Proposed regulations remove look-through rule for qualified investment entities

Background

A U.S. real property interest includes a direct interest in U.S. real property and, absent an exception, shares in a USRPHC. A USRPHC is essentially any domestic corporation if, on certain testing dates, the fair market value of the corporation’s U.S. real property equals or exceeds 50% of the fair market value of its real property and assets used in a trade or business. REITs and certain RICs, which are classified as QIEs for U.S. tax purposes, often fall within the definition of a USRPHC due to their extensive holdings in U.S. real property. As a result, under section 897, a foreign investor’s gain on QIE shares will generally be taxed as income that is effectively connected to a U.S. trade or business (ECI) unless an exception applies. However, if the QIE is domestically controlled within the meaning of section 897(h), shares in the QIE are not treated as a U.S. real property interest even if the QIE would otherwise be classified as a USRPHC.

Section 897(h) provides that a QIE is domestically controlled if, throughout the five-year period preceding a disposition, less than 50% of the value of the QIE stock is held “directly or indirectly” by foreign persons. On April 24, 2024, Treasury and the IRS released final regulations under section 897 (TD 9992, the “2024 Final Regulations”) that define indirect ownership for purposes of determining whether qualified investment entities (REITs and RICs) are domestically controlled. In the 2024 Final Regulations, Treasury and the IRS adopted rules that would determine whether a QIE is domestically controlled by looking through a domestic corporation if foreign persons own more than 50% of the U.S. corporation (subject to a transition rule for existing structures).

For example, suppose a REIT has three shareholders: Foreign Investor A owns 30% directly, Foreign Investor B owns 19% directly, and a U.S. corporation (blocker) owns 51%. The U.S. blocker is owned 100% by Foreign Investor C. Under the 2024 Final Regulations, the look-through rule would trace Foreign Investor C’s ownership through the blocker, resulting in 100% foreign ownership and the REIT would not be domestically controlled.

The Proposed Regulations

The Treasury Department and the IRS received feedback from taxpayers on the 2024 Final Regulations recommending the withdrawal of the domestic corporation look-through rule based on the practical difficulty of tracing upstream ownership, legal uncertainty, and the potential chilling effects on investment in U.S. real property. Commenters also argued that Congress did not intend for a corporate look-through rule under section 897(h)(4)(B), and that the presence of look-through rules elsewhere in section 897 suggests a narrower approach was intended. In response to taxpayer’s concern, Treasury and the IRS issued proposed regulations Oct. 20, 2025, that would remove the domestic corporation look-through rule and treat all domestic C corporations as non-look-through persons in determining whether a qualified investment entity is domestically controlled.

Returning to the example above, under the proposed regulations, the U.S. blocker is treated as a U.S. person, so only Foreign Investor A’s and B’s direct ownership (49%) counts as foreign. The REIT would be domestically controlled, and Foreign Investors A, B, and C are shielded from direct FIRPTA exposure by the blocker. However, the blocker would generally pay regular U.S. corporate tax on any gain from selling its 51% of the REIT shares.

The proposed regulations include reliance language which allows taxpayers to apply the removal of the look through rule to transactions occurring on or after April 25, 2024 (the date the 2024 Final Regulations went into effect), even before the proposed regulations are finalized. The proposed regulations only affect the domestically controlled exception under FIRPTA and do not change other FIRPTA rules, such as the definition of a USRPHC or the general taxation of QIEs.