Non-U.S. taxpayers are generally exempt from U.S. federal income tax on gain from the sale of U.S.-situs capital assets. The one major exception is U.S. real estate. Under the Foreign Investment in U.S. Real Property Tax Act (FIRPTA), gain from the sale of U.S. real estate by a non-U.S. taxpayer is subject to U.S. federal income tax at graduated U.S. income tax rates applicable to U.S. persons. In addition, when FIRPTA applies, the purchaser of the U.S. real estate typically is required to withhold 10% of the purchase price. With the amount of foreign capital invested in South Florida real estate, planning around FIRPTA has become one of the primary concerns facing non-U.S. taxpayers.
Recently, Representatives Kevin Brady of Texas and Joseph Crowley of New York proposed a significant change (introduced as H.R. 2870) to the FIRPTA provisions. If enacted in its current form, H.R. 2870 hopefully would draw significant new foreign capital into the U.S. real estate market by modernizing certain exemptions under FIRPTA, as well as by clarifying the application of certain FIRPTA provisions to real estate investment trusts (REITs) and their shareholders.
What is a REIT?
In general, a REIT is a company that owns – and typically operates – income-producing real estate or real estate-related assets. To qualify as a REIT, a company must have the majority of its assets and income connected to real estate investment and must distribute at least 90% of its taxable income to shareholders annually in the form of dividends. In addition to paying out at least 90% of its taxable income annually in the form of shareholder dividends, a REIT must:
- Be an entity that would be taxable as a corporation but for its REIT status;
- Be managed by a board of directors or trustees;
- Have shares that are fully transferable;
- Have a minimum of 100 shareholders after its first year as a REIT;
- Have no more than 50% of its shares held by five or fewer individuals during the last half of the taxable year;
- Invest at least 75% of its total assets in real estate assets and cash;
- Derive at least 75% of its gross income from real estate related sources, including rents from real property and interest on mortgages financing real property;
- Derive at least 95% of its gross income from such real estate sources and dividends or interest from any source; and
- Have no more than 25% of its assets consist of non-qualifying securities or stock in taxable REIT subsidiaries.
Application to Publicly-Traded REITs
Under current law, foreign shareholders owning 5 percent or less of a publicly-traded REIT are not subject to U.S. federal income tax under the FIRPTA provisions upon a sale of the REIT’s shares or the receipt of a capital gain distribution from the REIT. The proposed legislation would increase this ownership threshold from 5 to 10%, bringing the FIRPTA regime in line with the definition of a portfolio investor used in most modern U.S. income tax treaties, as well as the definition applicable to foreign investors in U.S. debt securities under the “portfolio interest” rules. This will allow foreign investors to dramatically increase their investments in publicly traded U.S. REITs without being subject to U.S. federal income tax under FIRPTA. Ordinary dividend distributions from REITs made to foreign shareholders, however, would continue to be subject to the 30% U.S. withholding tax, unless reduced pursuant to an applicable income tax treaty.
Application to Liquidating Distributions from a REIT
The proposed legislation also would provide a significant incentive for non-U.S. taxpayers to invest in U.S. real estate by avoiding the inconsistent tax treatment of a liquidating distribution from a REIT from an actual sale of the REIT shares. The bill accomplishes this result by overriding the conclusion set forth by the IRS in Notice 2007-55. Prior to 2007, liquidating distributions from a REIT or redemptions of a REIT’s shares generally were treated as a sale of the REIT’s shares. Assuming the non-U.S. taxpayer was able to meet the publicly-traded REIT exception (discussed above) or the domestically controlled REIT exception (discussed below), this result provided a tax-free exit strategy. In 2007, however, the IRS issued Notice 2007-55, in which it claimed that REIT redemptions and liquidating distributions should be treated as capital gain distributions, which are generally subject to FIRPTA if paid to non-U.S. taxpayers. Under H.R. 2870, REIT redemptions and liquidating distributions are treated the same as an actual sale of the REIT’s shares. Therefore, the proposed legislation would restore the original position of the IRS.
Application to Domestically Controlled REITs
Finally, the proposed legislation would provide a workable solution for publicly-traded REITs to rely on the domestically controlled exception to FIRPTA. In particular, under FIRPTA, gain resulting from the sale or disposition of stock of a domestically controlled REIT (i.e., a REIT, 50% of the stock of which is held by U.S. persons) is not subject to FIRPTA. Historically, it has proved difficult for many publicly traded REITs to rely on this exception. This is because the REIT frequently lacked the information to identity the “small” shareholders (i.e., those holding a less than 5% interest in the REIT).
H.R. 2870 would address this concern by providing that a publicly-traded REIT may presume that all less than 5% shareholders are U.S. persons, except where the REIT has actual knowledge to the contrary. In addition, the proposed legislation also would clarify that shares in a REIT held by an upper-tier REIT will be treated as held by a foreign person unless the upper-tier REIT is itself domestically controlled.