Final regulations on domestically controlled REITs include look-through rule

On April 24, 2024, Treasury and the IRS released final regulations under section 897 (TD 9992, the “Final Regulations”) that define indirect ownership for purposes of determining whether qualified investment entities, primarily real estate investment trusts (REITs), are domestically controlled. The Final Regulations adopt most of the proposed regulations published on Dec. 29, 2022 (REG-100442-22, the “Proposed Regulations”) and retain the controversial look-through rule for US corporations but increase the foreign ownership threshold for look-through treatment from 25% to 50%.

The Final Regulations include a transition rule that exempts existing REITs from the look-through rule for 10 years following the effective date of the regulations. However, existing REITs will become ineligible for the transition rule if the REIT acquires a substantial amount of new US real property or there is a significant change in ownership.

The Final Regulations also clarify that a qualified foreign pension fund is treated as a foreign person for purposes of determining whether a REIT is domestically controlled.¹

Under section 897, enacted by the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), gain on the disposition of a US real property interest by a nonresident individual or a foreign corporation is generally subject to US tax as income that is effectively connected with a US trade or business (ECI).

A US real property interest includes a direct interest in US real property and shares in a US real property holding corporation (USRPHC). A USRPHC is essentially any domestic corporation if, on certain testing dates, the fair market value of the corporation’s US real property equals or exceeds 50% of the fair market value of its real property and assets used in a trade or business.

REITs, which are classified as US corporations for US tax purposes, often fall within the definition of a USRPHC due to their extensive holdings in US real property such that a foreign investor’s gain on the investment will generally be taxed as ECI unless an exception applies. However, if the REIT is domestically controlled, shares in the REIT are not treated as a US real property interest even if the REIT would otherwise be classified as a USRPHC.²

Section 897(h)(4)(B) provides that a REIT is domestically controlled if, throughout the five-year period preceding a disposition, less than 50% of the value of the REIT stock is held “directly or indirectly” by foreign persons.³  Section 897 does not define indirect ownership for this purpose. Prior to the issuance of the Proposed Regulations, the IRS had taken the position in PLR 200923001 that one would not look through a US corporation for this purpose, regardless of the percentage of foreign shareholders in the US corporation.⁴  Many foreign investors structured their investments in a REIT based on the position taken by the IRS in that Private Letter Ruling (PLR) (i.e., that US corporate ‘blockers’ would be treated as shareholders for purposes of testing control of a REIT). The Proposed Regulations took the opposite approach and would have required that ownership of the REIT be determined by looking through a US corporation if 25% or more of the US corporation was owned by foreign persons. The Final Regulations adopt the look through rule for US corporations but increase the foreign ownership threshold to 50%. Thus, only for purposes of determining whether a REIT is domestically controlled under the Final Regulations, shareholders of the REIT are determined by looking through a US corporation if foreign persons own more than 50% of the US corporation.

Many foreign investors invest in a REIT through a US corporation (a ‘US blocker’) to shield the foreign investors from earning ECI directly, which would create an obligation to file a US tax return. In many cases, more than 50% of the US blocker is owned by foreign investors. Prior to the Final Regulations, some foreign investors may have taken the position that the US blocker was not a USRPHC because its primary asset, the REIT stock, was not a US real property interest by reason of being owned by the US blocker that allowed it to qualify as domestically controlled. As a result, when foreign investors sold their shares in the US blocker, they may have determined that they were not required to recognize that gain as ECI under section 897 or file US returns. See illustration below.

However, under the Final Regulations, this structure will no longer shield foreign investors from FIRPTA or the obligation to file a US tax return to report the gain on their investment as ECI. In cases where the US blocker corporation is primarily owned by foreign investors, ownership for purposes of testing the REIT for the domestically controlled exception will be determined by looking through the US blocker to its foreign shareholders.⁵  If the foreign shareholders indirectly own more than 50% of the REIT through the US blocker, the REIT will not qualify for the domestically controlled exception and will be considered a USRPHC if it owns primarily US real property. Assuming the US blocker’s main asset is the shares in the REIT, the US blocker will also be considered a USRPHC such that when the foreign investors dispose of their shares in the US blocker they will generally be taxed on gain from the shares as ECI and will be required to report that gain on a US return (even if the tax on the gain is collected through withholding under section 1445).

However, because a US corporation is not subject to the look through rule unless more than 50% of the value of the corporation’s shares are owned by foreign persons, the Final Regulations allow up to 74.5% of foreign investment in a REIT, through a combination of direct and indirect foreign investment through a US corporation, without disqualifying the REIT for the domestically controlled exception. For example, a REIT may qualify for the domestically controlled exception with 49% direct investment by nonresident individuals or other non-look through foreign persons, and indirect foreign investment of 25.5% through a US corporation (i.e., 51% x 50%). In this example, illustrated below, the US blocker would not be considered a look through person and the REIT would be domestically controlled based on the ownership of the US corporation.

Transition Rule

The Final Regulations apply to transactions occurring on or after April 25, 2024, the effective date of the regulations. Although the Final Regulations only apply prospectively to transactions occurring after the effective date of the regulations, due to the 5-year look back period for testing domestically controlled status, the final regulations may have retroactive effect.

To mitigate this retroactive effect, the Final Regulations include a transition rule that turns off the look through rule for foreign owned US corporations if the REIT was in existence on April 25, 2024.⁶ However, to qualify for the transition rule, the REIT must satisfy the following conditions throughout the period beginning April 25, 2024, and ending on the date of disposition:

1. the aggregate value of US real property acquired by the REIT after April 25, 2024, is not more than 20% of the value of US real property held by the REIT on April 25, 2024; and
2. the percentage of REIT stock held (directly or indirectly) by one or more non-look through persons on April 25, 2024, does not increase by more than 50%.

If these conditions are not met on any day during the transition period, the look-through rule for US corporations will be turned back on the following day.

The transition rule may provide an opportunity for foreign investors in existing domestically controlled REIT structures to exit their investment without being subject to FIRPTA and US reporting requirements. However, foreign investors in existing REIT structures will need to carefully monitor direct and indirect ownership transfers to avoid disqualifying the structure for the transition rule.

REITs and asset managers should carefully review their structures and the impact these rule changes have on the ability of their foreign investors to rely on the domestically controlled REIT exception.

_{¹This is the case even though section 897(l) provides that a qualified foreign pension fund is not treated as a nonresident alien individual or foreign corporation for purposes of exempting the qualified foreign pension fund from the scope of section 897.}

_{² If the REIT is publicly traded, investors who own 10% or less in the REIT may qualify for a publicly traded exception in section 897(c)(3). However, foreign investors in privately held REITs often rely on the section 897(h)(2) exception for shares in a domestically controlled qualified investment entity.}

_{³ The testing period generally includes the 5-year period ending on the date of disposition.}

_{⁴ Although PLRs are not precedential, PLR 200923001 was cited by the Joint Committee on Taxation in a report regarding the enactment of section 897(h)(4)(E) as part of the Protecting Americans from Tax Hikes Act of 2015 (the “PATH Act”).}

_{⁵ Although the Final Regulations generally classify US corporations (other than S corporations) as non-look through persons, an exception applies to non-public foreign controlled domestic corporations. Under the Final Regulations, a non-public US corporation is treated as a look-through person if it is a “foreign-controlled domestic corporation.”  A “foreign-controlled domestic corporation” is defined in Reg. section 1.897-1(c)(3)(v)(B) as a domestic C corporation where foreign persons hold (directly or indirectly) more than 50% of the value of the corporation’s stock.}

_{⁶ The Reg. section1.897-1(c)(3)(vi) transition rule does not apply to the final regulation’s definition of foreign persons. Consequently, qualified foreign pension funds will be treated as foreign persons as of April 25, 2004, and because it appears to be viewed by Treasury and the IRS as a clarification and not a change in law, the IRS may treat qualified foreign pension funds as foreign persons with respect to transactions that occurred prior to the effective date of the final regulations.}