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 signiŽcant eects it has on REITs.
Late last year, President Bush signed the American
Jobs Creation Act of 2004, which, among other things,
amends certain provisions of the Internal Revenue
Code relating to real estate investment trusts
(‘‘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 anticipated eect on REITs.
Amendments Aecting The 10 Percent Value
Test
A REIT generally may not own securities having a
value of more than 10 percent of the total value of the
outstanding securities of any one issuer (the ‘‘10
Percent Value Test’’). Debt securities that qualify
under the ‘‘straight debt safe-harbor,’’ however, are
not subject to this limitation. ‘‘Straight debt’’ generally is deŽned for this purpose as any written unconditional promise to pay on demand or on a speciŽed date
a Žxed amount in money if the interest rate and interest
payment dates are not contingent on proŽts, the borrower's discretion, or similar factors, and the debt is
not convertible. Under prior law, straight debt would
only qualify for the straight debt safe-harbor if:
E the issuer was an individual;
E the only securities of the issuer held by the REIT
and any taxable REIT subsidiary (‘‘TRS’’) of the
REIT were straight debt; or
E the issuer was a partnership in which the REIT
held at least a 20 percent proŽts interest.
Although the Internal Revenue Code established
these provisions as alternatives, the relevant legislative
Michael J. Brody, a partner of Latham & Watkins LLP in Los Angeles,
can be contacted at (213) 891-8724 or michael.brody@lw.com. Ana R.
Genender, an associate with Latham & Watkins LLP in Los Angeles,
can be contacted on (213) 891- 8721 or ana.genender@lw.com.
history states that the 20 percent proŽts interest test
needed to be met with respect to all partnership issuers
in order for their debt securities to Žt within the straight
debt safe-harbor.
Exclusion Of Certain Securities From 10
Percent Value Test
The RIA provides that certain securities, in addition to
those that meet the straight debt safe-harbor, are not
subject to the 10 Percent Value Test, including any
loan to an individual, estate or government, any obligation to pay rents from real property, ‘‘467 rental agreements,’’ and any security issued by a REIT. These
exclusions were not available under prior law. Accordingly, the RIA allows REITs to make loans to individuals or others that do not constitute straight debt, without
regard to the 10 Percent Value Test. In addition, the
RIA eliminates concern that amounts payable under a
lease (e.g., past due rents) could constitute a security
for purposes of the 10 Percent Value Test. Finally, the
RIA authorizes the IRS to provide guidance on arrangements that will not constitute a security for
purposes of the 10 Percent Value Test, even though the
arrangements could constitute a ‘‘security’’ for purposes of the Investment Company Act of 1940.
The DeŽnition Of Straight Debt
Under prior law, for a debt instrument to constitute
straight debt, the interest rate and interest payment
dates could not be contingent on proŽts, the borrower's
discretion, or similar factors. The RIA expands the definition of straight debt to include certain debt instruments that provide for the following contingencies:
E the contingency relates to the time of payment
and does not have a signiŽcant eect on the
instrument's yield to maturity;
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REIT Improvement Act Becomes Law
E the contingency relates to the time of payment
and neither the aggregate issue price nor the aggregate face amount of the issuer's instruments
held by the REIT exceeds $1,000,000 and not
more than 12 months of interest that has not yet
accrued can be required to be prepaid thereunder;
or
E the contingency relates to the time or amount of
payment and is based upon a default or exercise
of a prepayment right, but only if such contingency is consistent with customary commercial
practice.
As a result of these changes, REITs may make loans
with broader repayment features than were permitted
under prior law.
Ownership Of Interests In The Issuer
Under prior law, subject to the discussion in this article
regarding loans to partnerships, for the straight debt
safe-harbor to apply, the REIT and any TRS of the
REIT could not own any securities of the issuer, other
than securities that met the straight debt safe harbor.
As a result of the RIA, a loan to a corporation or
partnership may qualify as straight debt if the REIT
group (including any TRS more than 50 percent of
which is directly or indirectly owned by the REIT (a
‘‘Controlled TRS’’)) holds securities of the issuer that
qualify as straight debt and securities that do not
qualify as straight debt, provided such nonqualifying
securities do not have an aggregate value of greater
than one percent of the issuer's outstanding securities.
This provision allows a REIT to make straight debt
loans to entities in which it owns a de minimis interest,
even if such interest is not itself straight debt.
Loans To Partnerships
Under prior law, if a REIT held debt of a partnership,
for the straight debt safe-harbor to apply, the legislative history of the Internal Revenue Code suggested
that the REIT was required to own at least a 20 percent
proŽts interest in the partnership. The RIA does away
with this requirement by explicitly stating that a
straight debt loan to a partnership in which a REIT
owns no other securities, or de minimis securities, will
qualify for the straight debt safe-harbor. The RIA also
eliminates on a retroactive basis, the provision allowing a REIT to make a straight debt loan to a partnership in which it owns a 20 percent proŽts interest.
While it is not entirely clear, it is possible that a REIT
that relied on this provision could, retroactively, fail
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
address it. Accordingly, REITs that have made such
loans should consult tax counsel to conŽrm they are in
compliance with the 10 Percent Value Test, as
amended by the RIA.
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Ten Percent Value Test Look-Through Rule
A REIT is treated as owing its proportionate share of
the assets owned by any partnership in which it is a
partner, determined in accordance with the REIT's
capital interest in the partnership and without taking
into account the ownership of other partnership
securities. Under the RIA, solely for purposes of the
10 Percent Value Test, the REIT's interest in partnership assets is based upon the REIT's proportionate
interest in all securities issued by the partnership other
than securities which are not subject to the 10 Percent
Value Test (e.g., 467 rental agreements or rent receivables) and straight debt (the ‘‘10 Percent Value Test
Look-Through Rule’’). This change may complicate
REITs' compliance eorts because REITs may need to
prepare two sets of ‘‘look-through’’ calculations for
certain partnerships or LLCs (i.e., one for purposes of
the 10 Percent Value Test and one for purposes of all
other REIT qualiŽcation requirements). The RIA also
clariŽes that a REIT's interest as a partner in a partnership is not considered a security for purposes of the 10
Percent Value Test.
Exclusion Of Certain Loans To Partnerships
The RIA provides that certain debt instruments issued
by partnerships to REITs are not treated as securities
for purposes of the 10 Percent Value Test. First, a debt
instrument issued by a partnership to a REIT that does
not qualify for the straight debt safe-harbor is not
considered a security to the extent of the REIT's interest as a partner in the partnership. Second, a debt
instrument issued by a partnership to a REIT that does
not qualify for the straight debt safe-harbor will not be
considered a security if at least 75 percent of the
partnership's gross income (including gross income
from prohibited transactions) constitutes qualifying
income for purposes of the 75 percent gross income
test. This change provides signiŽcant exibility to REITs in making loans to partnerships that own and lease
real property.
Other Considerations
In addition to examining any loans made to partnerships in which a REIT owned a 20 percent proŽts interest to determine whether ownership of any those loans
could violate the 10 Percent Value Test, as amended
by the RIA, REITs also should consider reviewing the
terms of securities that previously were transferred to a
TRS to determine whether the REIT could hold some
portion or all of those securities directly in light of the
changes made by the RIA.
Monetary Penalties In Lieu Of REIT DisqualiŽcation For Failure To Meet Certain Requirements—Asset Tests
A REIT is required to meet certain tests with respect to
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the nature of its assets. Under prior law, if a REIT
failed to meet the asset tests at the close of any quarter,
the REIT would lose its status as a REIT, if the failure
was not cured within 30 days after the close of the
quarter. This limited 30 day cure period applied even if
the REIT was not aware of the violation. The RIA
provides a longer cure period for violations of the
REIT asset tests.
The RIA provides that a REIT will be deemed to
have met the 10 Percent Value Test, the 10 percent voting power test, and the 5 percent asset test if the value
of the non-qualifying assets:
E does not exceed the lesser of (a) one percent of
the total value of the REIT's assets at the end of
the applicable quarter or (b) $10,000,000 (the ‘‘de
minimis amount’’); and
E the REIT disposes of the non-qualifying assets
within (a) six months after the last day of the
quarter in which the failure to satisfy the asset
tests is discovered or (b) the period of time
prescribed by the IRS.
For violations of any of the asset tests due to reasonable cause and not willful neglect that are in excess
of the de minimis amount described above, the RIA
permits the REIT to avoid disqualiŽcation after the 30
day cure period by taking certain steps, including:
E the disposition of sucient assets to meet the asset test within (a) six months after the last day of
the quarter in which the failure to satisfy the asset
tests is discovered or (b) the period of time
prescribed by the IRS;
E paying a tax equal to the greater of (a) $50,000 or
(b) the highest corporate tax rate multiplied by
the net income generated by the non-qualifying
assets; and
E disclosing certain information to the IRS.
While REITs should continue to carefully monitor
their assets on a quarterly basis, these provisions of the
RIA reduce the penalty for failing to satisfy an asset
test in many cases. In light of these provisions, a REIT
that has an asset protection trust in place may want to
re-examine the terms of such trust, especially with respect to de minimis violations of the asset tests.
Income Tests
REITs are required to meet two tests with respect to
the nature of their income on an annual basis, generally referred to as the 75 percent gross income test and
the 95 percent gross income test. Under prior law, if a
REIT failed to satisfy one or both of these tests for any
taxable year, it may nevertheless have qualiŽed as a
REIT for the year if it was entitled to relief under
certain provisions of the Code. Generally, a REIT
could avail itself of the relief provisions if:
E its failure to meet these tests was due to reasonable cause and not due to willful neglect;
E it attached a schedule of the sources of its income
to its federal income tax return; and
E any incorrect information on the schedule was
not due to fraud with intent to evade tax.
The RIA modiŽes this rule by providing that if a
REIT failed to satisfy one or both of the 75 percent or
95 percent gross income tests for any taxable year, it
may nevertheless qualify as a REIT for the year if:
E following the REIT's identiŽcation of the failure
to meet one or both of the gross income tests, the
REIT Žles a schedule in accordance with Treasury regulations to be prescribed; and
E its failure to meet these tests was due to reasonable cause and not due to willful neglect.
Other Failures To Comply With Requirements
The RIA also provides relief in the event that a REIT
violates other provisions of the Internal Revenue Code
that, under prior law, would have resulted in its failure
to qualify as a REIT if:
E the violation is due to reasonable cause and not
due to willful neglect;
E the REIT pays a penalty of $50,000 for each failure to satisfy the provision; and
E the violation does not include a violation described under ‘‘Monetary Penalties in Lieu of
REIT DisqualiŽcation For Failure to Meet Certain
Requirements—Assets Tests’’ and ‘‘Income
Tests’’ above.
Conformity With General Hedging DeŽnition
Under prior law, if a REIT entered into an interest rate
swap or cap contract, option, futures contract, forward
rate agreement, or any similar Žnancial instrument to
hedge indebtedness incurred or to be incurred to
acquire or carry ‘‘real estate assets,’’ any periodic
income or gain from the disposition of that contract
generally constituted qualifying income for purposes
of the 95 percent gross income test, but not the 75
percent gross income test. The RIA amends this rule
and generally provides that income of a REIT attributable to a hedging transaction that is properly identiŽed
in accordance with rules set forth in Section 1221(a)(7)
of the Internal Revenue Code, including gain from the
sale or disposition of such a transaction, does not constitute gross income for purposes of the 95 percent
gross income test (i.e., as opposed to being qualifying
income), to the extent that the transaction hedges debt
incurred or to be incurred by the REIT to acquire or
carry real estate assets. Note that Section 1221(a)(7),
among other things, requires a hedging transaction to
be clearly identiŽed on the REIT's books and records
on the day it is acquired. While this change in law generally did not apply until 2005, it appears that there is
no exception or grandfathering provision for previ-
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REIT Improvement Act Becomes Law
ously acquired hedges. Accordingly, REITs should
review their outstanding hedges to conŽrm that they
have been properly identiŽed in accordance with Section 1221(a)(7).
Penalty Tax For Failure To Meet 95 Percent
Gross Income Test
The RIA amends the provisions of the Internal Revenue Code relating to the penalty tax imposed on REITs
for failing to meet the 95 percent gross income test.
This amendment is a technical correction and generally increases the penalty for failing to meet the 95
percent gross income test.
Rent Received From A TRS
In general, rent received from tenants that are related
to the REIT, applying a 10 percent direct or indirect
ownership test, do not qualify as rents from real
property. However, a REIT's ownership of more than
10 percent of the stock of a TRS will not disqualify the
rent paid by the TRS if:
E the rent paid by the TRS is substantially comparable to the rent paid by the other tenants of the
REIT for comparable space; and
E at least 90 percent of the leased space at the property is leased to tenants other than TRSs of the
REIT and other than related party tenants (the
‘‘limited rental exception’’).
The RIA clariŽes the limited rental exception by
providing that the substantially comparable requirement in the Žrst bullet point above is only tested upon
entering into a lease, at the time of each extension and
at the time of certain modiŽcations of the lease. However, in the case of a Controlled TRS, any increase in
the rents after a modiŽcation of a lease will not qualify
as ‘‘rents from real property.’’
Redetermined Rents
In general, redetermined rents are rents from real property that are overstated as a result of services furnished
by a TRS to the REIT's tenants. Any redetermined
rents are subject to a 100 percent penalty tax. Under
prior law, amounts received by a REIT for services
customarily furnished or rendered in connection with
the rental of real property and provided by a TRS were
excluded from treatment as redetermined rents and
therefore, avoided the penalty tax. The RIA eliminates
this exclusion.
ModiŽcation Of FIRPTA
The RIA changes certain rules that apply to investment
in REITs by foreign investors. Under prior law, pursuant to the Foreign Investment in Real Property Tax Act,
or ‘‘FIRPTA,’’ distributions by a REIT to a non-U.S.
4
stockholder that were attributable to gain from sales or
exchanges of U.S. real property interests by the REIT,
whether or not designated as capital gain dividends,
would cause the non-U.S. stockholder to be treated as
recognizing such gain as income eectively connected
with a U.S. trade or business. Non-U.S. stockholders
generally would be required to pay tax at the same rates
applicable to U.S. stockholders, subject to a special
alternative minimum tax in the case of nonresident
alien individuals. Also, such gain may have been
subject to a 30 percent branch proŽts tax in the hands
of a corporate non-U.S. stockholder.
Under the RIA, capital gain distributions made by a
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
that own Žve percent or less of the REIT. This changes
the requirement under prior law that such investors Žle
a U.S. tax return because they were treated as engaging in a U.S. business as a result of their receipt of
REIT capital gain distributions, and excludes such
distributions to portfolio investors in publicly traded
REITs from the branch proŽts tax on the U.S. operations of a non-U.S. corporation. This change should
make an investment in U.S. REITs more attractive to
foreign stockholders.
ModiŽcation Of Prohibited Transaction SafeHarbor
Any gain a REIT realizes on the sale of any property
held as inventory or otherwise held primarily for sale
to customers in the ordinary course of business is
treated as income from a prohibited transaction that is
subject to a 100 percent penalty tax. The Internal Revenue Code contains a safe-harbor for determining
whether a particular sale will constitute a prohibited
transaction. The RIA expands this safe-harbor to
include certain sales of property used in the trade or
business of producing timber.
ModiŽcation Of REIT Taxable Income
The RIA modiŽes the calculation of REIT taxable
income to take into account the modiŽcations to the
rules regarding failures of the asset tests described
above.
Expansion Of DeŽciency Dividend Procedures
The RIA expands the deŽnition of ‘‘determination’’ as
it relates to the rules regarding deŽciency dividends.
Eective Dates
The provisions contained in the RIA relating to the
straight debt safe-harbor (other than the changes to the
10 Percent Value Test Look-Through Rule) and the
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rent received from a TRS apply to taxable years ending after December 31, 2000, and the 10 Percent Value
Test Look-Through Rule and the remaining provisions
generally apply to taxable years beginning after the
date the RIA was enacted (i.e., the taxable year beginning January 1, 2005 for most REITs).
Note: This article is only a brief summary of the main
provisions of the RIA and does not address all aspects
of the legislation or all eects it may have on a REIT.
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