Domestically Controlled REITs Under Proposed Regulations
February 02, 2023
By Arthur Khaimov and Benjamin Feldman
On December 29, 2022, the Treasury Department and the IRS released guidance on issues related to IRC Sec. 897, which may impact structures that real estate funds and REITs use to shield foreign investors from U.S. tax exposure. Real estate fund sponsors need to review their current structures to stay in compliance with the proposed regulation guidelines. In addition, a real estate fund sponsor may have to notify their foreign investors due to a side letter obligation, notifying them that a REIT they invest in may no longer be considered domestically controlled. Below is a brief summary of background and the impact these proposed regulations may have on taxpayers.
IRC Sec. 897 provides that foreign investors must generally treat gains from the sale of a U.S. real property interest (“USPRI”), i.e., U.S. real property, as effectively connected with a U.S. trade or business. Definition of a USPRI also includes equity interests in a U.S. real property holding corporation (“USRPHC”), which is generally a corporation with more than 50% of its assets represented by USPRIs. The disposition of USPRIs typically triggers potential tax exposure for foreign investors, as well as withholding requirements for the seller under the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”). An important exception to the treatment of a disposition of an equity interest being subject to FIRPTA withholding is the sale of stock shares of a “domestically controlled” REIT ("DCR").
Domestically Controlled REIT
A REIT is domestically controlled if less than 50% of its stock is directly or indirectly owned by foreign persons continuously during the five-year period ending on day of sale or period during which the REIT was in existence, if shorter. While the sale of REIT stock would seem to fall under IRC Sec. 897 -- thereby imposing tax on foreign persons -- there is a key exception to this rule with the sale of stock shares of DCRs. A foreign person disposing of DCR shares generally would not be subject to U.S. tax.
As stated above, the definition of a DCR looks for “direct or indirect” foreign person ownership but there has been ambiguity concerning when it is necessary to “look-through” the direct owners to the ultimate indirect owners for purposes of this test. Due to absence of clear guidance on this issue, many have relied upon Private Letter Ruling 200923001, which refers to Treas. Reg. 1.857-8, which states that the actual owner of the REIT is the person who is required to include in gross income the dividend received. As such, a C corporation who is foreign owned but that includes a REIT’s dividend on its U.S. corporate tax return will count as a non-foreign person for purposes of DCR rules despite their indirect foreign ownership.
Moreover, the proposed regulations bring an example where a REIT is 49% owned by a foreign person and remaining 51% owned by a U.S. partnership, which is 100% owned by foreign persons. Although 100% of REIT stock is indirectly owned by foreign persons, the proposed regulations state that, under current law and the lack of definitive guidance, the taxpayer could assert that for purposes of DCR ownership rules, this scenario would result in the REIT being “domestically controlled” thereby making the sale of shares tax free to a foreign investor. To clarify the current law, the Treasury Department and the IRS have concluded that such interpretations are incorrect and provided further guidance.
DCRs Under the Proposed Regulations
In order to determine whether a REIT is a DCR, the proposed regulations apply a “look-through” approach until you reach a “non-look-through person.” An example of some non-look-through persons are individuals, domestic C corporations (other than foreign-owned domestic corporations), foreign corporations (including foreign governments), publicly traded REITs, etc. A look-through person is any person that is not a non-look-through person.
Generally, domestic C corporations are non-look-through entities, but the proposed regulations apply a “limited” look-through approach for domestic C corporations that are foreign owned. A “foreign owned domestic corporation” is defined as a U.S. corporation that is (i) not publicly traded and (ii) whose stock is owned directly or indirectly 25% or more by foreign persons. This could potentially impact many real estate funds and REITs, as a common technique to shield foreign investors from taxes imposed by IRC Sec. 897 was by using a “blocker corporation” owned by foreign investors that typically hold more than a 25% stake in the corporation. Under the proposed regulations, such a structure would be looked through to determine if a REIT would be considered a DCR. The IRS believes that the new proposed look through methods are consistent with the definition of “indirect” ownership as codified in IRC Sec. 897(h)(4)(B).
Foreign investors and real estate fund sponsors need to review their current structures to determine whether they satisfy the proposed regulation guidelines as the IRS may challenge positions contrary to the proposed look-through rules before the issuance of final regulations.