The IRS on April 25 published final regulations (TD 9992) limiting the eligibility of a real estate investment trust (REIT) to qualify as a “domestically controlled REIT,” thereby curtailing the common use of such structures to avoid U.S. income tax on foreign investors’ gains on sales of REIT stock.
The final rules adopt, but limit the scope of, proposed rules issued in December 2022 and add a transition rule to address concerns about retroactive effect.
Domestically Controlled REIT
Many private real estate partnership funds hold U.S. real property through REITs. The general rule under Section 897(a)(1) and (c) is that gain to a foreign investor on the sale of a “United States real property interest” (USRPI) is treated as “effectively connected income” and, thus, is subject to U.S. income tax. For this purpose, under Section 897(c)(1) and (2), a USRPI includes stock of a “US real property holding corporation,” which generally includes a REIT that holds US real property as its primary asset.
However, U.S. income tax is generally not imposed if the REIT qualifies as a “domestically controlled REIT” (DC REIT), which includes a REIT in which less than 50% of the value of its stock was held, directly or indirectly, by foreign investors at all times during the REIT’s existence during the five-year period preceding the sale of the REIT stock. Although attribution rules are provided in several other contexts under Section 897, the statute does not define the term “directly or indirectly” for this purpose.
Structuring REITs with Foreign Investors via U.S. Corporations
It has generally been well accepted that the foreign status of a REIT’s direct and indirect owners is determined by looking through to the partners in a U.S. partnership that owns stock of the REIT.
However, the IRS ruled in PLR 200923001 that a U.S. corporation owned by foreign investors is treated as a U.S. shareholder of the REIT, i.e., there is no look-through to the foreign shareholders of the U.S. corporation. Under this approach, foreign investors could own more than 50% of the stock of a DC REIT, i.e., 49% directly and the balance indirectly through a U.S. corporation. Moreover, the favorable result in PLR 200923001 was cited with approval in the legislative history to section 322(b)(1)(A) of the Protecting Americans from Tax Hikes Act of 2015, Public Law 114-113, div. Q.
Accordingly, the REIT structure with foreign investors owning more than 50% of REIT stock, in part indirectly through a U.S. corporation, has been adopted by many private real estate partnerships in anticipation of the U.S. income tax exemption for foreign investors’ gain on the sale of DC REIT stock.
New Rules for DC REIT Status
The IRS in December 2022 issued proposed regulations that would have curtailed eligibility for DC REIT status by requiring a look-through to the domestic or foreign status of the shareholders of a nonpublic U.S. corporation unless the U.S. corporation were owned, directly or indirectly, less than 25% by foreign shareholders, in which case the U.S. corporation would qualify as a domestic REIT shareholder for this purpose.
The final regulations adopt the general look-through rule included in the proposed regulations but increase the percentage of foreign ownership required to look through a non-public U.S. C corporation from 25% or more to more than 50%. The IRS states that the modified final rule “significantly narrows the scope of look-through treatment” by limiting its application to domestic corporations that are “foreign-controlled” – not just “foreign-owned.”
Transition Relief
The proposed regulations were proposed to apply to transactions occurring on or after the date of publication of the final regulations. However, there were concerns that the proposed version of the rule would effectively apply retroactively because of the five-year lookback in determining DC REIT status.
The IRS declined to delay application of the final U.S. corporation look-through rule. However, the final regulations include transition relief for a 10-year period under which ownership structures in existence on April 24, 2024, are exempted from the final U.S. corporation look-through rule as long as, among other requirements:
- The REIT was a DC REIT under prior law;
- The REIT does not acquire, directly or indirectly, new USRPIs with a value of more than 20% of the value of USRPIs held, directly or indirectly, by the REIT on April 24, 2024; and
- There is no increase of more than 50% in the ownership of REIT stock by non-look-through persons, e.g., a nonpublic U.S. corporation owned no more than 50% by foreign investors after April 24, 2024.
Insight
The final regulations apparently permit foreign ownership of a DC REIT of almost 75%, e.g., 49.9% directly and 50% of the remaining 50.1% indirectly through a nonpublicly traded U.S. C corporation. Moreover, foreign ownership of a publicly traded U.S. corporation is generally disregarded for this purpose. Conversely, the rules do look through most other types of entities, such as partnerships, in determining DC REIT status.
The transition relief is very helpful, and eligible U.S. corporations should closely monitor asset acquisitions and foreign ownership to support continued qualification for transition relief.
Of course, the final regulations also include many other special rules and exceptions, e.g., for binding commitments on April 24, 2024, that must be considered in any specific situation.
