New tax rules for REITs and foreign investors in US real estate
INSIGHT ARTICLE |
The Protecting Americans from Tax Hikes Act of 2015 (The Act) was enacted on December 18, 2015, and codified some significant provisions affecting real estate investment trusts (REITs) and foreign investments in real estate, including the Foreign Investment in Real Property Tax Act (FIRPTA). This article aims to address these developments and what they may mean for REITs and foreign investors in U.S. real estate.
Restriction on tax-free spinoffs involving REITs
The Act amends section 355 to prevent business corporations from putting their real estate into REITs, where the income is generally not subject to a double tax. Under prior law, using a “spinoff,” a corporation could transfer its real estate into a REIT, without paying tax on any appreciation. In effect, it was viewed as tantamount to a sale-leaseback of the real estate, without any tax on the sale. Under the new rules, a spinoff involving a REIT will qualify as tax-free only if the original company and the new company are both REITs immediately after the distribution. This effectively prevents general business corporations from using this technique. An exception will allow a REIT to spin off a taxable REIT subsidiary (TRS) – which is not treated as a REIT – if, during the three years preceding the transaction, the REIT spinning off its subsidiary has been a REIT at all times, the subsidiary has been a TRS at all times and the REIT had control of the TRS at all times.
The new rules are effective for distributions made on or after December 7, 2015, unless the distribution is made pursuant to a plan described in a ruling request submitted to the Internal Revenue Service (IRS) on or before December 7, 2015. However, the Act also provides a 10-year prohibition on certain corporations making REIT elections if they have previously engaged in certain tax-free reorganizations.
Legislation of this nature was not unanticipated, as the IRS had recently released guidance announcing that they would not rule in this area and indicating their discomfort with the use of REITs in transactions of this nature.
Expanded safe harbors from prohibited transaction rules may permit more property sales by REITs
A new provision may allow a REIT to sell certain real property (not including inventory property) in an amount up to 20 percent of the fair market value (FMV) of its assets during a year, subject to a cap of 10 percent of the FMV of its assets over a rolling, three-year period. As an alternative to using FMV, this rule can be applied based on the basis of the assets, computed under the earnings and profits rules. These new rules apply to tax years beginning after the date of enactment (December 18, 2015).
This favorable legislation provides a REIT with additional flexibility in structuring disposition transactions to meet the safe harbors, especially in years when there is an unusual amount of sales. REITs must still meet the requirements that the property was held for more than two years for the production of rental income in order to use the new provision.
TRSs may now provide more services
Under certain prior law, prohibited transaction safe harbors for marketing and development services related to a property sold could only be performed by an independent contractor. The new law places a TRS on equal footing with an independent contractor, effectively eliminating these restrictions.
The new law also treats a TRS as favorably as an independent contractor, with respect to certain foreclosure property rules. Under prior law, section 856(e)(4)(C) mandated the use of an independent contractor to operate foreclosure property in certain cases. This new law allows a TRS to operate the property. This provision is effective for tax years beginning after December 31, 2015.
These rules allow REITs greater flexibility to use TRSs for certain activities and services, without losing the benefits of the safe harbor for certain property dispositions and in connection with the operation of foreclosure property.
Permanent reduction in built-in gain (BIG) tax recognition period from 10 to 5 years
REITs are subject to a BIG tax if a former C corporation elects REIT status, or a REIT acquires assets from a C Corporation in a carryover basis transaction and then disposes of the asset(s) at a taxable gain within a certain recognition period. Under prior law, the recognition period was generally 10 years. In recent years, the recognition period was temporarily shortened. The Act permanently provides that the recognition period is five years. These changes are effective retroactively to tax years beginning after December 31, 2014.
The new law provides more certain rules, and more favorable rules, when real estate corporations convert to REITs.
Reduction in percentage limitation on assets of REIT, which may be taxable REIT subsidiaries
The Act amends section 856(c)(4)(b)(ii) to reduce to 20 percent the limit on the percentage of the value of REIT assets that can consist of securities of one or more TRSs. The Housing and Economic Recovery Act of 2008 had previously increased this limit from 20 percent to 25 percent. The new law changes it back to 20 percent. This change is effective for tax years beginning after December 31, 2017. For REITs with TRSs currently valued over 20 percent, the value must be reduced to 20 percent or less no later than the end of the first quarter of 2018.
This reduction in the permitted size of a REIT’s TRS activities is not expected to have a substantial impact on most REITs, which typically do not come close to the limit.
Asset and income test clarification regarding ancillary personal property
The Act provides that ancillary personal property (e.g., appliances) leased with real property will be treated as real property for purposes of the 75 percent asset test as long as the rents attributable to the personal property are treated as rents from real property for purposes of the 75 percent income test.
In addition, an obligation secured by a mortgage on both real and personal property is treated as real property for purposes of the 75 percent income and asset tests, so long as the fair market value of the personal property secured by the mortgage does not exceed 15 percent of the total fair market value of the combined real and personal property. Under prior law, only a proportional test applied. This change is effective for tax years beginning after December 31, 2015.
This favorable legislation is a welcome modification. By aligning the income and asset tests for ancillary personal property, the new law simplifies compliance. For additional insight into what constitutes real property, please see our alert, IRS issues proposed REIT regulations further defining real property.
Debt instruments of publicly offered REITs and mortgages treated as real property
The Act provides that debt instruments issued by publicly offered REITs and mortgages on interests in real property (such as mezzanine debt secured by an interest in a real estate partnership) qualify as real estate assets for purposes of the 75 percent asset test. Further, income from such debt instruments is qualifying income for purposes of the 95 percent income test. However, it is not qualifying income for purposes of the 75 percent income test. In addition, not more than 25 percent of the value of a REIT’s total assets may consist of such debt instruments. These changes are effective for tax years beginning after December 31, 2015.
This favorable legislation, similar to the new rules for ancillary personal property, expands the definition of real property for purposes of the REIT income and asset rules. For additional insight into what constitutes real property, please see our alert, IRS issues proposed REIT regulations further defining real property.
In recent years, several taxpayers pursued and received favorable private letter rulings (PLRs) with respect to certain “counteracting” hedges used to offset a prior qualifying hedge. Consistent with the prior rulings, the new law expands the definition of a qualifying hedge to include such counteracting hedges. This rule is effective for tax years beginning in 2016.
This favorable legislation allows REITs to manage their interest rate risks more effectively and with greater tax certainty. While the new provision is consistent with IRS private rulings, it is important to remember that such rulings cannot be relied on, except by the taxpayers to whom they are issued. Our article, REITs must be aware of the unique tax rules for hedging instruments, provides some additional background and insights. REITs should remember that they must still comply with highly technical and time-sensitive hedge identification requirements
Alternative remedies to address certain REIT distribution failures of nonpublicly offered REITS
The new law grants the IRS authority to provide an alternative remedy for a private REIT that pays a preferential dividend. The IRS can excuse failures of the preferential dividend rules, where there is reasonable cause and the failure is not due to willful neglect. Before this change, the IRS was required to treat the dividend as not counting toward the REIT’s distribution requirement. This rule is effective for distributions made in tax years beginning after December 31, 2015.
This favorable legislation eliminates, for private REITs, one of the more significant traps for the unwary. This change allows for a more forgiving approach to inadvertent errors.
Repeal of preferential dividend rule for publicly offered REITs
The new law repeals the preferential dividend rule for publicly offered REITs, effective for tax years beginning after December 31, 2014. Unlike the new rule discussed above for private REITs, this completely eliminates the preferential dividend rule for publicly offered REITs.
This favorable legislation eliminates a significant trap for the unwary for public REITs.
Limitations on designation of dividends by REITs
The new law provides that the aggregate amount of REIT dividends (as defined in section 316) that can be designated as capital gain dividends or qualified dividends for a taxable year cannot exceed the total amount of dividends paid by a REIT for the tax year. Further, this provision grants the IRS authority to prescribe regulations or other guidance requiring the proportionality of the designation for particular types of dividends (e.g., ordinary dividends, capital gain dividends) among shares or beneficial interests in a REIT. This rule is effective for tax years beginning after December 31, 2015.
This rule was enacted in response to Revenue Ruling 2005-31, where the IRS had allowed a capital gains dividend larger than the actual amount distributed.
Withholding tax exception for interests held by foreign retirement or pension funds
The Act added section 897(l), which provides an exemption from FIRPTA taxation to certain qualified foreign pension funds and wholly owned subsidiaries of qualified foreign pension funds. The exemption applies to certain distributions and gains on dispositions of U.S. real property interest (USRPI). Qualified foreign pension funds must: (1) be created or organized under the law of a country other than the United States, (2) be established to provide retirement or pension benefits to participants or beneficiaries that are current or former employees (or persons designated by such employees) of one or more employers in consideration for services rendered, (3) not have a single participant or beneficiary with a right to more than 5 percent of its assets or income, (4) be subject to government regulation and provide annual information reporting about its beneficiaries to the relevant tax authorities in the country in which it is established or operates and (5) be subject to the laws of the country in which it is established or operates and either the (i) contributions to such entity are subject to tax, pursuant to local law, are deductible or excluded from the gross income of such entity or taxed at a reduced rate, or (ii) taxation of any investment income of such entity or arrangement is deferred or such income is taxed at a reduced rate. This exception is effective after December 18, 2015.
Whereas this change should prove to be quite beneficial for qualified foreign pension funds, foreign pension fund investors will still need to consider the U.S. taxation of rental income, interest income and other rental-related income when structuring their U.S. investments.
U.S. withholding agents will need to receive documentation from its foreign pension fund investors to determine if the pension fund is a qualified foreign pension fund. The Act allows the IRS to issue regulations on this topic.
Increase in the rate of withholding tax on dispositions of United States real property interests
Before The Act, transferees of U.S. real property were required to withhold 10 percent of the amount realized. The Act increases the percentage from 10 percent to 15 percent, except for certain residences valued under $1,000,000. This increase in the rate of withholding tax is effective for dispositions after December 18, 2015.
This unfavorable legislation serves as a revenue-raising provision aimed at offsetting the budgetary impact of the other, more favorable FIRPTA reform provisions in The Act. Under The Act, foreign taxpayers will continue to have the ability to provide a withholding certificate to the transferee to apply a reduced FIRPTA withholding tax rate on any transfer subject to FIRPTA. However, given the increase in the rate of withholding, foreign sellers are even more incented to provide appropriate withholding documentation to the transferee of the USRPI.
Increase to the FIRPTA publicly traded stock exception for publicly traded REITs
Gains realized by a foreign taxpayer with respect to the disposition of interests in certain USRPI, including gains derived from the sale of publicly traded REIT shares or capital gain dividends received from the REIT, are generally subject to U.S. taxation (FIRPTA tax). However, there are exceptions to this general rule in the case of foreign persons who own less than a threshold amount of stock in publicly traded companies (publicly traded stock exception). Prior to The Act, the publicly traded stock exception was available for any foreign person who owned 5 percent or less of stock in certain publicly traded companies. The Act added a new rule specifically increasing the ownership threshold to meet the publicly traded stock exception from “5 percent or less” to “10 percent or less.”
With respect to dispositions of publicly traded REIT shares, this provision is effective after December 18, 2015. With regards to distributions from REITs that are treated as a deduction for the taxable year of the REIT ending after December 18, 2015, this rule is effective on or after December 18, 2015.
By expanding the publicly traded stock exemption, this favorable legislation should increase the amount of foreign capital invested in U.S. publicly traded REITs by foreign investors.
Clarifications to determine whether a publicly traded REIT is domestically controlled
Generally, a foreign taxpayer’s gains resulting from the disposition of stock in a domestically controlled REIT are not subject to U.S. federal income tax. A domestically controlled REIT is a REIT where 50 percent or more of the stock is held by U.S. persons. The Act allows publicly traded REITs to presume that any shareholder with less than a 5 percent interest is a U.S. person, unless the publicly traded REIT has knowledge that the shareholder is foreign. This rule is effective after December 18, 2015.
Historically, publicly traded REITs had a difficult time in determining whether its investors are U.S. or foreign, due to the large number of small investors. This rule should ease the administrative burden of determining whether a publicly traded REIT is domestically controlled.
Other provisions of the Act
Our alert provides an overview of some of the other key provisions of The Act.
Employers should use the updated Form 941 to properly report new CARES Act and FFCRA credits beginning in the second quarter of 2020.
Provides more time to elect out of 163(j) interest deduction limitation for taxpayers with certain real property or farming businesses.
Real estate funds considering setting up a real estate investment trust should also consider the impact of a REIT on taxable investors.