On December 18, 2015, President Obama signed into law the “Protecting Americans from Tax Hikes Act of 2015” (the “Act”), a substantial piece of tax legislation that, among many other provisions, contains significant changes to the rules governing real estate investment trusts (“REITs”) and the Foreign Investment in Real Property Tax Act (“FIRPTA”).
The following are highlights of the changes to the REIT rules:
- Built-in Gain Recognition Period. The Act permanently extends the provision that reduces to five years (instead of ten) the period during which an S corporation (and, by extension, a REIT) is required to pay entity-level tax on any recognized built-in gain attributable to a period when the S corporation (or REIT) was a C corporation.
- REIT Spinoffs. Under the Act, Section 355 of the Internal Revenue Code of 1986, as amended (the “Code”) is amended to restrict tax-free spin-offs involving a REIT. Certain exceptions apply, including for situations in which both the distributing and controlled corporations are REITs immediately after the spin-off. The Act also contains a grandfather provision for spin-offs that were subject to ruling requests as of December 7, 2015.
- Taxable REIT Subsidiaries. The Act lowers the percentage of the total assets of a REIT that can be represented by securities of a taxable REIT Subsidiary (a “TRS”) from 25% down to 20%. This rule is effective starting in tax years beginning after 2017.
- Prohibited Transaction Safe Harbors. The Act provides for a new alternative safe harbor from the 100% prohibited transaction tax, allowing for a 3-year averaging of fair market value and adjusted tax basis for determining the percentage of assets that a REIT may sell annually.
- Preferential Dividends. The Act repeals the “preferential dividend” rule (under which REITs are not entitled to a dividend paid deduction for non-pro-rata dividends) for publicly-offered REITs. This provision applies retroactively to distributions in tax years beginning after 2014. Further, for non-publicly offered REITs, the Act provides that the IRS is granted authority to provide an alternative appropriate remedy (in lieu of a disallowance of the dividend paid deduction) for inadvertent failures to comply with the preferential dividend rule. This provision applies to distributions in tax years beginning after 2015.
- Designated Dividends. Under the Act, the total amount of dividends that a REIT may designate as capital gains dividends and qualified dividends with respect to any tax year may not exceed the total amount of dividends paid by the REIT with respect to such tax year.
- Debt Instruments as Real Estate Assets. The Act provides that debt instruments issued by publicly offered REITs are treated as real estate assets for purposes of the 75-percent REIT asset test. However, if the publicly-offered issuing REIT would itself not have qualified as a REIT if not for this new rule, then (1) no more than 25% of the value of the REIT’s assets can consist of such debt instruments and (2) the income from such debt instruments will not qualify for the 75-percent income REIT test. In addition, interests in mortgages on interests in real property are treated as real estate assets for purposes of the 75-percent REIT asset test.
- Ancillary Personal Property. Under the Act, personal property that is leased by a REIT is treated as real property for purposes of the 75-percent REIT asset test to the extent the rent from such personal property qualifies as rent from real property under the current rules (i.e., such personal property is leased in connection with real property and the rent attributable to such personal property is 15% or less of the total rent attributable to such real and personal property). A similar rule applies to mortgages secured by personal property.
- Hedging Provisions. The Act expands the REIT rules relating to hedging transactions to permit a REIT to terminate a hedging transaction (in connection with liabilities that are being extinguished or property that is being sold) through the use of additional hedging instruments without the REIT recognizing gross income under such additional hedging instruments for purposes of the REIT income tests.
- REIT Earnings and Profits. The Act contains a provision designed to avoid a mismatch between the earnings and profits of a REIT and its taxable income, but only for purposes of determining the tax treatment of the distribution in the hands of the REIT shareholder.
- TRS Services. Under the Act, a TRS is now permitted to perform certain services that were previously only permitted using independent contractors. Such services include development and marketing activities on behalf of the REIT, which will no longer jeopardize the REIT’s eligibility for the prohibited transaction safe harbor. However, the Act also expands the category of “redetermined income” subject to the 100% penalty tax (i.e., certain types of income between a REIT and a related party to the extent that the IRS redetermines the stated amount of income pursuant to Code section 482 as being not in accordance with an arm’s length standard) to also apply to income earned by a TRS for services provided by the TRS to its parent REIT.
- Dividends from Foreign Corporations Attributable to REIT Dividends. The Act provides that the general rule allowing corporations a dividends received deduction for dividends from a foreign corporation to the extent they are attributable to dividends received from an 80-percent owned domestic corporation will not apply if such 80-percent owned domestic corporation is a REIT or a regulated investment company (a “RIC”).
The following are highlights to the changes to the FIRPTA rules:
- Certain REIT and Other Stock. Under the Act, the percentage maximum stock ownership a shareholder may hold of a publicly-traded corporation without being treated as a US real property interest is increased from 5% to 10%. In addition, certain foreign publicly-traded entities may now own and dispose of an unlimited amount of stock treated as US real property interests without triggering FIRPTA withholding (though an investor that holds more than 10% of such a foreign entity is still subject to FIRPTA withholding).
- Foreign Pension Funds. Under the Act, foreign pension funds are no longer subject to FIRPTA withholding.
- Withholding Rate. The Act increases the FIRPTA withholding rate from 10 percent to 15 percent. Sales of personal residences where the amount realized is $1 Million or less is not subject to the increased rate. This provision is effective for dispositions occurring 60 days after the enactment of the Act.
- Cleansing Rule. Under the Act, the “cleansing rule” (which provides that a corporation that has disposed of all of its real property in taxable transactions will no longer be treated as a US real property holding corporation) no longer applies to REITs or RICs.