On April 24, 2024, the IRS and the U.S. Department of Treasury ("Treasury") issued final regulations relating to the qualification of a real estate investment trust ("REIT") or a registered investment company ("RIC") as a domestically controlled qualified investment entity (the "Final Regulations"). The Final Regulations finalize, with changes, the proposed regulations issued on December 29, 2022 (the "Proposed Regulations"). The Final Regulations generally (i) limit the scope of the look-through rule of the Proposed Regulations, which treats certain "foreign-owned domestic corporations" as flow-through entities for purposes of determining if a REIT owned, in part, by a "foreign-owned domestic corporation" qualifies as a domestically controlled REIT ("DC REIT"), and (ii) apply only prospectively (subject to a ten-year transition period for existing REITs that continue to meet certain requirements). The Final Regulations may impact sponsors and non-U.S. investors in real estate funds, private equity funds and other tax structures involving REITs.
Overview of Regulatory Position Prior to Proposed Regulations
Pursuant to the Foreign Investment in Real Property Tax Act of 1980 ("FIRPTA"), any gain or loss of a non-U.S. investor from the sale or other disposition of a U.S. real property interest ("USRPI") is considered to be income that is effectively connected with the conduct of a U.S. trade or business.1
A USRPI includes an interest in a U.S. real property holding corporation ("USRPHC"), i.e., a U.S. corporation with 50% or more of the fair market value of its business assets consisting of interests in U.S. real estate and related asset2 A REIT is generally considered a USRPHC because of the composition of its assets.
However, an interest in a domestically controlled qualified investment entity ("QIE"), such as a domestically controlled REIT (previously defined as a "DC REIT"), is not a USRP3 A domestically controlled QIE is any QIE in which less than 50% of the value of its stock was held directly or indirectly by foreign persons at all times during the shorter of (i) the five-year period ending on the date of the disposition or distribution, as applicable, or (ii) the period during which the QIE was in existence (the "five-year look-back period&rdqu4
The Code and the Treasury Regulations had not clearly addressed how to determine "indirect" ownership for purposes of determining whether a REIT qualifies for DC REIT status. However, the Treasury Regulations have provided that the "actual owners of stock," as determined under Treas. Reg. Sec. 1.857-8, must be taken into accoun5 The actual owner of REIT shares is the person who is required to include the dividends received on the shares in gross income (i.e., the shareholder of record of the REIT)6
Further, the IRS issued a private letter ruling in 2009 (the "2009 PLR") that provided that REIT stock owned by a non-U.S. person through a fully taxable U.S. corporation is to be treated as owned by such U.S. corporation, and not as owned "indirectly" by the non-U.S. person, for purposes of determining DC REIT statu7However, because a private letter ruling may only be relied upon by the taxpayer to which it is issued, it is not binding precedent with respect to other taxpayers.
Proposed Regulations
First, pursuant to the Proposed Regulations, "foreign-owned domestic corporations" ("FODCs") would have been treated as flow-through entities for purposes of determining DC REIT status (the "look-through rule&rdqu8 Under the Proposed Regulations, an FODC is any non-publicly traded U.S. corporation if non-U.S. persons hold directly or indirectly 25% or more of the value of its outstanding stock, after applying certain look-through rule9
The preamble to the Proposed Regulations (the "Preamble") noted that the Treasury and IRS believe reliance on Treas. Reg. Sec. 1.857-8 alone to determine DC REIT status is incorrect, as Treas. Reg. Sec. 1.857-8 is only intended to ensure that the beneficial owner of stock is taken into account when different from the shareholder of record.10The Preamble did not directly address the potential inconsistency with the 2009 PLR, which also cited those regulations to support its conclusion.
Second, the Proposed Regulations clarified that a qualified foreign pension fund ("QFPF") or a qualified controlled entity ("QCE") would always be treated as a "foreign person" for purposes of determining the status of a REIT as a DC REIT.11 Under the FIRPTA rules, both a QFPF and a QCE are generally exempt from U.S. tax pursuant to FIRPTA.12
Third, the Proposed Regulations may have been relevant for determining DC REIT status during periods before the date on which the Proposed Regulations were finalized, to the extent the five-year look-back period for DC REIT status related to a transaction that occurred after the Proposed Regulations were finalized, but included periods before the date of finalization. As such, there was the potential that the Proposed Regulations could have been applied retroactively.
In sum, pursuant to the Proposed Regulations, a REIT would have been required to look through a fully-taxable U.S. corporation that qualifies as an FODC, for purposes of determining DC REIT status, and this rule may have been applied retroactively.
Interim Period between Proposed Regulations and Final Regulations
The IRS and Treasury received comment letters from the American Bar Association, real estate groups (including the American Investment Council and Nareit) and law firms that generally noted that the Treasury lacked the statutory authority to propose the look-through rule of the Proposed Regulations and cautioned that the look-through rule and its retroactive nature could have a chilling effect on non-U.S. investment in U.S. real estate held by REITs.
Addressing these comments relating to the posture of the Proposed Regulations, David Berke of the IRS Office of Associate Chief Counsel (International) said, "[w]e are thinking through the comments received including whether to provide transitional relief..."13 Ultimately, as previewed, the Treasury and IRS did provide transitional relief in the Final Regulations.
Final Regulations
First, the Final Regulations limit the look-through rule to situations where non-U.S. persons own a significant percentage of a REIT and increase the amount of non-U.S. ownership required to apply the look-through rule from "25% or more" to "more than 50%." Accordingly, an FODC is any non-publicly traded U.S. corporation if non-U.S. persons hold directly or indirectly more than 50% of the fair market value of its outstanding stock, after applying certain look-through rules.14The preamble to the Final Regulations notes that the reference to the 2009 PLR in a Joint Committee on Taxation Report did not indicate that Congress endorsed the conclusion in the 2009 PLR, and hence, was inapplicable.
Second, the Final Regulations clarify that a QFPF or a QCE will be treated as a "foreign person" for purposes of determining a REIT's status as a DC REIT, consistent with the approach in the Proposed Regulations.15
Finally, the Final Regulations introduce a transition rule, which exempts existing DC REIT structures from the look-through rule until April 24, 2034, provided that certain asset and ownership requirements are met (the "transition rule"). First, a REIT is prohibited from acquiring USRPI that, in the aggregate, exceed 20% of the total FMV of all of its USRPI as of April 24, 2024 (the "asset requirement").sup>16 Second, a REIT cannot have a significant change in ownership, which occurs when the ownership by "non-look-through persons" (i.e., persons other than FODCs, REITs, RICs, etc.) has increased by more than 50 percentage points, in the aggregate, compared to their ownership on the date when the Final Regulations were published in the U.S. Federal Register (i.e., April 25, 2024) (the "ownership requirement").17
If either the asset requirement or the ownership requirement is not met, the REIT at that time becomes subject to the look-through rule. Further, if applicable, the Final Regulations only apply prospectively and do not apply to any portion of the five-year look-back period when the transition rule applied to a REIT.18
Practical Application of Proposed Regulations
Both sponsors and investors in real estate funds, private equity funds and other investment structures involving DC REITs should analyze the application of the narrower look-through rule of the Final Regulations to their funds or investment structures and any applicable covenants and/or representations relating to DC REIT status or withholding taxes in fund documents (including side letters). Based on our experience, sponsors and investors alike undertook a similar analysis after the Proposed Regulations were issued.
Further, the Final Regulations do not provide guidelines regarding procedures to determine if a U.S. corporation is an FODC, and a REIT must take appropriate measures to determine the identity of its direct and indirect shareholders in determining whether it qualifies as a DC REIT. As such, among other actions, sponsors of REITs may include questions and confirmations relating to potential investors' direct and indirect shareholding in subscription documents to determine whether REITs in their fund structures qualify as DC REITs.
In practice, some real estate funds may currently rely on the direct shareholding of their U.S. taxable investors (that are not FODCs) and U.S. tax-exempt investors for purposes of qualifying a REIT as a DC REIT and therefore may not be impacted by the Final Regulations. Particularly, U.S. taxable investors generally would choose to invest directly in a REIT, rather than through a U.S. corporation, to avoid the additional layer of tax introduced by investing in a REIT indirectly through a U.S. corporation. U.S. tax-exempt investors may also choose to invest directly in a REIT, as the REIT often shields such investors from incurring unrelated business taxable income (assuming that the U.S. tax-exempt investors' interest in the REIT is not debt financed and that the pension-held REIT rules under Section 856(h)(3)(D) do not apply).
For example, 51% of the stock of a REIT (that expects to generate a substantial amount of REIT "capital gain dividends") may be held by U.S. taxable investors and U.S. tax-exempt investors, and 49% of the stock may be held by a non-publicly traded U.S. corporation that is held collectively by non-U.S. investors. Here, the look-through rule of the Final Regulations is not expected to impact the REIT's qualification as a DC REIT because 51% of the REIT's direct shareholders constitute U.S. taxable investors and U.S. tax-exempt investors (regardless of the non-U.S. investors' indirect shareholding through the U.S. corporation), assuming that no transfers or redemptions cause the percentage of the REIT that is owned by U.S. investors to fall below the required threshold.19
Finally, as noted, a REIT that qualifies as a DC REIT but for the look-through rule of the Final Regulations is grandfathered under the transition rule. If such "grandfathered" REIT foresees that it will fail to meet either the asset requirement or the ownership requirement, then non-U.S. investors in such REIT should consider selling or disposing of their stock in such REIT during the transition period (prior to such failure). For example, if a "grandfathered" REIT fails to meet either the asset requirement or the ownership requirement on January 1, 2026, it will be subject to the Final Regulations starting on such date. Therefore, if a non-U.S. investor in such REIT sells or disposes of its stock on January 1, 2027, the REIT will not be treated as a DC REIT, because it did not qualify as a DC REIT for one year out of the five years in the five-year look-back period (i.e., from January 1, 2026, to January 1, 2027). The same conclusion should apply to the extent that the non-U.S. investor disposes of its interest after January 1, 2026, but before January 1, 2027. However, if the non-U.S. investor sells or disposes of its stock in such REIT prior to January 1, 2026, the REIT should qualify as a DC REIT under the transition rule, and the non-U.S. investor should generally be exempt from U.S. tax pursuant to FIRPTA.
Effective Date
Subject to the transition rule, the Final Regulations apply to transactions occurring on or after the date when the Final Regulations are published in the U.S. Federal Register (i.e., April 25, 2024).
Footnotes
1 Section 897(a).
2 Section 897(c)(2).
3 Section 897(h)(2); Treas. Reg. Sec. 1.897-1(c)(2)(i).
4 Section 897(h)(4).
5 Treas. Reg. Sec. 1.897-1(c)(2)(i).
6 Treas. Reg. Sec. 1.857-8(b).
7 PLR 200923001 (June 5, 2009).
8 Prop. Reg. Sec. 1.897-1(c)(3)(iii)(B).
9 Prop. Reg. Sec. 1.897-1(c)(3)(v)(B).
10 The Preamble also notes that Treas. Reg. Sec. 1.897-1(c)(2)(i) does not provide any guidance on the meaning of "held directly or indirectly by foreign persons."
11 Prop. Treas. Reg. Secs. 1.897-1(c)(3)(iv)(A) and 1.897-1(c)(3)(vi)(A), Example 1(4).
12 See Section 897(l).
13 See A. Velarde, "ABA Section of Taxation Meeting: IRS Weighing Relief From REIT Domestic Control Rules," Tax Notes (May 8, 2023).
14 Treas. Reg. Sec. 1.897-1(c)(3)(v)(B).
15 Treas. Reg. Sec. 1.897-1(c)(3)(iv).
16 Treas. Reg. Sec. 1.897-1(c)(3)(vi)(A)(2).
17 Treas. Reg. Sec. 1.897-1(c)(3)(vi)(A)(3).
18 Treas. Reg. Sec. 1.897-1(c)(3)(vi)(C).
19 See V. Anil Kumar and M. Levine, "Proposed Regulations on Domestically Controlled REITs Introduce Seismic Changes," Practical Tax Strategies, pg. 7 (June 2023).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.