The AJCA Changes Many REIT Rules

The American Jobs Creation Act of 2004 (AJCA) made numerous changes to the detailed rules governing real estate investment trusts (REITs); many of these changes are favorable. For example, REITs are more attractive to foreign investors under the new law, and certain failures to meet the detailed REIT qualification rules result in less dire consequences. The AJCA also changed the REIT qualification rules and some depreciation rules affecting real estate. This item summarizes the AJCAs REIT-related law changes.

95% Income Test

One of the REIT qualification rules is the Sec. 856(c)(2) 95% income test, which generally requires that a REIT derive at least 95% of its gross income from certain passive sources. If a REIT fails this test, a portion of its gross income is subject to a penalty tax under Sec. 857(b)(5), computed using a complicated formula intended to distinguish a REITs qualifying net income from its nonqualifying income.

Penalty tax change: AJCA Section 243(e) changed the part of the penalty tax formula relating directly to the 95% income test; it increased this component to the amount by which 95% (formerly 90%) of the REITs gross income exceeds the amount of items subject to the 95% income test. This change may increase (and will not decrease) a REITs penalty tax liability.

Penalty tax computation: This computation begins with the greater of the excess of (1) 95% (pre-AJCA, 90%) of the REITs gross income (excluding income from prohibited transactions) over qualified gross income under the Sec. 856(c)(2) 95% income test; and (2) 75% of the REITs gross income (excluding that from prohibited transactions) over the qualified gross income under the Sec. 856(c)(3) 75% income test (this test is beyond this items scope).

Next, the greater of these two amounts is multiplied by a fraction. Under Sec. 857(b)(5), the fractions numerator is REIT taxable income computed without regard to (1) the dividends-paid deduction (DPD); (2) the deduction for the Sec. 857(b)(5) penalty tax; (3) any net operating loss deduction; and (4) any net capital gain. The fractions denominator is the REITs gross income, less (1) gross income from prohibited transactions; (2) gross income from foreclosure property which, but for the foreclosure property provisions (see Sec. 856(e)) would not be qualified income under the 75% income test; (3) long-term capital gain; and (4) short-term capital gain to the extent of short-term capital loss.

Hedging transactions: AJCA Section 243(d) also excluded income generated by hedging transactions from gross income for purposes of the 95% income test and modified the applicable definition of hedging to conform to that provided in Sec. 1221(b)(2)(A)(ii) and (iii); see Sec. 856(c)(5)(G).

Straight Debt Exception to 10% Rule for Securities

REITs cannot own more than 10% of (1) an issuers voting securities or (2) the value of an issuers outstanding securities, under Sec. 856(c)(4)(B)(iii)(II) and (III). However, Sec. 856(m) provides an exception for straight debt securities. Under pre-AJCA Sec. 856(c)(7), many debts owed to a REIT by individuals and businesses did not qualify for this exception. AJCA Section 243(a)(2) added a safe harbor to Sec. 856(m), excluding from the 10% value test loans to individuals or estates, Sec. 467 rental agreements, obligations to pay real property rents, certain government bonds and REIT securities. AJCA Section 243(a)(2) also provided favorable modifications to certain details of the straight debt exception; see Sec. 856(m)(2).

Taxable REIT Subsidiaries

AJCA Section 243(b) amended the taxable REIT subsidiary (TRS) rules intended to prevent income shifting from a TRS to a REIT. Sec. 857(b)(7)(A) provides that a 100% excise tax may be imposed on non-arms-length rents. Under prior law, this tax did not apply to services customarily rendered in connection with real property rentals; see pre-AJCA Sec. 857(b)(7)(B)(ii). AJCA Section 243(c) removed this customary services safe harbor. Rents from TRSs, under certain circumstances, may be treated as qualified rental income (i.e., income treated as rents from real property for Sec. 856 purposes). AJCA Section 243(b) added new safe harbor provisions for testing whether rents from TRSs are qualified rental income; see Sec. 856(d)(8)(A).

Timber REITs

The AJCA added safe harbor rules for real estate sales by timber REITs. According to Sec. 857(b)(6)(D), transactions complying with these rules are not prohibited transactions.

Status Preservation

AJCA Section 243(f) provides relief for certain failures to comply with some of the REIT requirements. If a REIT fails to meet the Sec. 856(c)(4) asset test, REIT status is nevertheless preserved, according to Sec. 856(c)(7)(B), if (1) the failure was due to reasonable cause and not willful neglect, (2) the failure is corrected and (3) a penalty is paid (except for de minimis cases). Other requirements and conditions apply.

Foreign Shareholders

Secs. 857(b)(3)(F) and 897(h)(1), as amended by AJCA Section 418(a) and (b), treat capital gain distributions on REIT stock owned by foreign investors as dividends, if the foreign investor owns a sufficiently low percentage of the stock (5% or less). This modification brings the treatment of REIT distributions to foreign investors into closer alignment with that of other corporate distributions. It eliminates certain unfavorable tax results previously required under the Foreign Investment in Real Property Tax Act of 1980.

Effective Dates

The AJCAs modifications to the 95% income test, customary services exception and the timber REIT, status preservation and foreign shareholder rules apply to tax years beginning after Oct. 22, 2004. The other new REIT rules described above apply to tax years beginning after 2000.

Depreciation

The AJCA also amended certain real property depreciation rules. Specifically, AJCA Section 211(a)(c) reduced the depreciation period for certain leasehold improvements to 15 years and requires use of the straight-line method; see Sec. 168(e)(3)(E)(iv) and (e)(6). Under prior law, the depreciation period was generally 39 years (27.5 years for residential property). Another new rule, Sec. 168(e)(3)(E)(v) and (e)(7), allows 15-year straight-line depreciation for improvements made to buildings used predominantly as restaurants. To qualify for either of these depreciation benefits, the improvements must be placed in service (1) after Oct. 22, 2004 and before 2006; and (2) more than three years after the buildings construction was completed. Additional conditions apply to the leasehold improvements provision.

The depreciation changes for qualified leasehold improvements and qualified restaurant property are generally quite favorable for real estate holders. For REITs, however, there is an important side effectthese changes increase the difference between the depreciation used for computing taxable income and that used for computing earnings and profits (E&P). This issue is not unique to the 2004 depreciation changes; it occurs whenever Congress enacts tax law allowing real estate to be depreciated over less than 40 years. The issue arises because Sec. 312(k)(3) requires use of alternative depreciation system (ADS) depreciation in computing E&P. The Sec. 168(g)(2) ADS rules provide that the depreciation period for nonresidential real property and residential rental property is 40 years, and require use of the straight-line method.

Thus, 40-year straight-line is used to calculate real estate depreciation when computing a REITs E&P. This is slower than the cost recovery periods used to compute taxable income, and particularly slower than the accelerated 15-year period granted by the two new depreciation provisions. The E&P computation is important for calculating the dividends paid to shareholders and the REITs DPD.

Conclusion

The AJCA included many provisions affecting REITs; overall, their effect is quite favorable. However, some REITs will be adversely affected by the new rules. Tax advisers should be sure to consider the new law when advising REIT clients.

From Stefan Gottschalk, J.D., LL.M., CPA, Washington, DC