 changed this by allowing REITs to self manage and operate many types of income producing properties. The investment community responded favorably to the additional control this legislation granted to the REIT industry. Also as a consequence of this amendment, the management fees REITs previous had paid out to independent contractors, most of which were C-Corps, could be internalized and thus would not be subjected to corporate taxation. Unfortunately for the hotel industry, REITs were still restricted from earning active business income even if the business had a strong connection to real estate. Therefore services provided for the benefit of a single tenant still needed to be provided by an independent contractor or operating company. The TRA 1986 also included a new provision enabling REITs to operate through Qualified REIT Subsidiaries (QRS). This provision, in keeping with the practices of the real estate industry, permits a REIT to manage its properties through a QRS thus limiting its liability with respect to the operations of the property. A QRS is a separate legal entity whose stock is 1% owned by the 2 The TRA of 1986 reduced the maximum corporate tax rate from 46 percent to 34 percent. It also reduced the number of individual tax brackets to two- 15 percent and 28 percent.

16 REIT, but whose separate federal tax status is ignored. Therefore, the tax attributes of a QRS are treated as those of a REIT. This provision comforted many in the investment industry because it shielded a REIT's portfolio from the damage of a single under performing property while allowing a REIT access to revenue from operations of their properties tax-free. Modifications to the safe harbor rule regarding prohibited transactions were also legislated in the TRA of A REIT is now allowed to make seven sales, instead of 5, in a taxable year with out a corporate tax occurrence. Moreover, there was no limit on the number of sales as long as the total adjustable basis of the properties sold did not exceed 1 percent of the REIT's assets at the beginning of that year. Expenditures for improvements on property owned by and subsequently sold by a REIT increased from 2 percent of its adjusted basis to 3 percent during the four years prior to sale. The Technical and Miscellaneous Act of 1988 Largely due to the increased role of management in a REIT, afforded to them by the TRA 1986, many REITs contained integrated real estate service companies. REITs then sought to capitalize on their in-house expertise in the fields of property management, development and other services by offering them to third parties. Unfortunately, the income resulting from "active" third party business is considered non-qualifying or "bad" income for a REIT and would be subjected to corporate level taxation. In an effort to stay within the income and asset requirements of the REIT structure while extracting value from third party fee income, some REITs formed separate corporations to house their service operations. These corporations were not QRS; rather, they were organized with two classes of stock: voting and non-voting stock. The non-voting stock was held by the REIT and paid dividends allowing the REIT to retain most of the income generated by the impermissible business. In 1988, the IRS allowed for the formation of these "preferred stock subsidiaries". The IRS concluded that the dividends did represent qualified income for purposes of the income test, and the holding of non-voting stock did not violate the asset test which states that a REIT can not own more 3 than 1% of the outstanding voting securities. 3 Richard T. Garrigan and John F. Parsins, Real Estate investment Trusts: Structure, Anaysis and Strategy (New York: McGraw-Hill, 1998), p. 16

17 The Revenue Reconciliation Act of Reconciling Domestic Pension Fund Investors While the TRA 1986 encouraged and assisted the growth of REITs by making them a more attractive real estate investment vehicle, the real estate market was still capital constrained in the late 8's and early 9's. Moreover, hindering the growth of many of the mid-sized and smaller REITs were certain organizational requirements inherent in the REIT structure. The "5 or fewer rule" is an organizational requirement in place to guard against concentration of ownership. It generally means that no more than 5 percent of a REIT's stocks value can be owned by five or fewer individuals during a taxable year. Prior to being amended in the Revenue Reconciliation Act of 1993 (RRA 1993), it limited some REIT's ability to attract the attention and capital of large institutional investors, most notably domestic pension funds. The rule was amended with a "look through" provision that deemed the beneficiaries of the pension fund as individual investors rather than considering the pension fund as a sole investor for purposes of this ownership concentration calculation. This amendment served to mitigate investor's fears of violating the ownership requirements of a REIT, increased the liquidity of REITs, encouraging institutional investment, and increased access to growth-generating capital. The Real Estate Investment Simplification Act of A REIT Friendly Act Among the many benefits of the Real Estate Investment Simplification Act of 1997 (REITSA 1997), it allowed REITs to perform nontraditional services for a fee as long as they do not exceed 1% of the property's gross income. While this was beneficial to the REIT industry as a whole, the hotel REITs didn't gain much ground from this reform. Hotels generate a substantial amount of their revenue from nontraditional services (i.e., maid, food, beverage and telephone), upwards of 4%4. The 1999 Budget Proposal - Closing Certain REIT Loopholes The 1999 Budget Proposal, introduced by the Clinton Administration in early 1998, contains three proposals that impact the REIT industry. The aim of the proposals is to "eliminate unwarranted benefits and adopt other revenue measures". The Administration contends that some REITs conduct business or execute transactions that deviate from the intention of the REIT provisions. These "borderline" transactions are typically tax avoidance measures that have been allowed by, or granted reprieve from, existing REIT laws by interpretation thereof They include restrictions on: the 4 PKF Consulting, Hotel Development, (Urban Land Institute, Washington, DC) 1996 p 4.

18 formation of preferred stock subsidiaries and closely held REITs, and further acquisitions under the Paired-share REIT structure. As discussed above, a 1988 IRS interpretation of the REIT laws has allowed many REITs to form taxable "preferred stock" subsidiaries to conduct third-party business. The REIT is allowed to own 9% or more of the economic benefits of non-reit corporation (subsidiary) through the retention of non-voting stock. The subsidiary pays dividends on non-voting stock out of the "active" business revenue it generates. These dividends represent qualified income to the REIT. This arrangement has invoked concern from the Administration. They contend that the subsidiary is typically levered with debt from the REIT and that much of the REITs general and administrative costs are covered by the subsidiary. This would allow the subsidiary to shield most of its income from corporate level taxation thus passing on the majority of its income to the REIT in the form of dividends and above mentioned "excess" interest and administrative expenses. The Clinton Administration's 1999 Budget proposes to limit a REIT from holding no more than 1% of the vote or value of non-reit securities. Similar to their concern with "preferred stock subsidiaries" is the belief held by the Administration that the intent of the "closely held" limitation on REITs is being side stepped by interpretations of the current test. To ensure that REITs are widely held entities as intended for the benefit of small real estate investors. Along with the "five or fewer rule discussed above, ownership must be held be 1 persons including individuals, corporations and trusts. The Administration contends that corporations and other non-individual entities (i.e., REITs) are using closely held REIT subsidiaries to take advantage of their tax-free status. The current "closely held" tests are satisfied as follows: the corporation holds common stock with 1% voting rights and a majority of the total REIT value. The REIT issues non-voting stock worth a fraction of the total REIT value to 99 shareholders. Thus there are 1 owners, and the majority owner is not an individual.

19 This perceived abuse would be eliminated by the Administration's proposal to add an additional "closely held" test. This proposed test would prohibit any person (including corporations, trusts, or partnerships) from owning greater than5% of the voting stock or 5% of the total value of a REIT. And lastly, the Administration proposes to prohibit the remaining paired share REITs from further acquisitions under their unique grandfathered structure. Currently, REIT legislation requires only the REIT side of the stapled entity to meet the REIT qualification tests. As such, the "active" net operating income that "C" corporation earns, and would otherwise be subjected to corporate level taxation, can be passed to the REIT in the form of rent or qualified REIT income. The proposal would treat the REIT and stapled "C" corporation as one entity for the purpose of the REIT qualification tests, and therefore effectively remove the ability to shelter taxable operating income through this structure on further acquired properties.

20 CHAPTER 3: The Paired Share REIT: Aligning Ownership and Operations As discussed in Chapter 2, the REIT provisions of the Internal Revenue Code have evolved in an effort to perfect the REIT structure as a real estate investment vehicle attuned to the requirements of the public markets and the practices of the real estate industry. The IRS has remained consistent, though, in its restrictions on a REIT to earn active business income. The requirement that REITs be largely passive owner-entities is one of the concessions a REIT must make in order to be allowed the benefit of no corporate level taxation. It also serves to discourage a REIT from holding properties (restricted assets) that may have a strong real estate component but which primarily generate income from the services provided in connection with those property types. These restricted assets are, most notably, hotels, racetracks, casinos, parking garages, golf course and health care facilities. To remain compliant with the REIT provisions, a REIT is entitled to revenue derived from owning title to these properties, typically in the form of rent or lease payments. A REIT cannot earn active business income from the operations housed in these properties. In an effort to derive revenue from the operations of their properties without earning "active" business income, some REITs petitioned and eventually received permission from the IRS to form stapled entities. 5 The formation of a stapled entity requires creation of two companies, a REIT and an operating company. As a stapled entity, a share of stock in the REIT is stapled or paired with a share of stock in the operating company. Each paired share stock is required to trade as a single unit and, therefore, both companies are owned by the same shareholders (see Exhibit 3.1). Though the shares trade as one, the two companies are separate entities with regard to the IRS. Accordingly, the strictures of the REIT provisions due not apply to the operating company typically organized as a "C" corporation. As a "C" corporation, the operating company has no restrictions on the type of business it can operate and, therefore, can collect revenue that 5 Section 269B of the IRS Code, refers to stapled entities as "any group of two or more entities if more than 5 percent of value of the beneficial ownership in each of such entities consist of stapled interest." Section 269B defines stapled interests as "by reason of form of ownership, restrictions on transfer, or other terms or conditions, in connection with the transfer of 1 of such interest the other such interest are also transferred or required to be transferred."

21 Paired-Share REIT Structure EXHIBIT 3.1 " I tloaw-

22 results from services provided in conjunction with restricted assets, i.e. non-qualifying or "bad" REIT income. The REIT, functioning as a lessor, receives a rent or lease payment from the operating company who has operational control of the property. This rent payment now represents qualifying or "good" REIT income. The original intent behind pairing these companies was to allow the shareholders of the paired share REIT to enjoy the full economical benefit from both the ownership and operations of the asset. The ability to adopt the paired share REIT format was available to all existing and newly formed REITs from the time of its inception, 1977, until it was outlawed by Congress in the DEFRA Surprisingly, it was only employed by six REITs during that period. Many have speculated that management of the conventional REIT at that time may not have considered thoroughly the advantages of the Paired Share structure. This was primarily because most REITs were not holding restricted assets and/or generating enough service revenue ("bad" REIT income) that could largely benefit from the avoidance of corporate level taxation. Also, the conventional REIT had been granted some lenience by the passage of the TRA 1976 in regard to the services they could provided for the benefit of the tenant without having the service income be considered non-qualifying (see Chapter 2). Many also speculated at the time that there would be further liberalization of the IRS's rule, thus granting more service income conduit status. Though the tax advantages of the Paired Share REIT have been the most poignant argument for the benefits and productiveness of the structure, it is important to explore the other advantages associated with this REIT structure as they relate to the public ownership of real estate. Tax Shelter Advantages The tax advantage of the Paired Share REIT is predicated on a shared management team and its ability to avoid, or materially reduce, corporate level taxation on active business income. This is accomplished by management's careful allocation of revenue and expenses. The operating company, required as a C corporation to pay corporate level tax on its taxable income, stands to benefit from management's decision to allocate a disproportionate amount of tax deductible expenses, effectively reducing its taxable income and tax burden. The "disproportionate"

23 expenses incurred by the operating company are commonly a portion of the REIT's overhead and above market lease payments made to the REIT. The operating company's lease payments serve as income to the REIT and, therefore, to comply with REIT statutes must be based on revenue generated from property operations not net income.6 Management of the Paired Share REIT can structure the lease to result in an above market lease payment to the REIT which escapes taxation at the REIT level, thus affording the combined entity an effective tax shield on its otherwise taxable operating profits. Shareholder Benefits As managers of a publicly held entity, the shared management of a Paired Share REIT is able to utilize the advantages of its structure to increase shareholder value. Senior management of a Paired Share REIT can effectively invest in operationally intensive business while maintain tighter control over their assets and provide its shareholders with full economic benefit of the ownership and operation of their assets. In the absence of a structural link between ownership (REIT) and operations (operating company), a typical REIT must remain a passive real estate owner and rely on third party management to profitably operate the asset. This structure does not provide adequate alignment of the interests between ownership and operations. As noted above, the lessee of a REIT owned property pays rent based on revenue not operating profits. While this type of leasehold interest creates an incentive for the lessee to maximize profits, the REIT shareholders are not compensated fully on property level performance if, for instance, revenue is jeopardized because management's focus is on profits. As an example, a hotel operator may decide not to drop room rates to increase occupancy, and hence revenue, if doing so does not increase profits as well. With the Paired Share structure, the property is managed to maximize cash flow to its shareholders. With identical interests in both the ownership and operations of the property, shareholder are less concerned with operational conflicts or which entity is deriving the most benefit from property level operations. 6 "Rents from real property" are defined in IRC Section 856(d).

24 Another area for operational conflict between the lessee and lessor arises from decisions involving the disbursement of capital reserves and maintenance obligations. Depending on how the lease is structured, capital reserves may be funded by the lessor but spent at the discretion of the lessee. If a capital improvement funded out of reserves would favor decreasing operating expenses over increasing revenue, the lessee may be receiving the entire benefit of that expenditure since it in would result in increased operating profits. The lessor (REIT) can also be penalized if the lessee under-funds it maintenance obligations in an effort to increase its profits. The short-term benefits derived from this type of management can have long-standing detrimental effects on the ownership of the property. Once again, the Paired Share REIT structure mitigates these conflicts because a shared management team aligns the interest of both the operations (lessee) and ownership (lessor) of the property. The shareholders of traditional (non-paired Share) REITs which invest in restricted assets are at a distinct disadvantage to shareholders of a Paired Share REIT. Inherent in the Paired Share structure is the elimination of conflict of interest between ownership and operations/management. With cohesive business strategies, management of a Paired Share REIT will implement policy that maximizes after -tax cash flow to its collective shareholders. A Paired Share REIT's ability to avoid corporate level income taxation is clearly an advantage to the valuation of an operationally intensive business. One would estimate that the value derived from this structure would accrue to its shareholders, leading to an increased stock valuation and ultimately, a distinct competitive advantage. While this view is widely shared, it neglects to consider the strict requirements of the REIT provisions that are still embedded in the Paired Share REIT as well as the effect of capital structure on the perceived tax benefits of a Paired Share REIT versus a typical "C" Corporation. These issues are further explored and quantified in Chapter 5. The Hotel Industry and the Paired Share REIT Though one of the earliest ventures to form under the Paired Share REIT structure was a racetrack, Santa Anita Racetrack; the structure quickly gained the interest of hotel real estate companies. Though hotels are largely income producing real estate, their operations entail the

25 performance of many personal services and accordingly, much of their revenue and profits are derived from furnishing these services. Unfortunately, the REIT provisions state that the net operating income from these investments, due to the significance of the services provided to the tenant does not qualify as rent from real property. As such, a REIT is forbidden from owning a hotel and performing these services. The hotel REIT must, therefore, rely on third party management to operate the hotel. As discussed earlier, this creates operational conflicts and does not allow the shareholders of the REIT proper compensation from operating profits. The Paired Share REIT was a solution to this dilemma. It allowed a REIT to recapture lost operating profits (known as leakage) and through a shared management team align the interest of ownership and operations. Banning the Paired Share Structure As stated earlier, the Paired Share REIT format was legitimized by an IRS ruling (Section 269B), and amended in 1984 to effectively prevented new Paired Share REITs from forming. Congress determined at that time that: "stapling of corporate stock is a simple means of attempting to avoid tax rules intended to limit the abuse of the U.S. tax system or to limit the use of special tax benefits granted by Congress. Stapling of a tax entity with a nontaxable entity is particularly serious problem. In such cases, the shareholders (who are the same for both corporations) generally prefer profits to be realized in the nontaxable entity rather than in the taxable entity. The committee believes that not to do something to preclude the use of such a transparent device would lead to disrespect for the tax system." 7 It is unclear what provoked the congressional ban on stapled REIT entities. The six Paired Share REITs existing in 1983 were not then engaging in activities contrary to the spirit of the REIT provisions. Congress may have feared that allowing the Paired Share REIT structure to continue might invite the interest of corporations primarily conducting non-real estate business activities. It may have been speculated that such corporations would be attracted by the inherent tax 7 H.R, Rep. No. 432(11), 98th Cong., 2d Sess. 1984

26 advantages and resulting savings in dividend cost. Lerner described the benefits of this arrangement' as follows: "By Pairing its stock with the stock of a REIT holding the real estate assets of such nonqualifying corporation, such a corporation was able to essentially substitute pretax dividend payments for the after-tax dividend payments typically made by operating corporations." The amendment (to IRS section 269B) requires that both corporations under the Paired Share REIT umbrella be treated as a single entity for the purpose of determining REIT status. Congress's intend was to end any tax avoidance by active business that through a paired stock arrangement could effectively and legally place active business profits on the tax conduit side of the arrangement. More notably, the amendment grandfathered (applied prior law to) the six existing Paired Share REITs. They were (current names): Starwood Lodging (Starwood Hotels & Resorts), Santa Anita Realty (MediTrust), California Jockey Club (Patriot American Hospitality), First Union Real Estate, Corporate Property Investors, and Hollywood Park. Current Trends In the years following the ban on the formation of stapled entities, the grandfathered Paired Share REITs have all been witness to not only a rebounding real estate market with REITs at the helm, but a considerable gain in notoriety and interest. With the opportunity to form new Paired Share REITs eliminated, the once obscure and under-utilized conduit structure has become highly sought after. It has been speculated that the structure alone is worth $2 million, specifically, in the acquisition of Santa Anita Realty (a grandfathered Paired Share REIT), MediTrust was said to have paid close to $2 million net of other tangible assets. 9 The interest and notoriety of the Paired Share REIT has emerged primarily from the hotel sector. As of late, hotel REITs seemed to have benefited most from the improving health of the 8 Lerner, "REITs:Use of "Stock Pairing" Arrangements to Increase After-Tax Corporate Distributions, " 198 Tax Adviser 468 (198) 9 Green Street Advisors, Inc. "Paired Share REITs and the Paper Clip Alternative" August 12, 1997 pp. 8-9