United States: Congress Passes Significant FIRPTA Reforms Affecting Foreign Investment In U.S. Real Estate − Protecting Americans From Tax Hikes Act Of 2015

Last Updated: January 4 2016
Article by Gerald V. Thomas II and Michael R. Rodgers

On December 18, President Obama signed the Protecting Americans from Tax Hikes (PATH) Act of 2015 (the "Act") into law. The Act, among other things, provides for substantial reforms to the Foreign Investment in Real Property Tax Act (FIRPTA), many of which are likely to facilitate a significant amount of foreign capital investment in U.S. real estate. These reforms are important for a wide range of parties, including foreign investors, real estate investment trusts (REITs), and private equity funds investing primarily in U.S. real estate.

1. Repeal of FIRPTA for Interests Held by Foreign Retirement or Pension Funds

The Act completely exempts from FIRPTA any U.S. real property interest held by a qualified foreign pension fund. In order to so qualify, the foreign pension fund must be exempt from tax or subject to a reduced rate of tax in its resident jurisdiction, or contributions to such fund must be tax-deductible in the fund's resident jurisdiction. Additionally, the fund must adhere to certain "U.S.-based" criteria; specifically, the purpose of the fund must involve the administration and provision of retirement or pension benefits to employees, no single participant may hold the right to more than 5 percent of the fund's assets or income, and the fund must be subject to local government regulation, including rules requiring the fund to report annually to local tax authorities regarding its beneficiaries. This provision applies to dispositions and distributions made after the date of enactment of the Act.

This reform reflects a clear desire to put U.S. and foreign pension funds on equal footing with respect to real estate investments in the U.S., and is likely to result in a significant increase of foreign capital investments into the U.S. real estate market. Particularly for foreign pension funds, this provision should significantly reduce the once nearly stifling effect of FIRPTA on foreign investment in U.S. real estate.

2. Increased Threshold for Publicly Traded REIT Stock

Prior to the enactment of the Act, foreign investors owning 5 percent or less of a REIT, of which any of the classes of stock is traded on an established securities market, were not subject to FIRPTA upon a sale of such REIT stock or the receipt of a capital gain dividend from the REIT. The Act increases from 5 percent to 10 percent the maximum stock ownership a shareholder may hold in a publicly traded REIT to avoid having that stock treated as a U.S. real property interest on disposition. Also, the Act contains a complex system of rules to allow certain foreign publicly traded entities (corporations and partnerships) formed in jurisdictions that have a comprehensive income tax treaty with the U.S. and have an agreement for the exchange of information with respect to taxes with the U.S. and "qualified collective investment vehicles," to own and dispose of any amount of stock in a publicly traded REIT, without triggering FIRPTA. However, if any such entities (described in the preceding sentence) have investors that hold more than 10 percent of such stock or interests, the FIRPTA exemption will be reduced by the proportionate ownership of such holder. These provisions apply to dispositions and distributions on or after the date of enactment of the Act. The increased limitation for foreign "portfolio investors" and expansion to certain types of entities (discussed above) is likely to attract additional foreign capital in publicly traded REITs.

3. "Domestically Controlled" Presumptions

Under current law, gain resulting from the sale or disposition of stock of a "domestically controlled" qualified investment entity (i.e., a REIT or RIC, more than 50 percent of the stock of which is owned by U.S. persons), is not subject to FIRPTA. Typically, many publicly traded REITs have difficulty taking advantage of this FIRPTA exception because of lack of information regarding the U.S. or foreign status of their less than 5 percent shareholders. The Act provides new presumption rules for purposes of determining whether a REIT or RIC is "domestically controlled." First, shareholders owning less than 5 percent of stock in a qualified investment entity (e.g., a REIT or RIC) that is regularly traded on an established U.S. securities market will be treated as U.S. persons, absent actual knowledge of the qualified investment entity to the contrary. Also, REIT or RIC stock owned either by a publicly traded REIT or a RIC meeting certain requirements, will be presumed to be held by a foreign person unless the "upper-tier" REIT or RIC is domestically controlled, in which case, such stock will be treated as held by a U.S. person. Additionally, any stock in a RIC or REIT that is held by a RIC or REIT that is not publicly traded will be treated as held by a U.S. person only in proportion to the stock of the upper-tier RIC or REIT that is held (or treated as held) by a U.S. person. This provision takes effect on the date of enactment of the Act.

4. RICs Now Permanently Treated as Qualified Investment Entities

Prior to the enactment of the Act, a "qualified investment entity" included both a REIT and, until the beginning of 2015, a RIC which would otherwise be considered a U.S. real property holding company. The Act permanently modifies this rule to allow such a RIC to once again qualify as a qualified investment entity. This provision applies retroactively to January 1, 2015.

5. Increased Rate of FIRPTA Withholding on Dispositions of U.S. Real Property Interests

The Act increases the rate of withholding on dispositions of U.S. real property interests (other than the sale of a personal residence where the amount realized is $1 million or less) from 10 percent to 15 percent. Such increased rate is designed to collect a greater amount of the potential tax owed. This provision is effective for dispositions occurring 60 days after the date of enactment of the Act.

6. Interests in RICs and REITs Not Eligible for "Cleansing Rule"

Currently, under the so-called "cleansing rule," a corporation, the disposition of the stock of which would give rise to FIRPTA gain, may "cleanse" itself of its U.S. real property interest designation by disposing of all of its real estate assets in a taxable transaction. The Act essentially excludes RICs and REITs from eligibility for the "cleansing rule." This provision applies to dispositions on or after the date of enactment of the Act.

7. Certain Dividends Received From Foreign Corporations Attributable to RICs and REITs

Dividends received by U.S. corporations from foreign subsidiaries are generally not eligible for a dividend received deduction unless the dividend is attributable to (i) income effectively connected with a U.S. trade or business, or (ii) any dividend received (directly or through a wholly owned foreign corporation) from an 80 percent or more controlled U.S. subsidiary (the "look through rule"). The Act provides that for purposes of the look through rule, dividends from RICs and REITs are not treated as dividends from domestic corporations. As a result, under the Act, dividends received by U.S. corporations from a wholly owned foreign subsidiary that are attributable to a dividend received from a U.S. RIC or REIT will not be eligible for a dividend received deduction. This provision applies to dividends received from RICs and REITs on or after the date of enactment of the Act.

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.

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