United States: New Legislation Affects The Taxation Of REITs

The Protecting Americans from Tax Hikes Act of 2015 (the "Act") became law on Dec. 18, 2015. The Act retroactively extended, either permanently or temporarily, various tax provisions that Congress had periodically been extending on a temporary basis. In addition, the Act made important changes affecting the taxation of investments, including several changes specifically affecting real estate investment trusts ("REITs") and foreign investments in U.S. real estate. Summarized below are certain REIT-related provisions of the Act that may be of interest to funds with activities in that area, as well as other provisions of the Act. Our next issue will address changes affecting foreign investments in U.S. real estate.


Restrictions on REIT spinoffs

In several highly publicized transactions, operating businesses distributed their real estate assets in tax-free "spinoff" transactions, following which the real estate assets were held in tax-favored REITs. The Act restricts the ability to engage in such transactions in two ways. First, a spinoff involving a REIT will generally not qualify as tax-free if the distributing or the distributed corporation is a REIT, unless both corporations are REITs or, in certain circumstances, the distributed corporation is a taxable REIT subsidiary (a "TRS"). Second, neither the distributing nor the distributed corporation (nor any successor corporation) may elect to be treated as a REIT for 10 years following a tax-free spinoff. This provision applies to distributions on or after Dec. 7, 2015, unless a ruling request with respect to the transaction was initially submitted to the IRS on or before that date, provided that the request was not withdrawn, issued or denied as of that date.

Taxable REIT subsidiaries

Among the requirements that an entity must satisfy to be taxed as a REIT, at least 75% of its assets must be real estate assets (including obligations secured by real property), cash and cash items and government securities (the 75% asset test); at least 75% of its gross income must consist of real estate-related income (the 75% income test); and at least 95% of its gross income must consist of income that satisfies the 75% income test or other qualifying passive income, such as interest or dividends (the 95% income test).

REITs often hold nonqualifying assets, or assets that will generate non-qualifying income, in TRSs, which are taxed as corporations. Under existing law, the securities of one or more TRSs cannot represent more than 25% of the value of a REIT's assets. The Act reduces that limit to 20% of the value of a REIT's assets, effective for taxable years beginning after 2017.

The Act provides that a TRS is permitted to provide certain services to the REIT, such as marketing, that typically are done by a third party. In addition, a TRS is permitted to develop and market REIT real property without subjecting the REIT to the 100% prohibited transactions tax. However, payments for services provided by the TRS to its parent REIT are subject to a 100% excise tax to the extent they are not at arm's length. This provision is effective for taxable years beginning after 2015.

Preferential dividends

A REIT is entitled to a deduction for the dividends it pays, which generally results in the REIT's not being subject to tax on its income to the extent it distributes that income to its shareholders. The REIT must distribute at least 90% of its income (other than net capital gains) to its shareholders in order to be taxed as a REIT. A "preferential dividend" — that is, one that is not pro rata and favors some shares of stock over other shares of the same class — does not give rise to the deduction for dividends paid, resulting in tax at the REIT level and possible loss of REIT status. The Act repeals the preferential dividend rule for "publicly offered REITs," which are REITs that are required to file annual and periodic reports with the SEC. (Publicly offered regulated investment companies ("RICs") were already exempt from the preferential dividend rule.) This provision is retroactively effective and applies to distributions in taxable years beginning after 2014.

For REITs that are not publicly offered, the Act gives the secretary of the Treasury the authority to provide an appropriate alternative remedy (instead of disallowing the deduction for dividends paid) if the REIT's payment of a preferential dividend is inadvertent or due to reasonable cause and not willful neglect. This provision applies to distributions in taxable years beginning after 2015.

Treatment of ancillary personal property

For purposes of the 75% income test, rent attributable to personal property that is leased under or in connection with a lease of real property is treated as "good" income if the fair market value of the personal property does not exceed 15% of the total fair market value of the combined real and personal property. The Act makes clear that such personal property is treated as real property for purposes of the 75% asset test. In addition, an obligation secured by a mortgage on such property is treated as real property for purposes of the 75% asset test. This provision is effective for taxable years beginning after 2015.

Debt instruments of publicly offered REITs and interests in mortgages on interests in real property

The Act provides that debt instruments issued by publicly offered REITs (as well as interests in mortgages on interests in real property, such as an interest in a mortgage on a leasehold interest) are treated as real estate assets for purposes of the 75% asset test. (Equity interests in REITs were already treated as real estate assets.) Income from such debt instruments is not treated as "good" income for purposes of the 75% income test (unless the income would have so qualified under pre-Act law), but such income is "good" income for purposes of the 95% income test. No more than 25% of a REIT's assets may consist of such debt instruments. This change is effective for taxable years beginning after 2015.

Hedging provisions

Income from certain hedging transactions is excluded in computing the 75% and 95% income tests. The Act extends that exclusion to income from hedges of previously acquired hedges that a REIT entered into to manage risk associated with liabilities or property that have been extinguished or disposed of, effective for taxable years beginning after 2015.

Other Provisions

Exclusion of 100% of gain on certain small-business stock

Noncorporate taxpayers may exclude a specified percentage of their gain from the sale of "small-business stock" acquired at original issue and held for at least five years. Seven percent of such excluded gain was treated as an item of tax preference for alternative minimum tax purposes. The specified percentage has been increased on a temporary basis several times in the past, and was 100% for stock acquired after September 27, 2010, and before January 1, 2015; the minimum tax preference did not apply to gain excluded with respect to such stock. Effective for stock acquired after 2014, the Act makes the post-September 27, 2010, 100% exclusion permanent, and also permanently exempts such excluded gain from alternative minimum tax preference.

Reduction in S corporation recognition period for built-in gains tax to five years

S corporations generally are not subject to entity-level tax. However, if a C corporation has built-in gains at the time it converts to an S corporation, the S corporation is subject to tax at the highest corporate rate on any such built-in gain recognized during the applicable "recognition period." The same treatment generally applies to RICs and REITs that were formerly C corporations. The recognition period was initially 10 years, but was reduced to seven years (for 2009, 2010 and 2011) and then to five years (for 2012, 2013 and 2014). The Act permanently reduces the recognition period to five years, retroactively effective for taxable years beginning after 2014.

Interest-related and short-term capital gain dividends of regulated investment companies

Foreign persons are generally not subject to U.S. income or withholding tax on their capital gains or portfolio interest income. However, dividends from RICs to foreign investors were subject to withholding even if attributable to such interest income or short-term capital gains. The previous exemption of such dividends from withholding had expired effective December 31, 2014. The Act retroactively reinstates and makes permanent that exemption, so that properly reported interest-related and capital gain dividends from RICs will not be subject to withholding, effective for dividends paid with respect to any taxable year of a RIC beginning after 2014.

Extension and modification of research credit

The Act retroactively reinstates and permanently extends the research and development tax credit, which had expired at the end of 2014. In addition, beginning in 2016, an eligible small business ($50 million or less in gross receipts) may claim the credit against its alternative minimum tax liability, and the credit can be utilized by certain small businesses against their employer payroll tax liability.

Extension of subpart F exception for active financing income

A 10% U.S. shareholder of a controlled foreign corporation is required to include in income, on a current basis, its share of the "subpart F" income of the controlled foreign corporation. Under an "active financing" exception, which most recently expired as of the end of 2014, subpart F income did not include income derived in the active conduct of a banking, financing or similar business, or in the conduct of an insurance business. The Act retroactively reinstates that exception to 2015 and makes it permanent.

Temporary extension of bonus depreciation

The Act extends bonus depreciation for property acquired and placed in service during 2015 through 2019 (with an additional year for certain property with a longer production period). The bonus depreciation percentage is 50% for property placed in service during 2015, 2016 and 2017, and it phases down to 40% in 2018 and 30% in 2019.

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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