Real Estate Investment Trusts
Real Estate Investment Trusts
1962
Recommended Citation
Theodore Lynn, Real Estate Investment Trusts: Problems and Prospects, 31 Fordham L. Rev. 73 (1962).
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REAL ESTATE INVESTMENT TRUSTS: PROBLEMS
AND PROSPECTSt
THEODORE LYNN*
I. INTRODUCTION
IT would seem logical that entities engaging in essentially the same
activities should be taxed essentially the same-that the choice of
business form should not affect taxation and, in reverse, taxation should
not affect the choice of business form.' Yet, this is not so. The Internal
Revenue Code has been characterized, in this regard, as a "crazy-quilt
of exceptions, exemptions, deductions and special provisions." 2 In alter-
ing business entity taxation, special provisions have been made for regu-
lated investment companies, 3 common trust funds,* partnerships,O co-
operatives," life insurance companies, 7 mutual savings banks," and mutual
fire and casualty insurance companies. 9 In addition certain corporations
may elect to be treated as if they were not corporations,' and certain
other business enterprises may elect to be taxed as if they were corpora-
tions."
The most recent manifestation of Congress' sporadic interest in relief
of entity taxation is the real estate investment trust legislation, enacted in
1960 as an addition to the 1954 Code.' 2 As a result, real estate investment
trusts complying with sections 856 through 858 of the Code are granted
a deduction from corporate tax for dividends paid, including a capital
gains "pass-through."' 13 The writer submits that under present circum-
This article is based on an honor paper submitted to Profczsor Frank Sander of
Harvard Law School. The author is indebted to Professor Sander, Herbert Alport, Wilfred
Godfrey, Harry Goldberg, Marvin Kratter, Charles Post, Daniel Smith and David Wc-tfall.
* Member of the New York Bar.
1. The tax laws "must accord the same tax treatment to what is essentially the came
type of operation irrespective of the form in which it is cast." Address by Repre.entative
Ails, in Kilpatrick, Real Estate Investment Trusts, 3 Tax Revision Compendium 1697,
1700 (1959).
2. Cary, Pressure Groups and the Increasing Erosion of the Revenue Las, Joint Com-
mittee on the Economic Report, 84th Cong., 1st Ses. 260, 272 (1955).
3. Int. Rev. Code of 1954, § 851-55.
4. Int. Rev. Code of 1954, § 584.
S. Int. Rev. Code of 1954, §§ 701-71.
6. Int. Rev. Code of 1954, §§ 521-22.
7. Int. Rev. Code of 1954, 3§ S01-18.
S. Int. Rev. Code of 1954, 33 591-94.
9. Int. Rev. Code of 1954, 3§821-23.
10. Int. Rev. Code of 1954, §§ 1371-77.
11. Int. Rev. Code of 1954, § 1361.
12. Int. Rev. Code of 1954, §§ S56-53.
13. Int. Rev. Code of 1954, § 357(b).
FORDHAM LAW REVIEW [Vol. 31
stances, as a matter of fiscal policy and equity, the conduit treatment of
real estate investment trusts is not justified.
49. An early Treasury reaction is alleged to be: if realty trusts can tahe a deduction
for distributed income why can an automobile company not do so? The automobile
company can be said to be only in the business of investing in automobiles and pasAng
on the income to shareholders.
50. H.R. 4392, S4th Cong., 2d Sess. (1956).
51. 102 Cong. Rec. 15304, 15305 (1956).
52. Ibid.
53. H.R. 3102, S5th Cong., 1st Sess. (1957).
54. See note 50 supra.
55. HR. S3S, 85th Cong., 2d Sess. (1953).
56. H.R. 12559, 86th Cong., 2d Sess. (1960).
57. Pub. L. No. S6-779, S6th Cong., 2d Sess. (Sept. 14, 1960).
FORDHAM LAW REVIEW [Vol. 31
III. ANALYSIS OF THE CODE PROVISIONS AND TREASURY REGULATIONS
As a result of this legislation, a new entity, the real estate investment
trust, was made available for service as a tax free conduit for distributed
net income. The new law took effect on December 31, 196018 and on
April 28, 1962, the final treasury regulations pertaining to it were pro-
mulgated. 59
A. OrganizationAttributes for Real Estate
Investment Trust Qualification
To qualify as a real estate investment trust, an entity must: (1) be
organized as an unincorporated trust or association; 0 (2) be managed
by trustee(s);61 (3) contain transferable shares or certificates held by
100 or more persons; G2 (4) be taxable as a domestic corporation but for
this law; 6 3 (5) elect irrevocably to be treated as a real estate investment
trust; 64 (6) avoid control by five or fewer individuals of fifty per cent or
more of the trust's beneficial ownership during the last half of the
taxable year;6 5 (7) avoid the holding of any property for sale to cus-
tomers in the ordinary course of trade or business;' and (8) meet the
requirements of the law respecting assets, diversification, income, and
distribution. 7
1. Unincorporated Trust or Association
It is clear that a corporation cannot qualify as a real estate invest-
ment trust because of this provision,68 but there still seems to be some
question as to the ability of limited partnerships to qualify. Although
the statute requires management by "trustees," it permits "unincorpo-
rated associations" to qualify. Confusion was induced by this, since the
latter are not usually managed by trustees. The proposed regulations
expressly stated that an entity considered under state law to be a limited
partnership could not qualify "because a partner thereof is not consid-
ered to be a trustee. . . ."' This statement, however, has been deleted
58. Int. Rev. Code of 1954, §§ 856-58.
59. Treas. Regs. §§ 1.856-1 to 1.858-1 (1962).
60. Int. Rev. Code of 1954, § 856(a).
61. Int. Rev. Code of 1954, § 856(a) (1).
62. Int. Rev. Code of 1954, §§ 856(a) (2), 856(a) (5).
63. Int. Rev. Code of 1954, § 856(a) (3).
64. Int. Rev. Code of 1954, § 856(c) (1).
65. Int. Rev. Code of 1954, § 856(a) (6).
66. Int. Rev. Code of 1954, § 856(a) (4).
67. Int. Rev. Code of 1954, § 856(c) (2)-(6).
68. H.R. 1806, 87th Cong., 1st Sess. (1961) would have extended qualification to
corporations, but it was not enacted.
69. Proposed.Treas. Reg. § 1.856-1(d) (1), 26 Fed. Reg. 604 (1961).
1962] REAL ESTATE
from the final regulations and, therefore, it might be argued that the
inconsistency has been resolved in favor of allowing qualification for
limited partnerships. But the Code also prescribes that a real estate
investment trust must be subject to the corporate income tax but for
qualification. Limited partnerships are usually not subject to the corpo-
rate tax so that doubt still remains as to whether a limited partnership
may qualify as a real estate investment trust.
2. Management by Trustee(s)
The proposed regulations defined a "trustee" as one who holds legal
title to the property, has exclusive control over the trust management and
affairs "free from any power of control on the part of shareholders other
than the right to elect trustees," and has exclusive control over property
management including the sale thereof."0 This definition elicited much
protest among the interested parties. One conunentator argued that
shareholders should be permitted to amend and terminate the trust,
vote on mortgaging or selling substantially all the trust property, ap-
prove trustee compensation, remove trustees, and approve management
contracts. 7 A second noted that state law restrictions require the use
of nominees in certain situations and, therefore, suggested that this
should be allowed.72 The final treasury regulations have incorporated
some of the above suggestions. Now, the trustee's continuing exclusive
authority over the management and affairs of the trust will be considered
to exist "even though the trust instrument grants to the shareholders"
the rights and powers "to elect or remove trustees; to terminate the
trust; and to ratify amendments to the trust instrument proposed by
the trustee."73 Furthermore, the trustee will be considered as holding
legal title to the trust property even when the title is held in the name
of a nominee for the exclusive benefit of the trust.-'
Certain critics' suggested changes, such as beneficiary power to amend
the trust, hire the independent contractor and approve trustee compensa-
tion, were not included. It is submitted that this was correct since
Congress specifically chose the business trust form which is traditionall ,
one of little control by the beneficiary. This entire, question recalls the
recuriing theme that conduit treatment has been granted in an area
where the end limits are ones of degree rather than of kind. While there
is no logical reason to stop at the traditional business trust concept, this
70. Ibid.
71. Robbins, Comments Upon Proposed Regulations Relating to Real Estate Invest-
ment Trust, and Their Shareholders-Subchapter Al (1961).
72. Letter From Mr. Joseph W.Lund to the Internal Revenue Service (1961).
73. Treas. Reg. § 1.856-1(d)(1) (1962).
74. Ibid.
FORDHAM LAW REVIEW [Vol. 31
is where Congress arbitrarily drew the line, and it is no less logical
than any other line.
On the question of choice of trustees, it has been suggested that some
of the principal investors who have real estate experience should be
chosen. The prohibition against serving as both trustee and independent
contractor must, however, always be observed." Finally, state rules
against perpetuities may be applied against the trust and thus it might
be wise to include as "lives in being," young children of the trustees
in order to obtain additional continuity.
Then the regulations divide the concept of "services" into two categories:
"customary services for which no separate charge is made" and "services
for which a separate charge is made." Rent received for the former
will not be disqualified from the seventy-five per cent income test as
long as an independent contractor performs them, while rent received
for the latter will be disqualified. That which is customary and that
which is not customary is to be determined separately in each factual
situation.
It is rather unpleasant to realize that the question of trust qualifica-
tion, with its important economic consequences, may depend on whether
a telephone answering service is customary or extraordinary in the
specific fact pattern. It is not of much help to be told:
The supplying of water, heat, and light; the cleaning of windows, public entrances,
exits, and lobbies; the collection of trash; and the furnishing of elevator service,
telephone answering service, unattended parking lots, and watchman or guard
senices are examples of services which inay or may not (depending upon the cir-
cumstances) be customary or incidental to the mere rental of multiple-occupancy real
estate.' -
The only examples of services which are not customary are:
The furnishing of hotel, maid, boarding house, motel, attended parking lot, w:are-
house, or storage senices .... -122
The independent contractor must perform even customary services,
whatever they are, but the trust can bear the cost for them. The cost
of services which are not customary must be borne by the contractor
and a separate charge must be made for them. The independent con-
tractor must retain any amounts separately paid by the tenants for
"services," be they customary or noncustomary. A method of com-
pensating the contractor must be devised which will prevent the trust
from receiving income from services and which assures that the con-
(d) (1962).
120. Treas. Reg. § 1.856-4(b) (3) (i)
121. Treas. Reg. § 1.S56-4(b)(3)(i)(b) (1962). (Emphasis added.)
122. Treas. Reg. § 1.56-4(b)(3)(i)(c) (1962).
FORDHAM LAW REVIEW [Vol. 31
tractor will include in his taxable income all active service income.
Whether the trust can act as agent for the contractor in receiving money
from the tenants and passing it on to the contractor is unresolved.
Reasonable compensation based on an unadjusted percentage of gross
rents will usually be allowed.
The regulations are the only tangible "guide-lines" available regard-
ing the independent contractor device. The purpose of the concept is
to assure that the real estate investment trust will not derive any income
from active services, which income should be taxed to the independent
contractor outside the realty trust rules. But the several vague concep-
tual distinctions and the profusion of factual variations may result in
inadvertent disqualification and extensive litigation. It remains to be
seen whether the solution will not create more difficulties than the original
problem contemplated. The independent contractor concept, so vague
in theory, may become chaos in practice.
C. Asset Tests for Qualificationas a Real Estate Investment Trust
These rules deal with the nature of the assets and are to be dis-
tinguished from the previously discussed rules regarding source of income.
The statute provides for three tests regarding the type of assets which
a real estate investment trust may hold. First, seventy-five per cent
of the value of the trust's total assets must be in real estate, cash items,
and government securities. 2 ' Second, not more than twenty-five per cent
of the value of the trust's total assets may consist of nonqualifying
assets.' Third, not more than five per cent of the assets may be of
the nonreal-estate securities of any single issuer, nor may the trust
hold more than ten per cent of the voting securities of any single non-
real-estate issuer. 125
1. The Seventy-Five Per Cent Asset Test
Real-estate assets, cash items and government securities must comprise
seventy-five per cent of a trust's total assets. The definition questions
regarding "real property" and "interests in real property" have been
discussed previously. 26 The purpose of the seventy-five per cent asset
test is to require that the bulk of trust investments be placed in real
estate.
The seventy-five per cent asset test is one of comparative values at
a given time and the adjusted bases of the assets are irrelevant. "Value"
is defined as the fair market value as determined in good faith by the
123. Int. Rev. Code of 1954, § 856(c) (5) (A).
124. Int. Rev. Code of 1954, § 856(c) (5) (B).
125. Ibid.
126. See notes 100-02 supra and accompanying text.
1962] REAL ESTATE
trustees, except that the value of securities traded on an exchange
are their market quotations. 127 "Total assets" means gross assets and
it is doubtful that a deduction for mortgages or rental obligations will
be allowed.
The determination of whether the value of the trust's qualifying assets
constitutes seventy-five per cent of its total assets need only be made
at the end of those quarterly periods in which the trust has acquired new
property. Therefore, nonreal-estate asset "paper" appreciations in years
without acquisitions will not result in disqualification. Furthermore, the
trust has thirty days to eliminate any discrepancies resulting from a
comparative computation.
It may be that requiring valuation in the event of a minor acquisition
will be costily and burdensome. The disposition of substantially appre-
ciated property might be required if the seventy-five per cent asset test
is not satisfied, and the trust might incur a high tax cost. But it is
submitted that the law strikes a fair balance between a cumbersome
procedure of quarterly valuation and the desire that the bulk of the
trust's investments be placed in real estate.
Valuation would be required far more often if the trust wished to be
"open ended." An "open end" company guarantees to sell or redeem its
own shares at a price derived from an allocation of the underlying assets.
A "closed end" company exhibits a fixed capital structure and does not
sell or redeem its shares after the initial offering. It is submitted that
an "open end" trust will serve the small investor philosophy of the real
estate investment trust law better than a "closed end" trust. The small
investor prefers the liquidity of an "open end" trust. He prefers a valua-
tion of his interest which depends on underlying assets rather than the
vagaries of the stock market. Yet, most of the known "open end" funds
are valued daily. This is feasible when the fund's assets are comprised
of securities which have daily market valuations, but it is quite difficult
when relatively fixed real estate assets are involved. The second problem
with an "open end" real estate investment trust is the lack of liquidity
of real estate assets as compared with the liquid securities which com-
prise the bulk of regulated investment company assets. It is submitted
that the valuation difficulty might be met by monthly valuation. Re-
demption would be on a monthly basis, with those who present their
stock in the first twenty days of the month receiving redemption at the
end of the month. The trust would then have some time to sell sufficient
assets to meet a normal amount of redemptions. Liquidity might be
achieved by a "standby" purchase agreement bank loan, or by a surety
bond.
127. Treas. Reg. § 1.856-3(a) (1962).
FORDHAM LAW REVIEW [Vol. 31
An unintended use of the real estate investment trust device may be
trusts which deal solely in mortgages. Since mortgages on real estate
are comprehended in the seventy-five per cent asset test, a trust could
hold mortgages exclusively and still be granted a tax free "pass-through"
of income. High return but risky second mortgages could also be held.
This type of trust would also save expenses, as an independent con-
tractor would be unnecessary.
be wise. Also, reciprocally organized divided enterprises, with each tenant paying rent to
the real estate investment trust of the other, might be investigated.
154. Enterprise division for ezisting corporations would only involve previously
discussed problems if the trust restricted itself to property acquired after its creation.
155. Int. Rev. Code of 1954, § 351.
156. Int. Rev. Code of 1954, § 355 reads in part: "If ... a corporation ... distributes to
a shareholder, with respect to its stock . . all of the stock and securities in the controlled
corporation held by it immediately before the distribution ... then no gain or los shall hb
recognized to . . . such shareholder or security holder on the receipt of such stoc or
securities."
157. Compare Treas. Reg. § 1355-1(a) (1955), with Coady v. Commis sioner, 33 T.C.
771 (1960), aff'd mem., 2S9 F.2d 490 (6th Cir. 1961).
i5s. Appleby v. Commiss-ioner, 35 T.C. 755 (1961), aff'd mem., 296 F.2d 925 (3d Cir.),
FORDHAM LAW REVIEW [Vol. 31
reorganization sections require a "business purpose" which might be
difficult to sustain in this situation.
A partial liquidation might be an alternative method to effect the
enterprise division of an existing corporation. The corporation would
distribute the real property to its shareholders in a purported partial
liquidation under section 346.15 9 The shareholders would only undergo
capital gain treatment if a valid corporate contraction could be estab-
lished. The shareholders could then establish a real estate investment
trust which would hold the real estate and rent it to the corporation and
so forth. But section 346(b) would not be available, because that sec-
tion incorporates the same concept of two active businesses contained
in section 355.10
The concept of genuine corporate contraction is cloudy, but since
the distribution would be pro rata to the shareholders, it seems that
section 346(a)(2) would also not be available.' 0 ' The sanction for
failure to qualify under section 346 would be ordinary dividend treat-
ment for the shareholders.
It might further be suggested that the corporation redeem in full the
stock of some of the shareholders.10 2 These former shareholders would
then form a real estate investment trust and purchase the real estate
from the corporation with amounts received in the redemption. The
redeemed shareholders and the corporation would undergo capital gains
treatment. Even if this survives attack as a "sham," there are obvious
business problems and the essential substance of corporate division has
been lost.
Thus, in an enterprise division of an existing corporation, it is quite
likely that a dividend tax will have to be paid by the shareholders to
the extent of the corporation's earnings and profits. This expensive
consequence will dissuade most existing corporations from attempting
a corporate division. It may be warranted if the corporation is devoid
-of earnings and profits, or if some method can be devised to avoid
taxation. Otherwise, it is unlikely that there will be many corporations
sufficiently hardy to effect dividend treatment for their shareholders in
order to "buy" a law suit. Most existing corporations should, there-
fore, wait until this area has been further charted.
cert. denied, 370 U.S. 910 (1962); Treas. Reg. § 1.355-1(c) (2) (1955). See also Rev. Rul.
59-400, 1959-2 Cum. Bull. 114.
159. Int. Rev. Code of 1954, § 346.
160. Treas. Reg. § 1.346-1(c) (1955). See note 158 and accompanying text.
161. See Chandler v. Commissioner, 22 T.C. 1158 (1954), aft'd, 228 F.2d 909 (6th
Cir. 1955) (per curiam).
162. Int. Rev. Code of 1954, § 302.
1962] REAL ESTATE
C. Bzsizess Requiring an Independent Contractor
Previously it was asserted that common ownership of a real estate
investment trust and a corporate tenant, while risky, is not literally
violative of the statute. In those situations, it is the tenant and not
an independent contractor who is performing any and all service-type
activities. In a multiple tenant situation, however, an independent con-
tractor will usually be necessary. Office buildings and hotels will usually
require independent contractors to provide services. In these situations,
there will be no "tenant" which can perform the services for itself.
Common ownership will therefore be barred because of the thirty-five
per cent rule preventing substantial
63
common ownership of the trust
and the independent contractor
The thirty-five per cent rule does not literally prevent the situation
where a real estate investment trust would rent to a "tenant" who would
in-turn "sublet" the premises. The original tenant would perform the
services that an independent contractor would perform. Provided that
no shareholder of the tenant owned ten per cent of the trust, the attribu-
tion rules presumably would not apply and the real estate investment
trust would not be deemed to own the tenant. Hence, it would not
receive any disqualifying income from the tenant. This manipulation,
however, would most likely be pierced by the courts. In the multiple
tenant situation various services must be performed, and calling the
person who performs them "tenant" should not change the substance
of the situation. Also, state laws which provide that a "guest" at a
hotel is not a "tenant" should not change the result.
Hence, in the situation where it is contemplated that there will be a
disparate group of tenants, such as an office building or a hotel, it
appears unlikely that the enterprise division device can be utilized.
V. REGULATION
Real estate investment trust legislation was ostensibly prompted by
a desire to give small investors an opportunity to derive income from
real property interests. The inapt analogy of regulated investment com-
panies was offered in support of this concept. Yet the parallel has not
been extended to the one area in which it has merit: the need for some
form of operational regulation. It is submitted that legislation similar
to the Investment Company Act of 1940 should be enacted.
Real estate is a narrow field which requires very technical expertise.
The average investor will not usually have this expertise. He must,
163. See note 116 supra and accompanying text.
FORDHAM LAW REVIEW [Vol. 31
therefore, place great reliance on the trustees of a real estate investment
trust. The absence of operational regulation creates a potentially danger-
ous situation where the fraud or incompetence of unregulated trustees
could result in great loss. "[O]ver the years real estate has probably lost
money for a larger percentage of investors than any other single form
of financial venturing .... "164
Furthermore, deceptively high offers of approximately a twelve per
cent "return" are not rare for real estate syndications'"° and, pre-
sumably, trusts. Such offers induce the entry of unsophisticated small
investors. These investors do not realize that the "return" is in part,
a refund of capital. Often they do not comprehend that the trust will
have to invest in risk enterprises in order to maintain a high percentage
of profit.' 6
Moreover, there may be intense promotion of certain real estate in-
vestment trusts. Witness the promotion of regulated investment com-
panies and the problems there arising even though they are regulated.
Promotibn may be intense because there is a large profit potential for
promoters: they can sell property they own to the trust for an un-
regulated amount; they can become the independent contractor for an
unregulated compensation; their associates can become trustees of the
trust for an unregulated remuneration; their law firms can earn un-
regulated fees; their associates can become investment advisors at un-
regulated salaries, and so forth.6
Finally, investment in real estate investment trusts is inherently
"glamorous." These trusts are congressionally induced entities specifically
-designed to provide tax benefits for small investors. For the first time,
a freely transferable tax-free conduit, which might even be traded on a
stock exchange, is available. It may not be too surprising if the small
investor joins with something less than dispassionate analysis.
164. C. G. Haynsworth, N.Y. World Telegram and Sun, April 10, 1961, p. 27, col. 3.
165. For a discussion of real estate syndicates see Berger, Real Estate Syndication:
Property, Promotion, and the Need for Protection, 69 Yale L.J. 725 (1960); Comment,
Real Estate Syndication, 30 Fordham L. Rev. 440 (1962).
166. "Today . . . returns of over 7 or 72 percent cannot be paid on real estate equities
with safety. . . . Unfortunately, the . . . psychology is being built up. .. " Charles Noyes,
N.Y. World Telegram and Sun, Dec. 28, 1960, p. 19, col. 1.
167. See, e.g., the following advertisement: "SOMETHING NEW HAS BEEN ADDED
• . . ANNOUNCING . . . FIRST REAL ESTATE INVESTMENT TRUST FUND . . .
Organized Especially to Qualify for the Tax Benefits of the New Federal Law Which Grants
Tax Exemptions .. . REAL ESTATE SYNDICATE INVESTMENT HAS IN THE PAST
AFFORDED DISTRIBUTIONS TO ITS OWNERS AT THE RATE OF APPROXI-
MATELY 10% OR MORE PER ANNUM . . . Special Tax Advantages available for the
first time ... ." N.Y. Times, Jan. 15, 1961, § 8, p. 5R, col. 1-3.
1962] .REAL ESTATE