The American Jobs Creation Act provides sizable tax cuts for U.S. businesses.
Last fall President Bush signed into law the American Jobs Creation Act of 2004, which provides additional deductions and reduced tax rates for many qualifying U.S. businesses. The AJCA is the most far-reaching tax cut in years and benefits both individual and corporate taxpayers, including U.S. manufacturers, multinational corporations, small businesses, and partnerships.
The AJCA also includes numerous provisions that benefit commercial real estate professionals and investors as well as businesses within the industry. For example, improvements to non-residential and restaurant real property placed in service between Oct. 22, 2004, and Jan. 1, 2006, generally now have 15-year recovery periods rather than the previous 39-year life in computing straight-line depreciation. The accelerated depreciation allows quicker tax write-offs, generates a beneficial non-cash expense to offset operational income, and decreases taxable income.
Several changes also have been made to real estate investment trusts' definition and taxation rules. Generally, REITs are corporate entities that are required to distribute 90 percent of their income to shareholders by year-end. The Internal Revenue Code allows REITs to deduct the required distributions with minimal tax liability. However, the AJCA has simplified the process and added levels of tax-status protection by relaxing the requirements REITs must meet to maintain their IRC status. The changes to these requirements are explained below.
Organizational Structure. With the exception of its initial year, a REIT must have 100 or more shareholders. This provision remains the same.
The 75 Percent Asset Test. At the close of each quarter, a REIT must have at least 75 percent of its assets invested in real estate assets, cash or cash items, and government securities. The AJCA allows REITs six months to comply with this requirement. In addition, REITs may not hold one issuer's securities that represent more than 5 percent of the total REIT assets, more than 10 percent of the voting securities, or 10 percent of the value of any one issuer's outstanding securities. The AJCA provides that REITs will not lose their tax status for failing to satisfy these requirements if the REIT identifies and remedies the failure within a specified time period.
The 95 Percent Income Test. To qualify as a REIT, at least 95 percent of an entity's gross income must be derived from certain passive sources, including interest dividends and income that qualifies for the 75 percent test. In addition, at least 75 percent of its income must be derived from certain real estate sources such as rental income and gains from the sale or disposition of real property. The AJCA provides that a REIT will not be disqualified if after it identifies its failure to satisfy the 75 percent or 95 percent tests, it provides a schedule for the tax year in accordance with Internal Revenue Service regulations with a description of each item of gross income subject to these tests. In addition, the REIT will not be disqualified if the failure to meet these tests is due to reasonable cause and not willful neglect. However, there still is a penalty for not meeting these requirements.
Income Distribution. Since REITs are required to distribute 90 percent of their income to shareholders before the end of the taxable year, inadequate distributions are taxed.
Failing to meet these requirements may lead to a REIT's disqualification, causing the IRS to treat the entity as a C corporation. Under this status, the entity would not be able to deduct dividends paid and would be subject to corporate tax rates.
Under the AJCA, a REIT may avoid disqualification for failing to meet certain REIT-status requirements provided that the failure was due to reasonable course and not willful neglect, the failure is corrected, and except for certain failures not exceeding a minimal amount, a penalty is paid. For other than the 75 percent and 95 percent gross income tests, penalties are imposed per $50,000 for failing to meet each asset test.
The AJCA also affects foreign investment in REITs. Specifically, it relaxes the stipulation that foreign investors who receive REIT distributions must file U.S. tax returns. Previously, foreign investors were required to treat certain otherwise non-taxable capital gains from the sale of U.S. real property as though such gain effectively was connected with a U.S. trade or business. The foreign recipients of REIT capital gain distributions were subject to 35 percent withholding (or lower treaty rate) and were required to file a U.S. tax return. Now foreign investors must treat the distribution as an ordinary REIT dividend — not as a capital gain dividend. The ordinary REIT dividend is subject to 30 percent withholding (or lower treaty rate), and no U.S. tax return is required.
Other Businesses Affected
The AJCA also has added Section 199 to the IRC, which expands the definition of manufacturer to include engineering, construction, and architectural services. Qualifying taxpayers that now fall under the manufacturer definition can take advantage of a tax deduction that reduces their effective rate from 35 percent to 32 percent for 2005 and 2006. The tax rate reduction is scheduled to increase to 6 percent for 2007 through 2009 and 9 percent beginning in 2010.
Legislative committees are in the process of disseminating the regulations that provide additional AJCA details and guidance to taxpayers. As Congress continues to implement the Act's provisions, commercial real estate investors and businesses can look forward to the benefits this new legislation brings.