The reforms generally encourage foreign investment in U.S. real estate.
The enacted Protecting Americans from Tax Hikes Act of 2015 (the Act) contains numerous reforms to the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) and the taxation of real estate investment trusts (REITs). Highlights of these changes are discussed below.
Foreign Pension Fund Exemption
The Act exempts "qualified foreign pension funds" from FIRPTA taxation so long as such a fund is not already engaged in a business in the United States to which real estate gains are attributable. A foreign pension fund generally is considered qualified if it is created or organized under non-U.S. law, is subject to foreign government regulation and certain information reporting, is established to provide retirement or pension benefits to employees, has no greater-than-5-percent beneficiaries, and enjoys a reduction in tax in its home jurisdiction. The exemption also applies to foreign pension fund investments in U.S. real property interests made through partnerships.
There remain a number of questions on which types of funds will be qualified. For example, it is unclear whether government plans that are in the nature of a social security fund will be qualified foreign pension funds because they include beneficiaries who are not "employees" of the state.
Expansion of Portfolio Investor Exemption
Under prior law, a foreign shareholder of a publicly traded REIT was not subject to FIRPTA taxation upon the sale of the REIT’s stock or the receipt of a "capital gain dividend" distribution from the REIT, provided that the shareholder owned less than 5 percent of the REIT’s stock. The Act raises this threshold to 10 percent.
The Act also exempts certain foreign publicly traded entities from FIRPTA taxation upon their sale of REIT stock or the receipt of a "capital gain dividend" distribution from a REIT, except to the extent that an investor in such a foreign publicly traded entity constructively holds more than 10 percent of the REIT’s stock.
Clarification of Domestic Control for Exemption Purposes
A foreign investor’s sale of stock of a "domestically controlled" REIT is not subject to FIRPTA taxation. A domestically controlled REIT is, generally, a REIT where the majority of its value is owned by U.S. persons. Historically, this exemption has been of limited value because of the inability to determine if the domestic control test has been met.
The Act permits the presumption that an owner of less than 5 percent of a class of stock of a publicly traded REIT is a U.S. person for purposes of the domestically controlled rules unless the REIT has actual knowledge otherwise. This significantly increases the ability to rely on the exemption.
Increase in FIRPTA Withholding Rate
If no exception applies, the Act increases the rate of withholding on the disposition of a U.S. real property interest from 10 percent to 15 percent, effective for dispositions after February 16, 2016.
Restrictions on REIT Spin-Offs
Corporations often seek to separate their real estate assets from their operating assets in a tax-efficient manner. One method for achieving this has been for a corporation to spin off its real estate assets tax free into a REIT, which itself generally is not subject to corporate-level tax, provided it annually distributes all of its taxable income to its shareholders.
The Act generally provides that a corporation’s spin-off of its real estate assets into a REIT is subject to tax at both the corporate and shareholder levels. Exceptions are provided if both the distributing corporation and the spun-off corporation are REITs after the spin-off or, in certain circumstances, if the spin-off is by a REIT of its "taxable REIT subsidiary," or "TRS." Further, the Act provides that, if a corporation effectuates a tax-free spin-off, neither the corporation nor the spun-off entity may elect REIT status for the following 10 years.
Reduced Recognition Period for Built-in Gains Tax Under prior law, a REIT was subject to corporate-level tax on the built-in gain of an asset if the asset was held prior to, and sold within 10 years of, the corporation becoming a REIT (or sold within 10 years of the date of acquisition of the asset from another corporation in a tax-free transaction, if applicable).
The Act reduces the recognition period from 10 years to five years.
Reduced Limitation on Percentage of TRS Assets Presently, up to 25 percent of a REIT’s asset value may comprise securities in taxable REIT subsidiaries. The Act reduces this to 20 percent for tax years beginning after 2017.
Debt Instruments of ‘Publicly Offered’ REITs Treated as Real Estate Assets To qualify as a REIT, at least 75 percent of the REIT’s assets must consist of enumerated assets, and at least 75 percent and 95 percent of its income must be derived from enumerated sources. Under the Act, for purposes of the 75 percent asset test, debt instruments offered by "publicly offered REITs," and interests in mortgages on real property, will be treated as real estate assets. Income from debt instruments issued by publicly offered REITs will be treated as qualifying income for the 95 percent income test, but not the 75 percent income test, unless the income is otherwise qualifying income under current law. No more than 25 percent of a REIT’s assets may be publicly offered REIT debt instruments. A publicly offered REIT means a REIT that is required to file annual and periodic reports with the Securities and Exchange Commission under the Securities Exchange Act of 1934. These changes broaden the assets and income that count in meeting the REIT qualification tests.
For purposes of the 75 percent income test, rent attributable to personal property leased in connection with real property has been treated as qualifying REIT income so long as the rent allocable to such personal property did not exceed 15 percent of the total rent attributable to both the real and personal property. However, personal property was not considered a qualifying REIT asset for purposes of the 75 percent asset test.
The Act aligns the 75 percent asset test with the 75 percent income test. Personal property leased with real property will be treated as real property for purposes of the 75 percent asset test to the extent that rent attributable to such personal property is treated as rent from real property for purposes of the 75 percent income test. In addition, income from an obligation secured by a mortgage on real property and personal property will be treated as qualifying under the 75 percent income test, so long as the value of personal property does not exceed 15 percent of the total fair market value of the real property and personal property. Such mortgages will also be considered a real estate asset for purposes of the 75 percent asset test.
Repeal of Preferential Dividend Rule for Publicly Offered REITs
Prior to the Act, a preferential dividend did not give rise to a dividends-paid deduction. A dividend is preferential unless it is distributed, pro rata, with no preference to any share of stock compared to other shares of the same class of stock. The Act has removed that restriction for "publicly offered" REITs so that preferential dividends may now give rise to a dividends-paid deduction. This clears the way for preferred investments into "publicly offered" REITs .
The reforms generally encourage foreign investment in U.S. real estate. The rules taxing certain real estate asset spin-offs will hamper investor efforts to separate such assets from operating assets for governance and market valuation purposes. The reduction in the recognition period for REIT asset built-in gain taxation may encourage asset transfers. Although many of the REIT provisions are favorable, some are not, and REITs must closely monitor the rules to ensure compliance.