REIT Improvement Act Becomes Law
←
→
Page content transcription
If your browser does not render page correctly, please read the page content below
REIT Improvement Act Becomes Law
Copyright © 2005 Thomson/West. Originally appeared in the Spring 2005 issue of Real Estate Finance Journal.
For more information on that publication, please visit http://west.thomson.com. Reprinted with permission.
Michael J. Brody and Ana R. Genender
In this article, the authors summarize the main provisions of the REIT
Improvement Act and address the signicant eects it has on REITs.
Late last year, President Bush signed the American history states that the 20 percent prots interest test
Jobs Creation Act of 2004, which, among other things, needed to be met with respect to all partnership issuers
amends certain provisions of the Internal Revenue in order for their debt securities to t within the straight
Code relating to real estate investment trusts debt safe-harbor.
(‘‘REITs’’). These provisions are commonly referred
to as the REIT Improvement Act (the ‘‘RIA’’). The
following is a brief summary of the RIA and its antici-
Exclusion Of Certain Securities From 10
pated eect on REITs. Percent Value Test
The RIA provides that certain securities, in addition to
Amendments Aecting The 10 Percent Value those that meet the straight debt safe-harbor, are not
subject to the 10 Percent Value Test, including any
Test loan to an individual, estate or government, any obliga-
A REIT generally may not own securities having a tion to pay rents from real property, ‘‘467 rental agree-
value of more than 10 percent of the total value of the ments,’’ and any security issued by a REIT. These
outstanding securities of any one issuer (the ‘‘10 exclusions were not available under prior law. Accord-
Percent Value Test’’). Debt securities that qualify ingly, the RIA allows REITs to make loans to individu-
under the ‘‘straight debt safe-harbor,’’ however, are als or others that do not constitute straight debt, without
not subject to this limitation. ‘‘Straight debt’’ gener- regard to the 10 Percent Value Test. In addition, the
ally is dened for this purpose as any written uncondi- RIA eliminates concern that amounts payable under a
tional promise to pay on demand or on a specied date lease (e.g., past due rents) could constitute a security
a xed amount in money if the interest rate and interest for purposes of the 10 Percent Value Test. Finally, the
payment dates are not contingent on prots, the bor- RIA authorizes the IRS to provide guidance on ar-
rower's discretion, or similar factors, and the debt is rangements that will not constitute a security for
not convertible. Under prior law, straight debt would purposes of the 10 Percent Value Test, even though the
only qualify for the straight debt safe-harbor if: arrangements could constitute a ‘‘security’’ for pur-
E the issuer was an individual; poses of the Investment Company Act of 1940.
E the only securities of the issuer held by the REIT
and any taxable REIT subsidiary (‘‘TRS’’) of the The Denition Of Straight Debt
REIT were straight debt; or Under prior law, for a debt instrument to constitute
E the issuer was a partnership in which the REIT straight debt, the interest rate and interest payment
held at least a 20 percent prots interest. dates could not be contingent on prots, the borrower's
Although the Internal Revenue Code established discretion, or similar factors. The RIA expands the def-
these provisions as alternatives, the relevant legislative inition of straight debt to include certain debt instru-
ments that provide for the following contingencies:
Michael J. Brody, a partner of Latham & Watkins LLP in Los Angeles, E the contingency relates to the time of payment
can be contacted at (213) 891-8724 or michael.brody@lw.com. Ana R.
Genender, an associate with Latham & Watkins LLP in Los Angeles, and does not have a signicant eect on the
can be contacted on (213) 891- 8721 or ana.genender@lw.com. instrument's yield to maturity;
THE REAL ESTATE FINANCE JOURNAL/SPRING 2005 1
@MAGNETO/VENUS/PAMPHLET02/ATTORNEY/REFJ/BRODYCPY SESS: 1 COMP: 04/26/05 PG. POS: 1REIT Improvement Act Becomes Law
E the contingency relates to the time of payment Ten Percent Value Test Look-Through Rule
and neither the aggregate issue price nor the ag-
A REIT is treated as owing its proportionate share of
gregate face amount of the issuer's instruments
the assets owned by any partnership in which it is a
held by the REIT exceeds $1,000,000 and not partner, determined in accordance with the REIT's
more than 12 months of interest that has not yet capital interest in the partnership and without taking
accrued can be required to be prepaid thereunder; into account the ownership of other partnership
or securities. Under the RIA, solely for purposes of the
E the contingency relates to the time or amount of 10 Percent Value Test, the REIT's interest in partner-
payment and is based upon a default or exercise ship assets is based upon the REIT's proportionate
of a prepayment right, but only if such contin- interest in all securities issued by the partnership other
gency is consistent with customary commercial than securities which are not subject to the 10 Percent
practice. Value Test (e.g., 467 rental agreements or rent receiv-
As a result of these changes, REITs may make loans ables) and straight debt (the ‘‘10 Percent Value Test
with broader repayment features than were permitted Look-Through Rule’’). This change may complicate
under prior law. REITs' compliance eorts because REITs may need to
prepare two sets of ‘‘look-through’’ calculations for
certain partnerships or LLCs (i.e., one for purposes of
Ownership Of Interests In The Issuer the 10 Percent Value Test and one for purposes of all
Under prior law, subject to the discussion in this article other REIT qualication requirements). The RIA also
regarding loans to partnerships, for the straight debt claries that a REIT's interest as a partner in a partner-
safe-harbor to apply, the REIT and any TRS of the ship is not considered a security for purposes of the 10
REIT could not own any securities of the issuer, other Percent Value Test.
than securities that met the straight debt safe harbor.
As a result of the RIA, a loan to a corporation or Exclusion Of Certain Loans To Partnerships
partnership may qualify as straight debt if the REIT
group (including any TRS more than 50 percent of The RIA provides that certain debt instruments issued
which is directly or indirectly owned by the REIT (a by partnerships to REITs are not treated as securities
‘‘Controlled TRS’’)) holds securities of the issuer that for purposes of the 10 Percent Value Test. First, a debt
qualify as straight debt and securities that do not instrument issued by a partnership to a REIT that does
qualify as straight debt, provided such nonqualifying not qualify for the straight debt safe-harbor is not
securities do not have an aggregate value of greater considered a security to the extent of the REIT's inter-
than one percent of the issuer's outstanding securities. est as a partner in the partnership. Second, a debt
This provision allows a REIT to make straight debt instrument issued by a partnership to a REIT that does
loans to entities in which it owns a de minimis interest, not qualify for the straight debt safe-harbor will not be
even if such interest is not itself straight debt. considered a security if at least 75 percent of the
partnership's gross income (including gross income
from prohibited transactions) constitutes qualifying
Loans To Partnerships income for purposes of the 75 percent gross income
Under prior law, if a REIT held debt of a partnership, test. This change provides signicant exibility to RE-
for the straight debt safe-harbor to apply, the legisla- ITs in making loans to partnerships that own and lease
tive history of the Internal Revenue Code suggested real property.
that the REIT was required to own at least a 20 percent
prots interest in the partnership. The RIA does away Other Considerations
with this requirement by explicitly stating that a
In addition to examining any loans made to partner-
straight debt loan to a partnership in which a REIT
ships in which a REIT owned a 20 percent prots inter-
owns no other securities, or de minimis securities, will
est to determine whether ownership of any those loans
qualify for the straight debt safe-harbor. The RIA also
could violate the 10 Percent Value Test, as amended
eliminates on a retroactive basis, the provision allow-
by the RIA, REITs also should consider reviewing the
ing a REIT to make a straight debt loan to a partner-
terms of securities that previously were transferred to a
ship in which it owns a 20 percent prots interest.
TRS to determine whether the REIT could hold some
While it is not entirely clear, it is possible that a REIT
portion or all of those securities directly in light of the
that relied on this provision could, retroactively, fail
changes made by the RIA.
the 10 Percent Value Test if the loan was not otherwise
exempt under a new RIA provision. NAREIT is aware
of this issue and has requested a technical correction to Monetary Penalties In Lieu Of REIT Disquali-
address it. Accordingly, REITs that have made such cation For Failure To Meet Certain Require-
loans should consult tax counsel to conrm they are in
compliance with the 10 Percent Value Test, as ments—Asset Tests
amended by the RIA. A REIT is required to meet certain tests with respect to
2 THE REAL ESTATE FINANCE JOURNAL/SPRING 2005
@MAGNETO/VENUS/PAMPHLET02/ATTORNEY/REFJ/BRODYCPY SESS: 1 COMP: 04/26/05 PG. POS: 2the nature of its assets. Under prior law, if a REIT E it attached a schedule of the sources of its income
failed to meet the asset tests at the close of any quarter, to its federal income tax return; and
the REIT would lose its status as a REIT, if the failure E any incorrect information on the schedule was
was not cured within 30 days after the close of the not due to fraud with intent to evade tax.
quarter. This limited 30 day cure period applied even if The RIA modies this rule by providing that if a
the REIT was not aware of the violation. The RIA REIT failed to satisfy one or both of the 75 percent or
provides a longer cure period for violations of the 95 percent gross income tests for any taxable year, it
REIT asset tests. may nevertheless qualify as a REIT for the year if:
The RIA provides that a REIT will be deemed to
E following the REIT's identication of the failure
have met the 10 Percent Value Test, the 10 percent vot-
to meet one or both of the gross income tests, the
ing power test, and the 5 percent asset test if the value
REIT les a schedule in accordance with Trea-
of the non-qualifying assets:
sury regulations to be prescribed; and
E does not exceed the lesser of (a) one percent of
E its failure to meet these tests was due to reason-
the total value of the REIT's assets at the end of
able cause and not due to willful neglect.
the applicable quarter or (b) $10,000,000 (the ‘‘de
minimis amount’’); and
E the REIT disposes of the non-qualifying assets Other Failures To Comply With Requirements
within (a) six months after the last day of the The RIA also provides relief in the event that a REIT
quarter in which the failure to satisfy the asset violates other provisions of the Internal Revenue Code
tests is discovered or (b) the period of time that, under prior law, would have resulted in its failure
prescribed by the IRS. to qualify as a REIT if:
For violations of any of the asset tests due to rea- E the violation is due to reasonable cause and not
sonable cause and not willful neglect that are in excess due to willful neglect;
of the de minimis amount described above, the RIA
permits the REIT to avoid disqualication after the 30 E the REIT pays a penalty of $50,000 for each fail-
day cure period by taking certain steps, including: ure to satisfy the provision; and
E the disposition of sucient assets to meet the as- E the violation does not include a violation de-
set test within (a) six months after the last day of scribed under ‘‘Monetary Penalties in Lieu of
the quarter in which the failure to satisfy the asset REIT Disqualication For Failure to Meet Certain
tests is discovered or (b) the period of time Requirements—Assets Tests’’ and ‘‘Income
prescribed by the IRS; Tests’’ above.
E paying a tax equal to the greater of (a) $50,000 or
(b) the highest corporate tax rate multiplied by Conformity With General Hedging Denition
the net income generated by the non-qualifying Under prior law, if a REIT entered into an interest rate
assets; and swap or cap contract, option, futures contract, forward
E disclosing certain information to the IRS. rate agreement, or any similar nancial instrument to
While REITs should continue to carefully monitor hedge indebtedness incurred or to be incurred to
their assets on a quarterly basis, these provisions of the acquire or carry ‘‘real estate assets,’’ any periodic
RIA reduce the penalty for failing to satisfy an asset income or gain from the disposition of that contract
test in many cases. In light of these provisions, a REIT generally constituted qualifying income for purposes
that has an asset protection trust in place may want to of the 95 percent gross income test, but not the 75
re-examine the terms of such trust, especially with re- percent gross income test. The RIA amends this rule
spect to de minimis violations of the asset tests. and generally provides that income of a REIT attribut-
able to a hedging transaction that is properly identied
in accordance with rules set forth in Section 1221(a)(7)
Income Tests of the Internal Revenue Code, including gain from the
REITs are required to meet two tests with respect to sale or disposition of such a transaction, does not con-
the nature of their income on an annual basis, gener- stitute gross income for purposes of the 95 percent
ally referred to as the 75 percent gross income test and gross income test (i.e., as opposed to being qualifying
the 95 percent gross income test. Under prior law, if a income), to the extent that the transaction hedges debt
REIT failed to satisfy one or both of these tests for any incurred or to be incurred by the REIT to acquire or
taxable year, it may nevertheless have qualied as a carry real estate assets. Note that Section 1221(a)(7),
REIT for the year if it was entitled to relief under among other things, requires a hedging transaction to
certain provisions of the Code. Generally, a REIT be clearly identied on the REIT's books and records
could avail itself of the relief provisions if: on the day it is acquired. While this change in law gen-
E its failure to meet these tests was due to reason- erally did not apply until 2005, it appears that there is
able cause and not due to willful neglect; no exception or grandfathering provision for previ-
THE REAL ESTATE FINANCE JOURNAL/SPRING 2005 3
@MAGNETO/VENUS/PAMPHLET02/ATTORNEY/REFJ/BRODYCPY SESS: 1 COMP: 04/26/05 PG. POS: 3REIT Improvement Act Becomes Law
ously acquired hedges. Accordingly, REITs should stockholder that were attributable to gain from sales or
review their outstanding hedges to conrm that they exchanges of U.S. real property interests by the REIT,
have been properly identied in accordance with Sec- whether or not designated as capital gain dividends,
tion 1221(a)(7). would cause the non-U.S. stockholder to be treated as
recognizing such gain as income eectively connected
with a U.S. trade or business. Non-U.S. stockholders
Penalty Tax For Failure To Meet 95 Percent generally would be required to pay tax at the same rates
Gross Income Test applicable to U.S. stockholders, subject to a special
The RIA amends the provisions of the Internal Reve- alternative minimum tax in the case of nonresident
nue Code relating to the penalty tax imposed on REITs alien individuals. Also, such gain may have been
for failing to meet the 95 percent gross income test. subject to a 30 percent branch prots tax in the hands
This amendment is a technical correction and gener- of a corporate non-U.S. stockholder.
ally increases the penalty for failing to meet the 95 Under the RIA, capital gain distributions made by a
percent gross income test. REIT whose shares are publicly traded on a U.S.
exchange are treated as ordinary dividends if such
distributions are received by non-U.S. stockholders
Rent Received From A TRS that own ve percent or less of the REIT. This changes
In general, rent received from tenants that are related the requirement under prior law that such investors le
to the REIT, applying a 10 percent direct or indirect a U.S. tax return because they were treated as engag-
ownership test, do not qualify as rents from real ing in a U.S. business as a result of their receipt of
property. However, a REIT's ownership of more than REIT capital gain distributions, and excludes such
10 percent of the stock of a TRS will not disqualify the distributions to portfolio investors in publicly traded
rent paid by the TRS if: REITs from the branch prots tax on the U.S. opera-
tions of a non-U.S. corporation. This change should
E the rent paid by the TRS is substantially compa-
make an investment in U.S. REITs more attractive to
rable to the rent paid by the other tenants of the
foreign stockholders.
REIT for comparable space; and
E at least 90 percent of the leased space at the prop-
erty is leased to tenants other than TRSs of the Modication Of Prohibited Transaction Safe-
REIT and other than related party tenants (the Harbor
‘‘limited rental exception’’).
The RIA claries the limited rental exception by Any gain a REIT realizes on the sale of any property
providing that the substantially comparable require- held as inventory or otherwise held primarily for sale
ment in the rst bullet point above is only tested upon to customers in the ordinary course of business is
entering into a lease, at the time of each extension and treated as income from a prohibited transaction that is
at the time of certain modications of the lease. How- subject to a 100 percent penalty tax. The Internal Rev-
ever, in the case of a Controlled TRS, any increase in enue Code contains a safe-harbor for determining
the rents after a modication of a lease will not qualify whether a particular sale will constitute a prohibited
as ‘‘rents from real property.’’ transaction. The RIA expands this safe-harbor to
include certain sales of property used in the trade or
business of producing timber.
Redetermined Rents
In general, redetermined rents are rents from real prop- Modication Of REIT Taxable Income
erty that are overstated as a result of services furnished
by a TRS to the REIT's tenants. Any redetermined The RIA modies the calculation of REIT taxable
rents are subject to a 100 percent penalty tax. Under income to take into account the modications to the
prior law, amounts received by a REIT for services rules regarding failures of the asset tests described
customarily furnished or rendered in connection with above.
the rental of real property and provided by a TRS were
excluded from treatment as redetermined rents and Expansion Of Deciency Dividend Procedures
therefore, avoided the penalty tax. The RIA eliminates
this exclusion. The RIA expands the denition of ‘‘determination’’ as
it relates to the rules regarding deciency dividends.
Modication Of FIRPTA
The RIA changes certain rules that apply to investment Eective Dates
in REITs by foreign investors. Under prior law, pursu- The provisions contained in the RIA relating to the
ant to the Foreign Investment in Real Property Tax Act, straight debt safe-harbor (other than the changes to the
or ‘‘FIRPTA,’’ distributions by a REIT to a non-U.S. 10 Percent Value Test Look-Through Rule) and the
4 THE REAL ESTATE FINANCE JOURNAL/SPRING 2005
@MAGNETO/VENUS/PAMPHLET02/ATTORNEY/REFJ/BRODYCPY SESS: 1 COMP: 04/26/05 PG. POS: 4rent received from a TRS apply to taxable years end- Note: This article is only a brief summary of the main
ing after December 31, 2000, and the 10 Percent Value provisions of the RIA and does not address all aspects
Test Look-Through Rule and the remaining provisions of the legislation or all eects it may have on a REIT.
generally apply to taxable years beginning after the
date the RIA was enacted (i.e., the taxable year begin-
ning January 1, 2005 for most REITs).
THE REAL ESTATE FINANCE JOURNAL/SPRING 2005 5
@MAGNETO/VENUS/PAMPHLET02/ATTORNEY/REFJ/BRODYCPY SESS: 1 COMP: 04/26/05 PG. POS: 5@MAGNETO/VENUS/PAMPHLET02/ATTORNEY/REFJ/BRODYCPY SESS: 1 COMP: 04/26/05 PG. POS: 6
You can also read
