The AJCA changes many REIT rules.

• Author: Gottschalk, Stefan
• Position: American Jobs Creation Act of 2004, real estate investment trusts

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 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 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 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; and (4) short-term capital gain to the extent of short-term capital loss.

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