The AJCA changes many REIT rules.The American Jobs Creation Act of 2004 (AJCA AJCA American Jobs Creation Act of 2004 (US) AJCA American Jersey Cattle Association AJCA Association of Juvenile Compact Administrators AJCA All Japan Cooks Association AJCA Alabama Junior Cattlemen’s Association ) 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 REIT See: Real Estate Investment Trust REIT See real estate investment trust (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 AJCA's 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 REIT's 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 REIT'S gross income exceeds the amount of items subject to the 95% income test. This change may increase (and will not decrease) a REIT's penalty tax liability. Penalty tax computation: This computation begins with the greater of the excess of (1) 95% (pre-AJCA, 90%) of the REIT's 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 REIT'S 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 item's scope). Next, the greater of these two amounts is multiplied by a fraction. Under Sec. 857(b)(5), the fraction's numerator numerator the upper part of a fraction. numerator relationship see additive genetic relationship. numerator Epidemiology The upper part of a fraction is REIT taxable income Under the federal tax law, gross income reduced by adjustments and allowable deductions. It is the income against which tax rates are applied to compute an individual or entity's tax liability. The essence of taxable income is the accrual of some gain, profit, or benefit to a taxpayer. computed without regard to (1) the dividends-paid deduction (DPD DPD Department of Planning and Development DPD Dihydropyrimidine Dehydrogenase DPD Dead Peer Detection (Cisco) DPD Division of Parasitic Diseases (US CDC) DPD Dominant Wave Period DPD Drug Product Database ); (2) the deduction for the Sec. 857(b)(5) penalty tax; (3) any net operating loss operating loss The excess of operating expenses over revenue. As with operating income, operating losses exclude revenues and expenses from operations that are not considered a regular part of the business. Also called deficit. Compare operating income. deduction; and (4) any net capital gain. The fraction's denominator is the REIT's 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 Long-term capital gain A profit on the sale of a security or mutual fund share that has been held for more than one year. ; and (4) short-term capital gain Short-term capital gain A profit on the sale of a security or mutual fund share that has been held for one year or less. A short-term capital gain is taxed as ordinary income. 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 issuer's voting securities or (2) the value of an issuer's 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 Safe Harbor 1. A legal provision to reduce or eliminate liability as long as good faith is demonstrated. 2. A form of shark repellent implemented by a target company acquiring a business that is so poorly regulated that the target itself is less attractive. 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 Taxable REIT Subsidiaries (TRSs) allow real estate investment trusts (REITs) to more effectively compete with other real estate owners. They do this by providing services to tenants or third parties such as landscaping, cleaning or concierge, and they provide new AJCA Section 243(b) amended the taxable REIT subsidiary (TRS See traffic engineering methods. TRS - term rewriting system ) rules intended to prevent income shifting Income Shifting A strategy of moving a person's income from a high income bracket or tax rate to a lower one. Notes: One popular form of income shifting is applying some of a person's income to their child. See also: Income Tax, Tax Table from aTRS to a REIT. Sec. 857(b)(7)(A) provides that a 100% excise tax Excise Tax 1. An indirect tax charged on the sale of a particular good. 2. A penalty tax applied to ineligible transactions in retirement accounts. This penalty is assessed by and paid to the IRS. Notes: 1. may be imposed on non-arm's-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 safe harbor rule Antitrust law A federal guideline as to what constitutes antitrust activity, established by the FTC and Justice Dept, after specific legislation–which might be open to misinterpretation–is enacted. Cf Self-referral. t-or 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 An abbreviated form of the Latin Maxim de minimis non curat lex, "the law cares not for small things." A legal doctrine by which a court refuses to consider trifling matters. 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 AJCA's 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 A method employed to calculate the decline in the value of income-producing property for the purposes of federal taxation. Under this method, the annual depreciation deduction that is used to offset the annual income generated by the property is determined by dividing the 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 building's 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 effect--these 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 Depreciated may refer to:
Thus, 40-year straight-line is used to calculate real estate depreciation when computing a REIT's E&R 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 REIT's 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 LL.M Legum Magister (Master of Laws) ., CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. , WASHINGTON, DC |
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