On July 30, 2008, President Bush signed into law the Housing and Economic Recovery Act of 2008 (the “Housing Act”), which includes most of the REIT provisions previously proposed in the REIT Investment Diversification and Empowerment Act of 2007 (RIDEA). The new provisions relate to (i) foreign currency issues, (ii) limitations on holding taxable REIT subsidiary securities, (iii) prohibited transactions, and (iv) special rules for health care and lodging facilities. Unless otherwise indicated, all changes apply in taxable years beginning after July 30, 2008.
Foreign Currency Issues
The Housing Act contains a number of provisions relating to foreign currency gains (generally gains that are attributable to exchange rate changes involving a currency other than the REIT’s functional currency (i.e., a “nonfunctional currency”) and gives Treasury general authority to determine that other types of income may be disregarded in applying the 75% gross income test and/or the 95% gross income test or may be treated as qualifying income in applying the 75% gross income test and/or the 95% gross income test.
REIT Gross Income Tests and Foreign Currency Gains
Many REITs have increased their interest in foreign investments in recent years, but uncertainty regarding the treatment of foreign currency gains under the REIT gross income tests has complicated the structuring of foreign investments. The IRS has issued guidance in recent years, treating certain gains under Section 988 as qualifying income (Rev. Rul. 2007-33) and providing general guidance on the treatment of Section 987 branch remittances (Notice 2007-42). The Housing Act provides a comprehensive framework for applying the gross income tests to foreign currency gains.
- Disregarding Foreign Currency Gains. Contrary to the recent IRS guidance, under the Housing Act, foreign currency gains generally are not qualifying income for purposes of the gross income tests. On the other hand, the Housing Act provides that certain foreign currency gains are disregarded (not included in either the numerator or the denominator) in applying the gross income tests. Foreign currency gains that are not excluded are treated as nonqualifying income.
- “Real estate foreign exchange gain” is excluded in applying the 75% gross income test and the 95% gross income test. Real estate foreign exchange includes Section 988(b) (1) foreign currency gains attributable to (i) items of qualifying income or gain under the 75% gross income test (e.g., foreign currency gains arising from changes in currency rates between the time mortgage interest or rents from real property accrue and are received), (ii) the acquisition or ownership of obligations secured by mortgages on real property or on interests in real property (e.g., foreign currency gains arising upon receipt of principal on, or disposition of, a mortgage loan denominated in a nonfunctional currency), and (iii) becoming or being an obligor under obligations secured by mortgages on real property or on interests in real property and denominated in a nonfunctional currency (e.g., foreign currency gains arising with respect to payments on a qualifying REIT liability denominated in a nonfunctional currency). Real estate foreign exchange gain also includes Section 987 gain attributable to a qualified business unit (a “QBU,” generally a branch with a different functional currency) if the QBU satisfies the 75% gross income test for the year and the 75% asset test at the close of each quarter. The Secretary of the Treasury is authorized to treat additional foreign currency gains as real estate foreign exchange gain. Treasury is also expected to provide guidance on the treatment of Section 987 gains that are not treated as real estate foreign exchange gains.
- “Passive foreign exchange gain” is excluded in applying the 95% gross income test but is treated as nonqualifying income for purposes of the 75% gross income test (except to the extent that it also qualifies as real estate foreign exchange gain). Passive foreign exchange gain includes Section 988(b)(1) foreign currency gains attributable to (i) items of qualifying income or gain under the 95% gross income test, (ii) the acquisition or ownership of debt obligations, and (iii) becoming or being an obligor under debt obligations. The Secretary of the Treasury is authorized to treat additional foreign currency gains as passive foreign exchange gain.
Foreign currency gains will not be treated as real estate foreign exchange gain or passive foreign exchange gain and, accordingly, will be treated as nonqualifying income for purposes of the 75% and 95% gross income tests to the extent it is derived from dealing in, or substantial and regular trading in, securities.
These provisions apply to gains and items of income recognized after July 30, 2008.
- Hedging Income. The Housing Act makes two changes to the treatment of hedging income.
- Income from properly identified transactions that hedge indebtedness incurred or to be incurred to acquire or carry real estate assets has been treated as nonqualifying income for purposes of the 75% gross income test but is disregarded for purposes of the 95% gross income test. Under the Housing Act, such income is also disregarded for purposes of the 75% gross income test.
- The Housing Act also excludes hedging income for purposes of the 75% and 95% gross income tests if the hedge is properly identified and is entered into to manage currency risk with respect to income that qualifies under the 75% gross income test or the 95% gross income test (or assets that generate such income).
These provisions apply to gains and items of income recognized after July 30, 2008.
- Foreclosure Property. Foreign currency gains attributable to income from foreclosure property (that qualifies for purposes of the 75% and 95% gross income test) would be treated as permitted income from foreclosure property for purposes of the 75% and 95% gross income tests and the rules for taxation of income from foreclosure property. This provision applies to transactions entered into after July 30, 2008.
Currency Effects On Asset Tests
Changes in foreign currency exchange rates used to value a foreign asset will not cause a REIT to fail the REIT asset tests.
Foreign Currency Treated As Cash
Cash is a qualifying asset for purposes of the 75% asset test. The Housing Act treats foreign currency as cash for these purposes if it is the functional currency of the REIT or a QBU of the REIT, is held in the normal course of generating qualifying income or is directly related to acquiring or holding qualifying assets, and is not held in connection with a trade of business of trading or dealing in securities.
Foreign Currency Gains/Losses Attributable to Prohibited Transactions
Under the Housing Act, foreign currency gains and losses attributable to prohibited transactions are taken into account in determining the tax on prohibited transactions. This provision applies to sales made after July 30, 2008.
Taxable REIT Securities
The Housing Act expands the limitation on holdings of securities of taxable REIT subsidiaries (TRSs) from 20% to 25% of a REIT’s gross assets. The farm bill1 passed earlier this year provided a 25% limit for timber REITs, but that provision would have applied only for one year.
Gains on dealer sales generally are subject to a 100% prohibited transaction tax. Dealer status generally must be determined based on all of the facts and circumstances. The Code, however, provides a multi-factor safe harbor, with sales that qualify for the safe harbor avoiding the prohibited transaction tax. The safe harbor has been criticized as overly restrictive. The Housing Act modifies the safe harbor for avoiding the prohibited transaction tax.
The Housing Act reduces the minimum holding period in the safe harbor from four years to two years. The special two-year rule for timber enacted earlier this year generally is eliminated.
For REITs that cannot satisfy the seven sales limit in the safe harbor, the Housing Act changes the alternative limit of 10% of the adjusted basis of the REIT’s assets to either 10% of the fair market value or 10% of the adjusted basis of the REIT’s assets.
Treatment of Safe Harbor Gains
The Housing Act clarifies that gain from sales qualifying for the safe harbor is not treated as capital gain unless it would otherwise qualify as capital gain.
Health Care and Lodging Facilities
Health Care Facilities Leased to a TRS Rents from a lease of a lodging facility to a TRS generally avoid the related party rent prohibition. The Housing Act also permits health care facilities to be leased to a TRS as long as they are managed by an eligible independent contractor.
Operation of Health Care Facilities and Lodging Facilities
The Housing Act does not treat a TRS as operating or managing a qualified health care or lodging facility merely because the TRS holds a license or permit to do so. It also permits the TRS to be the employer of employees at health care and lodging facilities outside the United States as long as they are subject to the daily supervision and direction of an eligible independent contractor. In addition, the operator may be treated as an independent contractor even if the TRS bears the operating expenses or receives the revenues from the lodging or health care facility, net of operating expenses and fees payable to the operator.