Executive summary: New look-through rule may affect REIT domestically controlled status
The Treasury Department (Treasury) released new proposed regulations on Dec. 28, 2022, which would change the rules governing what constitutes a domestically controlled real estate investment trust (REIT). The proposed regulations would modify the REIT look-through rules for foreign owned domestic corporations. As a result of this modification to the REIT look-through rules, a REIT that would be considered domestically controlled under current law may be treated as not domestically controlled under the proposed regulation. In particular, simply inserting a U.S. C corporation between foreign investors and the REIT likely would no longer suffice to maintain a REIT’s domestic controlled status. As such, dispositions of such interests by foreign shareholders could give rise to taxable gains.
Summary of Current and Proposed REIT Domestic Control Rules
The Treasury released new proposed regulations on Dec. 28, 2022, which would change the rules governing what constitutes a domestically controlled REIT. A REIT is an entity that receives most of its income from passive real property and related investments and essentially receives pass-through treatment for income tax purposes.1 In order to be a classified as a REIT, an entity that is taxable as a domestic corporation must elect REIT status2 and meet all of the statutory requirements related to such status.3 In general, to qualify as a REIT, the entity’s assets must be at least 75% cash and cash items (including receivables), real estate assets or Government securities at the end of each quarter of the REIT's tax year.4 Moreover, a REIT must distribute substantially all of its taxable income each year, and at least 75% or more of its income in each year must be derived from real property investments such as rents, interest and sale proceeds.5 Additionally, a REIT must also meet the 95% income test in Section 856(c)(2).6
Under current law, a REIT is considered domestically controlled if less than 50% of its stock is directly or indirectly held by foreign investors at all times during the 5-year testing period.7 Furthermore, shareholders that own less than 5% of the publicly traded REITs are presumed to be U.S. holders unless the REIT has actual knowledge to the contrary.8 Notably, in the case of a domestic corporate shareholder of a REIT, there is no look through to the shareholders of that domestic corporate shareholder -- even if that corporation is wholly owned by foreign shareholders.9
Importantly, the stock of a domestically controlled REIT is not considered to be a U.S. real property interest (USRPI); accordingly, the sale of such stock by a foreign shareholder is generally not subject to U.S. federal income tax.10 By contrast, holding stock in a non-domestically controlled REIT is generally treated as USRPI and thus the sale of such shares by foreign holders is typically subject to US federal tax.11 The proposed regulations would change the REIT domestic control and look-through rules, which may result in adverse tax consequences to certain REIT structures.
The proposed regulations would modify the REIT look-through rules for foreign owned domestic corporations. Pursuant to these modifications, if foreign investors own, directly or indirectly, 25% or more of the fair market value (“FMV”) of any nonpublic domestic C corporation – for example, a domestic corporation interposed between such investors and an underlying REIT -- that corporation is treated as a foreign-owned domestic corporation. The proposal would then look through such foreign owned domestic corporation for purposes of determining if a REIT is domestically controlled. Accordingly, as a result of this modification to the REIT look-through rules, a REIT which would be consider domestically controlled under current law may be treated as not domestically controlled under the proposed regulations. The modifications made to the look-through rules under the proposed regulations would effect transactions executed on or after the date the regulations are finalized.
The following example demonstrates how the proposed look-through rules would apply. Assume a U.S. REIT (US REIT) is 49% owned by foreign individuals. The remaining 51% of the stock of US REIT is owned by a U.S. corporation (US Corp). US Corp is 50% owned by U.S. citizens and 50% owned by a domestic partnership (US Partnership). US Partnership is 50% owned by a domestic corporation (Corporate Partner) and 50% owned by foreign investor (Foreign Partners).
Pursuant to the look-through rule of the proposed regulations, since US Corp is not a public corporation US Corp’s shareholder, US Partnership, must be looked through to determine if US Corp is a foreign owned domestic corporation. Since US Partnership is 50% owned by Foreign Partner, US Corp is treated as being 25% owned by foreign investors and is therefore treated as a foreign owned domestic corporation. As a result of the look-through rule in the proposed regulations, US REIT is treated as being 61.75%12 owned by foreign investors and is thus treated as not domestically controlled.13 Accordingly, under the proposed regulations the sale of US REIT’s stock by US Corp is likely subject to US federal income tax.
The above demonstrates that the changes in the proposed regulations would significantly change what constitutes a domestic controlled REIT. As a result of the proposed regulations, consideration must be given to existing and prospective REIT structures which include foreign investors. Simply inserting a U.S. C corporation between foreign investors and the REIT may no longer suffice to maintain a REIT’s domestic controlled status. Accordingly, consultation with a tax professional is highly recommended when structuring REIT divestitures.