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REIT Provisions under American Jobs Creation Act of 2004

REIT Provisions under American Jobs Creation Act of 2004 I. OVERVIEW Under present law, a Real Estate Investment Trust ("REIT") is effectively a pass-through entity, achieving one level of taxation through a deduction for dividends paid to its shareholders under Internal Revenue Code (the "Code") section 857. To maintain its qualification as a REIT, a REIT must satisfy tests relating to: organizational structure, source of income, nature of assets, and distribution of income. The asset tests are generally measured each quarter. In order to maintain its status, a REIT is generally restricted to investing in passive investments, primarily in real estate (and to a lesser extent securities). The American Jobs Creation Act of 2004 (the "Jobs Act"), signed by President Bush on October 22, 2004, changed the law affecting REITS in the following ways: II. ASSET REQUIREMENTS A. Background To satisfy the REIT asset test requirements, at the close of each quarter of its taxable year, an entity must have at least 75% of the value of its assets invested in real estate assets, cash and cash items, and government securities (the "75% asset test"). The term real estate assets is defined to mean real property (including interests in real property and mortgages on real property) and interests in other REITs. Therefore, a REIT cannot own securities (other than government securities and certain real estate assets) with an aggregate value greater than 25% of the value of all of its assets. In addition, a REIT may not own such securities of any one issuer representing more than 5% of the total value of the REIT's assets, more than 10% of the voting securities of an issuer, or 10% of the value of the outstanding securities of any one issuer. Securities for purposes of these rules are defined by reference to the Investment Company Act of 1940. Prior to January 1, 2001, REITs were prohibited from owning more than 10% of the voting securities of any issuer, but ownership of nonvoting securities was not limited. Under applicable regulations, equity in partnerships was not treated as a security and instead the REIT was deemed to own its proportionate share of the partnership's assets. Effective January 1, 2001, the 10% asset test was changed to prohibit a REIT from owning more than 10% of the voting securities or securities representing more than 10% of the value of the securities of any issuer. As a result of this seemingly simple change in the statute, debt issued by partnerships was swept into the 10% asset test regime and the restrictions on owning corporate securities were greatly expanded. An exception was provided in limited cases involving "straight debt" (as defined under the S corporation rules with certain modifications). B. New Legislation The Jobs Act modifies the rules surrounding the "10% value test," in the following ways: 1. For purposes of the 10% value test, the term "securities" does not include: (a) Loans to individuals and estates; (b) Securities issued by REITS; (c) Securities issued by foreign, state and local governments (securities issued by the U.S. Government were always excluded); (d) Section 467 loans; (e) Obligations to pay rent; (f) Equity interests in a partnership. (g) Any other arrangement as determined by the Secretary. 2. The straight debt exception is modified as follows: (a) Securities qualifying as "straight debt" are not considered securities, for purposes of the 10% value test. (b) Securities will not be considered straight debt, if (i) the REIT owns any securities other than straight debt (i.e., "nonstraight debt" or equity) in the issuer and (ii) such other securities make up more than 1% of the value of the issuer's outstanding securities (including equity). (c) Straight debt will not fail to qualify as straight debt despite containing certain enumerated contingencies (which are very narrowly circumscribed). 3. The legislation adds a "super-look through" rule: (a) If a REIT owns securities in a partnership, then for purposes of the 10% value test, the REIT is deemed to own its share of the partnership's assets. (b) The REIT's share is equal to (i) the value of all securities of the partnership owned by the REIT other than straight debt (i.e., "nonstraight debt" or equity) divided by (ii) all securities of the partnership outstanding other than straight debt owned by the REIT. (c) As a result, any REIT owning debt in a partnership which does not qualify as straight debt will now need to examine the assets of the underlying partnership to determine whether the partnership's assets will cause the REIT to fail the 10% value test. 4. Two more exceptions were added to the 10% value test: (a) If a REIT owns equity in a partnership, other securities of such partnership owned by the REIT are disregarded to the extent of the REIT's equity ownership. Thus, for example, if a REIT owns 20% of a partnership and holds a $100 receivable from such partnership, for purposes of the 10% value test, only $80 of the receivable is taken into account. (b) Securities of a partnership issuer will not be considered securities for purposes of the 10% value test, if the partnership meets the 75% real estate gross income test (described in Part III below) which applies to REITs. Note: These two rules are ignored for purposes of the super-look through rule (but not for purposes of the 1% calculation described in paragraph 2(b) above). 5. These new rules are retroactive to taxable years beginning after December 31, 2000, except for the super-look through rule described in paragraph 3 above, which applies to taxable years beginning after October 22, 2004. III. RENTS FROM REAL PROPERTY; TRS RENTAL EXCEPTION; SAFE HARBOR TESTING DATES A. Income Requirements: Background In order for an entity to qualify as a REIT, at least 95% of its gross income generally must be derived from certain passive sources (the "95% income test"). In addition, at least 75% of its income generally must be derived from certain real estate sources (the "75% income test"; collectively with the 95% test, the "income tests"), including "rents from real property" , gain from the sale or other disposition of real property, and income and gain derived from foreclosure property. Rents from real property, for purposes of the income tests, generally do not include any amount received or accrued from any person in which the REIT owns, directly or indirectly, 10% or more of the vote or value. An exception applies, in certain cases, to rents received from a taxable REIT subsidiary of the REIT (a "TRS"). If a REIT leases space to a TRS, amounts paid by the TRS to the REIT will not be excluded from rents from real property if: (1) at least 90% of leased space at that property is rented to persons other than TRS's and entities related to the REIT (the "90% test"), and (2) the rent the TRS pays to the REIT is "substantially comparable" to rents paid for "comparable space" by the unrelated tenants of that property (the "substantial comparability test"). Prior to the new law, the two requirements stated above arguably had to be met at all times. B. New Legislation 1. The Jobs Act liberalizes this rule by providing specific testing dates. 2. If requirements (1) and (2) above are met at the following times: (a) At the time the TRS lease is entered into; (b) At the time of each extension of the lease (including failure to exercise a right to terminate); and (c) At the time of any modification of the lease, when there is a rent increase pursuant to such modification, then the 90% test and the substantial comparability test will be treated as continuing to be met, as long as there is no increase in the amount of space leased by the TRS or related parties. 3. Correction Period. If there is an increase in the space leased to a TRS during any calendar quarter with respect to any property, the 90% test and substantial comparability test will be treated as met during that quarter and the succeeding quarter if such requirements are met at the close of such succeeding quarter. 4. These new rules are retroactive to taxable years beginning after December 31, 2000. IV. REDETERMINED RENTS; 100% EXCISE TAX; DELETION OF CUSTOMARY SERVICES EXCEPTION FOR TRS A. Background Transactions between a TRS and a REIT are subject to a number of rules that are intended to prevent the TRS (taxable as a separate corporate entity) from shifting taxable income from its activities to the REIT (which is generally not subject to tax as a practical matter) or from absorbing more than its share of expenses. Generally, a REIT is subject to a 100% excise tax on "redetermined rents." Redetermined rents are the portion of rents paid by a tenant to a REIT that, under section 482 standards, would be allocated to a TRS as a result of services furnished by the TRS to tenants of the REIT. Prior to the new law, there was a safe harbor that allowed a REIT to be exempt from the 100% excise tax with respect to such rents if the rents were reallocated under section 482 for services performed by a TRS which are customary under section 856(d)(1)(B) or section 512(b)(3). B. New Legislation The Jobs Act repeals the safe harbor described above. The repeal is effective for taxable years beginning after October 22, 2004. V. NINETY-FIVE PERCENT INCOME TEST; HEDGING TRANSACTIONS A. Background Prior to the new law, under the 95% income test (except as provided in regulations), a payment to a REIT under an interest rate swap or cap agreement, option, futures contract, forward rate agreement, or any similar financial instrument, entered into by the REIT in a transaction to reduce the interest rate risks with respect to any indebtedness incurred or to be incurred by the REIT to acquire or carry real estate assets, and any gain from the sale or other disposition of any such investment, was treated as income qualifying for the 95% income test. B. New Legislation The Jobs Act generally conforms the definition of hedging instruments for purposes of the 95% income test to the general definition of "hedging" under section 1221, and excludes income from such hedging transactions from gross income for purposes of the 95% income test. Under the new law, income from a hedging transaction (as defined in section 1221(b)(2)(A)(ii) or (iii)), clearly identified under section 1221(a)(7), including gain from the sale or disposition of such a transaction, will be excluded from gross income under the 95% income test to the extent the hedge relates to indebtedness incurred or to be incurred by the REIT to acquire or carry real estate assets. This new hedging provision applies to taxable years beginning after October 22, 2004. VI. CONSEQUENCES OF FAILURE TO MEET REQUIREMENTS A REIT loses its status as a REIT, and becomes subject to tax as a C corporation, if it fails to meet the various tests regarding its sources of income, the nature and amount of its assets, its structure, and the amount of income distributed to shareholders. If a REIT election has been terminated, the successor corporation is not eligible to make an election to be treated as a REIT prior to the fifth taxable year which begins after the first taxable year for which the termination is effective. A. Income Test Failure; Exceptions 1. Background Under prior law, if a REIT failed to meet the income tests, but had set out the income it earned on a schedule (attached to the REIT's tax return) and any error in the schedule was not due to fraud with intent to evade tax, then the REIT did not lose its REIT status, provided that the failure to meet the 95% or 75% income test was due to reasonable cause and not to willful neglect. If the REIT qualified for this relief, the REIT had to pay the disallowed income as a tax to the Treasury. Under prior law, the amount of tax due was based on the greater of (i) the amount by which 90% of the REIT's gross income exceeded the amount of items qualifying under the 95% income test, or (ii) the amount by which 75% of the REIT's gross income exceeded the amount of items qualifying under the 75% income test. 2. New Legislation Under the Jobs Act, a schedule with a description of each item of the REIT's gross income for a taxable year is required to be filed with the IRS only after a failure to satisfy the 75% and/or 95% income test is identified by the REIT. The Jobs Act also amends section 857(b)(5) so that the tax liability owed by the REIT when it fails to meet the 95% income test is calculated by applying a taxable fraction based on 95%, rather than 90%, of the REIT's gross income. These provisions apply to taxable years beginning after October 22, 2004. B. Asset Test Failure; Exceptions 1. Background Under prior law, failure to satisfy the asset tests was excused only if the REIT eliminated the discrepancy within 30 days after the close of the quarter during which the failure occurred. 2. New Legislation Under the new law, two exceptions have been added. (a) Certain de mimimis Failures of 5% or 10% Asset Tests A REIT will not lose its REIT status for failing to satisfy the 5% and 10% asset tests in a quarter if: (i) the failure is due to the ownership of assets the total value of which does not exceed the lesser of (x) 1% of the total value of the REIT's assets at the end of the quarter for which such measurement is done and (y) $10 million; and (ii) the REIT either disposes of such assets causing the failure, within six months after the last day of the quarter in which the REIT identifies the failure (or such other time period prescribed by the Treasury), or otherwise meets the requirements of those rules by the end of such time period. (b) Larger Asset Test Failures (5%, 10%, 75% or Other Asset Tests) Under the Jobs Act, if a REIT fails to meet any of the asset test requirements for a particular quarter, and the failure doesn't qualify under the de minimis threshold described above, then the REIT still will be deemed to have satisfied the asset tests if: (i) following the REIT's identification of such failure, the REIT files a schedule with a description of each asset that caused the failure, in accordance with regulations prescribed by the Treasury; (ii) the failure is due to reasonable cause and not to willful neglect; (iii) the REIT disposes of such assets within 6 months after the last day of the quarter in which the identification of the failure occurred or such other time period as is prescribed by the Treasury (or the requirements of the rules are otherwise met within such period); and (iv) the REIT pays a tax (described below) on the failure. The tax that the REIT must pay on the failure is the greater of (i) $50,000, or (ii) an amount determined (pursuant to regulations) by multiplying the highest rate of tax for corporations under section 11, by the net income generated by the assets listed in the schedule described above (that caused the REIT to fail the asset test) for the period beginning on the first date of the failure and ending on the date the REIT has disposed of such assets (or the end of the first quarter during which there is no longer a failure of the asset tests). These provisions are effective for taxable years beginning after October 22, 2004. C. Other Failures of REIT Qualification Tests Under the Jobs Act, if a REIT fails to satisfy one or more requirements for REIT qualification, other than the 95% and 75% income tests and other than the new rules described above with respect to exceptions for failure of the asset tests, the REIT may retain its REIT qualification if: (i) such failures are due to reasonable cause and not to willful neglect; and (ii) the REIT pays a penalty of $50,000 for each failure. This provision is effective for taxable years beginning after October 22, 2004. D. Taxes and Penalties Paid Deducted From Amount Required to Be Distributed by REIT Any taxes or penalties paid under the new provisions are deducted from the net income of the REIT in determining the amount the REIT must distribute under the 90% distribution requirement. VII. OTHER CHANGES In addition to the foregoing, the following changes affecting REITs were made by the Jobs Act: A. Deficiency Dividends Technical changes were made to facilitate a REIT's ability to take advantage of deficiency dividend procedures in the event the REIT did not make sufficient distributions under the 90% distribution requirement in a prior period. These changes are effective for taxable years beginning after October 22, 2004. B. Exception to FIRPTA Treatment for Certain REIT Distributions 1. Background Under the Foreign Investment in Real Property Tax Act of 1980 ("FIRPTA"), a foreign shareholder of a REIT who receives certain distributions attributable to dispositions of U.S. real property by the REIT generally is treated as having disposed of an interest in U.S. real property; and gain from such deemed disposition is taxable under FIRPTA. Recipients of such dividends are required to file a U.S. tax return. In addition, if the shareholder is a foreign corporation, then any income may be subject to the 30% branch profits tax (or taxed at a reduced treaty rate). 2. New Legislation (a) The Jobs Act creates an exception to this "look-through" rule and excludes such distributions from treatment under FIRPTA for shareholders of a public REIT owning 5 percent or less of a class of the publicly traded stock of the REIT. Under this exception: (i) No U.S. tax return is required. (ii) The distribution is treated as an ordinary REIT dividend. (iii) The branch profits tax no longer applies. (b) The new exception conforms to the previously existing exception applicable for gain recognized by public shareholders owning less than 5% of a class of publicly traded REIT stock, upon disposition of their REIT shares and removes a substantial disincentive to foreign investment in public REITs. (c) This provision applies to taxable years beginning after October 22, 2004. C. Timber REITS The Jobs Act contains a modified prohibited transactions rule for timber REITs. If you have any questions regarding the enclosed, please call Ezra Dyckman (212) 903-8785, Lary Wolf (212) 903-8719, Morris Kramer (212) 903-8783, or Elliot Pisem (212) 903-8777. Roberts & Holland LLP