Real Estate Investment Trust Income: Selected Issues and Recent Changes in the Law

Authorized Reprint Real Estate Investment Trust Income: Selected Issues and Recent Changes in the Law Michael J. Brody, David O. Kahn, and Eric J. Matuszak * Real estate investment trusts (REITs) are the creation of legislation enacted in 1960 that was intended to provide the average investor with a tax-favorable method of investing in a diversified portfolio of real property, in much the same way mutual funds provide average investors with a tax-favorable method of investing in a portfolio of securities. 1 The rules in the 1960 legislation, as well as various amendments over the years, generally sought to ensure that REITs primarily act as passive investors in real estate assets and otherwise do not engage in the active conduct business activities. To qualify for taxation as a REIT, various tests imposed under the Internal Revenue Code must be met, including tests related to the REIT s gross income, asset composition, distribution levels, and diversity of stock ownership. If an entity qualifies for taxation as a REIT, it generally is not required to pay federal corporate income taxes on its net income that is currently distributed to stockholders. This treatment substantially eliminates the double taxation that ordinarily results from investment in a C corporation. This article focuses on certain rules related to the gross income test requirements applicable to REITs, including certain recent developments resulting from the American Housing Rescue and Foreclosure Prevention Act of 2008 (the 2008 Housing Act ) signed into law on July 30, 2008. 2 Introduction REITs must satisfy two gross income tests annually to maintain qualification as a REIT. First, subject to various exceptions, in each taxable year, * Michael J. Brody is a partner in the Los Angeles office of Latham & Watkins LLP. He can be reached at michael.brody@lw.com. David O. Kahn is a partner in the Los Angeles and San Diego offices of Latham & Watkins LLP. He can be reached at david.kahn@lw.com. Eric J. Matuszak is an associate in the Los Angeles office of Latham & Watkins LLP. He can be reached at eric.matuszak@lw.com. 1 See H.R. Rep. No. 86-2020, pt. II (1960). 2 PL 110-289 (July 30, 2008). 62

REAL ESTATE INVESTMENT TRUST INCOME 63 a REIT must derive at least 75% of its gross income from the following sources: 1. Rents from real property; 2. Interest on obligations secured by mortgages on, or interests in, real property; 3. Dividends and gain from the sale of shares in other REITs; 4. Abatements and refunds of taxes on real property; 5. Income and gain derived from foreclosure property; 6. Amounts received as consideration for entering into agreements (a) to make loans secured by mortgages on, or interests in, real property or (b) to purchase or lease real property; 7. Gain from the sale or other disposition of a real estate asset which is not a prohibited transaction; and 8. Income from the investment of the proceeds of an offering by the REIT of certain types of securities, including common stock, during the one-year period beginning on the date the proceeds were received. 3 Second, in each taxable year, a REIT must derive at least 95% of its gross income, excluding certain types of gross income, from the sources listed above plus the following additional sources: 1. Dividends; 2. Interest; 3. Gain from the sale or other disposition of stock and securities which are not treated as inventory or dealer property under the Internal Revenue Code; and 4. In very limited circumstances, certain mineral royalty income. 4 Accordingly, no more than 5% of a REIT s income may be derived from sources other than those described above. For purposes of the REIT gross income tests, a REIT must take into account 100% of the gross income of its qualified REIT subsidiaries as well as its proportional share of the gross income of any partnership in which the REIT is a partner. 5 For this purpose, a REIT s share of partnership income is based on the REIT s relative share of partnership capital, and the allocation provisions of the partnership agreement are essentially ignored. 6 3 Section 856(c)(3) 4 Section 856(c)(2)(I). 5 Section 856(i)(1), Reg. 1.856-3(g). 6 Reg. 1.856-3(g).

64 JOURNAL OF TAXATION OF INVESTMENTS Gross Income The term gross income, as used in the REIT gross income tests, generally has the same meaning as for other purposes of the Internal Revenue Code. 7 Certain items, however, are explicitly excluded from the REIT gross income tests; in other words, such items do not appear in either the numerator or the denominator of the qualifying income percentage calculations. Prohibited Transaction Income. Gross income from the sale or other disposition of property held primarily for sale to customers in the ordinary course of a trade or business is excluded from the REIT gross income tests. 8 Instead, the net income from such prohibited transactions is subject to a 100% tax. 9 By imposing a 100% penalty tax on such income, Congress hoped to ensure that REITs would derive their income from passive sources and not from the active development and dealing of real estate. 10 In general, whether a particular sale constitutes a prohibited transaction is determined based on the facts and circumstances surrounding the sale. 11 However, Congress provided a safe harbor which, if satisfied, ensures that certain sales of real estate by a REIT will not be treated as prohibited transactions. Prior to its amendment by the 2008 Housing Act, this safe harbor generally required that: The REIT held the property for at least four years prior to sale; The cost of the REIT s capital improvements to the property during the four-year period prior to sale did not exceed 30% of the sales price; During the taxable year, the REIT did not sell (1) more than seven properties or alternatively, (2) provided certain other requirements were met, properties with aggregate adjusted basis in excess of 10% of the aggregate basis of all the REIT s assets as of the beginning of the taxable year; and In the case of land or improvements not acquired through foreclosure, the REIT held the property for the production of rental income for at least four years. 12 The 2008 Housing Act amended this safe harbor test by reducing the four-year periods described above to two years and allowing REITs to 7 Reg. 1.856-2(c)(1). 8 Sections 856(c)(2)(D), 856(c)(2)(H), 856(c)(3)(C), 856(c)(3)(H). 9 Section 857(b)(6)(A). 10 See S. Rep. No. 94-938, pt. 3 (1976). 11 Reg. 1.856-5(b). 12 Former Section 857(b)(6)(C).

REAL ESTATE INVESTMENT TRUST INCOME 65 measure the 10% limit discussed above using either the tax basis or the fair market value of the property. 13 The amended safe harbor test applies to all sales of real estate assets by REITs made after July 30, 2008. 14 Hedging Income. The treatment of hedging income for purposes of the REIT gross income tests has been revised several times over the past five years. In general, for purposes of the REIT gross income tests, hedging income is currently defined as income from any transaction entered into in the normal course of business primarily to manage the risk of (1) interest rate fluctuations with respect to borrowings made or to be made by the REIT to acquire or carry real estate assets, or (2) for periods after July 30, 2008, currency fluctuations with respect to any item of REIT qualifying income. 15 For transactions entered into between January 1, 2005 and July 30, 2008, such income is: Excluded from the 95% gross income tests; and Treated as nonqualifying income for purposes of the 75% gross income test. 16 For hedging transactions entered into before January 1, 2005, hedging income is: Qualifying income for purposes of the 95% gross income test, but; and Treated as nonqualifying income for purposes of the 75% gross income test. 17 Finally, for transactions entered into after July 30, 2008, all such income is excluded from both REIT gross income tests. 18 As a result, a REIT must, on an ongoing basis, track the date on which it entered into a hedging transaction to determine its proper treatment. In addition, in order to qualify for the treatment described above, a REIT must identify the hedge in the manner and within the time specified in Section 1221(a)(7) and the associated Treasury regulations. Foreign Currency Gains. Prior to the 2008 Housing Act, the treatment of foreign currency gains for purposes of the REIT gross income tests was 13 Section 857(b)(6)(C). 14 See PL 110-289, 3071(d). 15 Section 856(c)(5)(G). 16 Former Section 856(c)(5)(G). 17 Former Section 856(c)(5)(G). 18 Section 856(c)(5)(G).

66 JOURNAL OF TAXATION OF INVESTMENTS subject to considerable uncertainty. In 2007, the IRS issued guidance indicating that REITs could apply the principles contained in proposed Treasury regulations to determine whether certain foreign currency gains constituted qualifying income. 19 As a result, foreign currency gains would generally be treated as qualifying income to the extent the underlying income (or asset generating the income) was also qualified. The 2008 Housing Act changed these rules. Beginning July 31, 2008, the following types of foreign currency gain are excluded from gross income for purposes of the 75% gross income tests: Foreign currency gain (as defined in Section 988(b)(1) of the Internal Revenue Code) attributable to (1) any item of qualifying income or gain under the 75% gross income test, (2) the acquisition or ownership of obligations secured by mortgages on real property or on interests in real property (other than foreign currency gain attributable to any item of income or gain described in clause (1)), or (3) becoming or being the obligor under obligations secured by mortgages on real property or on interests in real property (other than foreign currency gain attributable to any item of income or gain described in clause (1)); and Gain recognized under Section 987 which is attributable to a qualified business unit of the REIT (i.e., foreign currency gain recognized upon the remittance of earnings from a REIT s qualified business unit with a functional currency different from the REIT s), but only if such qualified business unit meets the requirements of the 75% gross income test for the taxable year, and the requirements of the 75% REIT asset test at the close of each quarter that the REIT directly or indirectly holds the qualified business unit. 20 In addition to the gains described above, for purposes of the 95% gross income test, foreign currency gains and gains recognized under Section 987 of the Internal Revenue Code are also excluded if attributable to: (1) any item of income or gain described in the 95% gross income test, (2) the acquisition or ownership of obligations (other than foreign currency gain attributable to any item of income or gain described in clause (1)), or (3) becoming or being the obligor under obligations (other than foreign currency gain attributable to any item of income or gain described in clause (1)). 21 The 2008 Housing Act also provides statutory authority to the Treasury to expand through regulations the 19 Rev. Rul. 2007-33, 2007-1 CB 1281; Notice 2007-21, 2007-1 CB 1281. 20 Section 856(n)(2). 21 Section 856(n)(3).

REAL ESTATE INVESTMENT TRUST INCOME 67 list of foreign currency items excluded from the 95% and 75% gross income tests. 22 Qualifying Income Categories As described above, there are several categories of qualifying income for purposes of the REIT gross income tests. Below is an overview of the rules applicable to certain key categories of qualifying income. Interest. For purposes of the REIT gross income tests, interest generally means compensation for the use or forbearance of money. 23 Except as discussed below, all interest income is qualifying income for purposes of the 95% gross income test. However, with the exception of interest from the investment of proceeds from certain capital raising transactions in the year following such transactions, interest is only qualifying income for purposes of the 75% gross income test if it is interest on an obligation which is adequately secured by a mortgage on, or interest in, real property. 24 For purposes of both gross income tests, the term interest generally does not include any amount received or accrued if the determination of all or part of the amount depends in any way on the income or profits of any person. 25 However, an amount generally will not be excluded from the term interest solely by reason of being based on a fixed percentage or percentages of receipts or sales. 26 Dividends. While dividends, as defined in Section 316, from any source are treated as qualifying income for purposes of the 95% gross income test, only dividends from other REITs are treated as qualifying income for purposes of the 75% gross income test. 27 Rents From Real Property. For equity or property holding REITs (as contrasted with mortgage REITs) the most significant category of qualifying income is typically rents from real property. Subject to the rules discussed below, rents from real property generally means the gross amount received from a third party for the use of the REIT s real property. 28 While this basic definition is relatively straightforward, there are a number of complicated and 22 Sections 856(n)(2)(C), 856(n)(3)(C). 23 Reg. 1.856-5(a). 24 Section 856(c)(3)(B). 25 Section 856(f)(1). 26 Section 856(f)(1)(A). 27 Section 865(c)(2)(A); 856(c)(3)(D). 28 Reg. 1.856-4(a).

68 JOURNAL OF TAXATION OF INVESTMENTS sometimes overlapping exceptions and qualifications designed to ensure that REITs do not conduct a business other than the relatively passive investment in real estate assets. In general, rents from real property include: (1) rents from interests in real property; (2) charges for services customarily furnished or rendered in connection with the rental of real property; and (3) certain rents attributable to personal property. 29 In addition, various classes of income are specifically excluded from the definition of rents from real property, including: (1) amounts that depend on the income or profits of a tenant; (2) amounts received from tenants in which the REIT actually or constructively owns a 10% or greater interest; and (3) impermissible tenant service income. 30 Rents From Interests in Real Property. For purposes of the REIT gross income tests, an interest in real property includes various forms of real property ownership, including fee ownership, co-ownership, leaseholds, options to acquire real property or leaseholds, timeshare interests and stock held as a tenant-stockholder in a cooperative housing corporation. 31 However, mineral, oil or gas royalty interests are not considered to be interests in real property for purposes of the requirements imposed on REITs. 32 In addition to basic rent for the use of real property, the following are examples of charges that have been treated as rents from real property : Reimbursement to the landlord by the tenant for real property taxes assessed against the property; 33 Late charges and interests on delinquent rent payments, additional charges representing the tenant s pro rata share of certain operating costs, and charges for the use of the property by pets; 34 A charge equal to a specified percentage of the excess of any rent received by the tenant from a subtenant over the rent paid by the tenant to the landlord with respect to any subleased space; 35 Additional amounts received by the landlord pursuant to specified escalation provisions, including provisions intended to cause tenants 29 Section 856(d)(1). 30 Section 856(d)(2). 31 Reg. 1.856-3(c). 32 Reg. 1.856-3(c). 33 Rev. Rul. 73-426, 1973-2 CB 223; PLR 8040113 (July 15, 1980). 34 See PLR 8040113 (July 15, 1980); PLR 8420012 (February 9, 1984). 35 Section 856(d)(6). See also PLR 200751023 (December 21, 2007); PLR 9719018 (May 9, 1997); PLR 9308013 (November 24, 1993); PLR 9122037 (March 1, 1991).

REAL ESTATE INVESTMENT TRUST INCOME 69 to bear their proportionate share of any increase in the cost of furnishing services; 36 Reimbursement of a landlord by the tenant for the cost of performing any obligation of the tenant under the lease which the tenant fails to perform; and 37 Substantial amounts paid for utilities in connection with the lease of data center properties. 38 Charges for Customary Services. A series of overlapping rules address the types of services that a REIT may provide for its tenants. Once again, these rules are intended to ensure that the REIT does not engage in the active conduct of a trade or business with its tenants, other than the leasing of interests in real property. In general, rents from real property includes charges for services customarily furnished or rendered in connection with the rental of real property, whether or not those charges are separately stated. 39 Services are treated as customary for purposes of this rule if they are of a type customarily provided to tenants of other properties of a similar class in the same geographic market in which the property is located. 40 While a REIT may provide its tenants with services customarily furnished or rendered in connection with the rental of real property, a REIT may only provide such customary services directly (i.e., through its own employees) if those services are customarily rendered in connection with the rental of space for occupancy only and are not considered rendered primarily for the convenience of the tenant. 41 Examples of these services include the provision of light, heat, or other utilities, trash removal, and general maintenance of common areas. 42 All other customary services must be provided through an independent contractor that is adequately compensated for such services and from whom the REIT does not derive or receive any income, or through a taxable REIT subsidiary of the REIT. 43 A taxable REIT subsidiary is any corporation owned, directly or indirectly, by a REIT which jointly elects with the REIT to be treated as a taxable REIT subsidiary of 36 Rev. Rul. 64-50, 1964-1 CB 231. 37 See PLR 8040113 (July 15, 1980). 38 See PLR 200752012 (December 28, 2007). 39 Section 856(d)(1)(B). 40 Reg. 1.856-4(b)(1). 41 Section 856(d)(7)(C)(ii); Regs. 1.856-4(b), 1.512(b)-1(c)(5). 42 Reg. 1.512(b)-1(c)(5). 43 Regs. 1.856-4(b)(1), 1.856-4(b)(5)(i); Section 856(d)(7)(C)(i).

70 JOURNAL OF TAXATION OF INVESTMENTS the REIT. 44 In general, a taxable REIT subsidiary may engage in any kind of business activity other than directly or indirectly operating or managing a lodging facility or a health care facility or directly or indirectly providing to any other person (under a franchise, license, or otherwise) rights to any brand name under which any lodging facility or health care facility is operated. 45 Non-customary services may be provided to a REIT s tenants through a taxable REIT subsidiary of the REIT, or through an independent contractor, but, in this later case, only if (1) the cost of the services is borne by the independent contractor, (2) a separate charge is made for the services which is received and retained by the independent contractor, and (3) the independent contractor is adequately compensated. 46 In order to qualify as an independent contractor that may provide customary or non-customary services for the tenants of a REIT, (a) the independent contractor may not own, directly or indirectly, a greater than 35% interest in the REIT, (b) not more than 35% of the interest of such independent contractor may be owned, directly or indirectly, by one or more persons owning a 35% or greater interest in the REIT, and (c) the REIT may not derive or receive any income from the independent contractor. 47 Rent Attributable to Personal Property. Rents from real property include rent attributable to personal property leased in connection with the lease of real property, but only if the amount attributable to such personal property does not exceed 15% of the total rent. 48 For purposes of this rule, the amount of rent deemed attributable to personal property in each year is the amount that bears the same ratio to the rent for the taxable year as the average of the fair market values of personal property at the beginning and at the end of the taxable year bears to the average of the aggregate of the fair market values of both the real property and the personal property at the beginning and at the end of the taxable year. 49 In general, for purposes of these rules, real property means land and improvements, such as buildings and other inherently permanent structures, including structural components of such buildings or structures. 50 However, 44 Section 856(l)(1). 45 Section 856(l)(3). A taxable REIT subsidiary may, however, invest in corporations that own, operate and/or manage lodging facilities or issue franchises for the operation of lodging facilities, as long as the taxable REIT subsidiary owns no more than 35% of the securities of such corporations. See PLR 200815026 (April 11, 2008). 46 Section 856(d)(7)(C)(i); Reg. 1.856-4(b)(5)(i). 47 Section 856(d)(3), 856(d)(7). 48 Section 856(d)(1)(C). 49 Section 856(d)(1). 50 Reg. 1.856-3(d).

REAL ESTATE INVESTMENT TRUST INCOME 71 assets accessory to the operation of a business, such as machinery, printing presses, office equipment, refrigerators, individual air-conditioning units, and furnishings do not constitute real property for these purposes, even if such items are fixtures under local law. 51 Rent That Depends on the Income or Profits of a Tenant. Subject to certain limited exceptions, rents from real property excludes any rents that depend, in whole or in part, on the income or profits derived by any person from the leased property. 52 However, rents based on a fixed percentage or percentages of receipts or sales are permissible. 53 In addition, rents determined on a percentage of receipts or sales in excess of a determinable amount will also qualify as rents from real property if: (1) the determinable amount does not depend on the income or profits of the tenant, (2) the percentages and determinable amount are fixed at the time the lease is entered into, and (3) changes to the percentages or determinable amount negotiated during the term of the lease do not have the effect of basing rent on the tenant s income or profits. 54 An exception exists in the case of a REIT that leases property to a tenant that derives substantially all of its income with respect to such property from the subleasing of substantially all of such property. 55 In that case, to the extent the subrent received by the tenant from its subtenants qualifies as rents from real property, the amount the REIT receives from the tenant will not be excluded from rents from real property even though the rent charged by the REIT is based on the income or profits of the tenant. 56 In addition, the IRS has ruled privately on several occasions that if a REIT charges a specified percentage of the excess of any rent received by the tenant from a subtenant over the rent paid by the tenant to the landlord with respect to any subleased space, that charge will not be excluded from the term rents from real property by reason of being based on the income or profits derived by any person with respect to the leased property, even if charge is earned in connection with the sublease of less than substantially all of the leased space. 57 51 Reg. 1.856-3(d). 52 Section 856(d)(2)(A). 53 Section 856(d)(2)(A). 54 Reg. 1.856-4(b)(3). 55 Section 856(d)(6). 56 Section 856(d)(6)(A). 57 See PLR 200751023 (December 21, 2007); PLR 9719018 (May 9, 1997); PLR 9308013 (November 24, 1993); PLR 9122037 (March 1, 1991).

72 JOURNAL OF TAXATION OF INVESTMENTS Rent From Related Parties. With the exception of certain rents received from its taxable REIT subsidiaries, rents from real property does not include rents received from a tenant in which the REIT, or an actual or constructive owner of 10% or more of the capital stock of the REIT, actually or constructively owns 10% or more of the interests (or, if the tenant is a corporation, 10% or more of the voting power or value of all classes of stock of the tenant). 58 Rents received from such a tenant that is a taxable REIT subsidiary, however, are not excluded from the definition of rents from real property as a result of this requirement if at least 90% of the space at the property to which the rents relate is leased to third parties, and the rents paid by the taxable REIT subsidiary are comparable to rents paid by our other tenants for comparable space. 59 Whether rents paid by a taxable REIT subsidiary are substantially comparable to rents paid by other tenants is determined at the time the lease with the taxable REIT subsidiary is entered into, extended, and modified, if such modification increases the rents due under such lease. 60 Notwithstanding the foregoing, however, if a lease with a controlled taxable REIT subsidiary is modified and such modification results in an increase in the rents payable by such taxable REIT subsidiary, any such increase will not qualify as rents from real property. 61 For purposes of this rule, a controlled taxable REIT subsidiary is a taxable REIT subsidiary in which a REIT owns stock possessing more than 50% of the voting power or value. 62 Special rules also apply in the case of certain lodging or health care facilities leased by a REIT to its taxable REIT subsidiary. Though taxable REIT subsidiaries are prohibited from operating or managing lodging facilities or health care facilities, these special rules permit a REIT to lease to its taxable REIT subsidiary real property which is a qualified lodging facility or a qualified health care property if such facility or property is operated on behalf of the taxable REIT subsidiary by an eligible independent contractor. 63 Prior to the Housing Act, this exception applied only to qualified lodging facilities, but the Housing Act created additional flexibility for health care REITs by extending the rule to qualified health care properties as well. For purposes of this exception, a qualified lodging facility is any hotel, motel 58 Section 856(d)(2)(B). 59 Section 856(d)(8)(A). 60 Section 856(d)(8)(A)(iii). 61 Section 856(d)(8)(A)(iii). 62 Section 856(d)(8)(A)(iv). 63 Section 856(d)(8)(B). Also, a taxable REIT subsidiary may own (as oppose to lease) a qualified lodging facility or a qualified health care property if such facility or property is operated on behalf of the taxable REIT subsidiary by an eligible independent contractor. See PLR 200813003 (March 3, 2008).

REAL ESTATE INVESTMENT TRUST INCOME 73 or other establishment in which more than half of the dwelling units are used on a transient basis, unless wagering activities are conducted in connection with the facility by any person who is engaged in the business of accepting wagers and who is legally authorized to engage in such business in connection with such facility. 64 A qualified health care property is any facility that is, or is necessary or incidental to the use of, a hospital, nursing facility, assisted living facility, congregate care facility, qualified continuing care facility or other similar licensed facility and which is operated by a service provider that is eligible to participate in Medicare with respect to such facility. 65 Impermissible Tenant Service Income. Rents from real property do not include impermissible tenant service income. 66 A REIT generates impermissible tenant service income to the extent it directly manages or operates a property or renders services to its tenants other than (1) through a taxable REIT subsidiary or independent contractor as described above, or (2) services that are customarily rendered in connection with the rental or space for occupancy only and not considered rendered primarily for the convenience of the tenant. 67 If the income from such services or, if greater, 150% of the direct cost to the REIT of furnishing such services, exceeds 1% of all amounts received by the REIT at a property during the year, all income generated by the REIT from that property will be treated as non-qualifying impermissible tenant service income for purposes of the REIT gross income tests. 68 Future Changes Finally, the 2008 Housing Act granted new power to the Treasury to promulgate regulations to define additional categories of income that will be treated as qualifying income or as not constituting gross income for purposes of the either or both of the REIT gross income tests. 69 In response to this new provision, practitioners are actively soliciting the IRS and Treasury to address, among other things, the treatment of subpart F income 64 Section 856(d)(9)(D). 65 Section 856(e)(6)(D). However, independent living facilities (i.e., age restricted multifamily rental projects with central dining facilities that provide residents, as part of their monthly fee, access to meals and other services such as housekeeping, linen service, transportation, social, and recreational activities that do not provide, in a majority of units, assistance with daily living and that have no licensed skilled nursing beds in the property) are not considered health care properties for purposes of this rule, and a taxable REIT subsidiary may directly operate or manage such facilities. See PLR 200813005 (March 28, 2008). 66 Section 856(d)(2)(C). 67 Section 856(d)(7); Regs. 1.856-4(b), 1.512(b)-1(c)(5). 68 Section 856(d)(7)(B). 69 Section 856(J).

74 JOURNAL OF TAXATION OF INVESTMENTS earned by REITs and income from passive foreign investment companies owned by REITs, with most practitioners asking that regulations be issued that will either treat such income as qualified income under the 95% gross income test or exclude such income from that test altogether. As of the date of this writing, the Treasury has yet to issue regulations that change the way these types of income, or any other category of currently unclassified income, are classified for purposes of the REIT gross income tests. Evolving REIT Distribution Policies To maintain its qualification as a REIT, each year a REIT must distribute at least 90% of its REIT taxable income (excluding any net capital gains) to its shareholders. 70 In addition, to avoid the payment of income tax, a REIT generally must distribute at least 100% of its REIT taxable income (including any net capital gain). 71 While in prior years, most REITs had ample cash to meet these distribution requirements through quarterly cash dividends, many REITs are currently adjusting their dividends policies to address the liquidity constraints caused by recent unprecedented events in the capital markets. One such method of cash deferral is for the REIT to declare a dividend during, and set the record date in, the last three months of the taxable year while paying the dividend in January of the following year. Such dividends are treated as paid by the REIT and received by the REIT s shareholders on December 31 of the year in which they are declared. 72 Another method that REITs may employ to preserve cash on their balance sheets while satisfying the REIT distribution requirements in the current taxable year is to declare a dividend before the due date of the current year s tax return (including extensions) and pay the dividend on or before the date of the first regular dividend payment after such declaration, provided such payment is made during the 12-month period following the close of such year. 73 Such distributions are taxable to the REIT s taxable shareholders in the year paid, even though the distributions relate to the prior year for purposes of the REIT distribution requirements. 74 Of course, both of these alternatives merely help by delaying cash distributions by the REIT for a limited period of time, not by eliminating the need for the cash distributions. However, REITs may also satisfy the REIT distribution requirement through certain taxable stock dividends. On December 10, 2008, the IRS issued Rev. Proc. 2008-68, which generally provides that 70 Section 857(a). 71 Section 857(b). 72 Section 857(b)(9). 73 Section 858(a). 74 Section 858(b).

REAL ESTATE INVESTMENT TRUST INCOME 75 for distributions declared on or after January 1, 2008 with respect to a taxable year ending on or before December 31, 2009, a distribution of stock by a publicly-traded REIT to its shareholders with respect to its stock will be treated as a dividend equal to the amount of money which could have been received if (1) each shareholder may elect to receive its dividend in either money or stock of equivalent value and (2) the limitation on the amount of money to be distributed in the aggregate to all shareholders is not less than 10% of the aggregate declared distribution. Thus, Rev. Proc. 2008-28 provides temporary relief to capital-constrained publicly-traded REITs that want to satisfy the REIT distribution requirements without distributing the entire amount in cash, and it expands previously issued private letter rulings with respect to similarly structured dividend programs by permitting the cash portion of the dividend to be capped at 10% (rather than 20%) of the total dividend amount. 75 Conclusion In developing the rules applicable to real estate investment trusts, Congress, and to a lesser extent, the Treasury, have sought to balance two competing objectives: (1) permit investors to participate and invest in a corporate entity holding real estate without being subject to the double taxation ordinarily associated with an investment in a c-corporation, and (2) limit the intrusion on the corporate tax regime generally imposed by Subchapter C by restricting REITs to holding and deriving income from relatively passive investments in real property and debt secured by real property. The manner in which this balance has been struck has evolved very substantially since the first REIT legislation was enacted in 1960, generally moving in the direction of allowing REITs greater flexibility to deal with real world business concerns and pressures. After 48 years, the rules delineating how various classes of income are treated for purposes of the 95% and 75% gross income tests applicable to REITs are now fairly detailed and complex. Even so, ambiguities, and in some cases, incongruities, have persisted. The 2008 Housing Act favorably resolves many income-related issues with which practitioners have struggled, and provides the Treasury with statutory authority to address other, as of yet unresolved issues, through future regulations. 75 See, e.g., PLR 200832009 (August 8, 2008); PLR 200817031 (April 25, 2008); PLR 200618009 (May 5, 2006).