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Tax Legislation for REITs and Foreign Investment in U.S. Real Estate

Jan 15, 2016

On December 18, 2015, President Obama signed into law the wide-ranging “Protecting Americans from Tax Hikes Act of 2015” (the “PATH Act” or “Act”), which contains significant changes to the rules governing real estate investment trusts (“REITs”) and investment in real estate by foreign investors.  

The following briefly highlights certain provisions that merit attention. 

Provisions Which Affect Foreign Investors in Real Estate 

  • Under the PATH Act, foreign pension funds are now exempt from FIRPTA tax and withholding on the disposition of a U.S. real property interest (“USRPI”) which includes U.S. real property holding corporations (“USRPHCs”). In the context of REITs, foreign pension plans were already excluded from FIRPTA if the REIT was domestically controlled (a domestically controlled REIT is not considered a USRPHC). The exemption now applies whether the REIT is domestically or foreign controlled.  Moreover, to the extent that a REIT disposes of a USRPI, any capital gain dividend is also exempt.  
  • Foreign shareholders who own less than 10% of a publicly traded REIT are now also generally exempt from FIRPTA tax and withholding. Previously, the exemption was for foreign shareholders who owned less than 5% of a public REIT’s stock.
  • The withholding rate on purchases of U.S. real estate from a foreign person has been increased from 10% to 15%, but the increase is not applicable to sales of personal residences where the amount realized is $1 million or less.
  • The Act permanently revives the previously expired provision that RICs were treated like REITs with respect to the exemption from FIRPTA for gain attributable to the sale of an interest in a publicly traded domestically controlled REIT.  

REIT Reforms

  • Under prior law, if a C corporation converted to an S corporation or REIT, by extension, any gain recognized within 10 years would be subject to entity level taxes. The Act reduces the period to 5 years.
  • The Act eliminates the ability of non-REIT entities to spinoff REIT entities in a tax-free manner (i.e., the Opco/Propco spinoffs which have been receiving a tremendous amount of attention in recent years).
  • The Act expands the current safe harbor REITs have for assessing prohibited transactions by providing an alternative which allows for a 3-year averaging of the fair market value and adjusted tax basis for determining the percentage of assets that a REIT may sell annually.
  • The Act repeals the “preferential dividend” rule for publicly traded REITs. This provision applies retroactively to distributions in tax years beginning after 2014. Further, for non-publicly traded REITs, the Act grants the IRS authority to provide an alternative appropriate remedy for inadvertent failures to comply with the preferential dividend rule. This provision applies to distributions in tax years beginning after 2015. 
  • The Act decreases the percentage of the total assets of a REIT attributable to securities of a Taxable REIT Subsidiary (“TRS”) from 25% down to 20%.  
  • 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.
  • The Act provides that the REIT asset test will include unsecured debt instruments issued by publicly traded REITs if the value of the debt instruments does not exceed 25% of the gross asset value of the REIT
  • Under the Act, the REIT asset test has been changed to provide symmetry between the income and asset tests as it they relate to personal property leased. If personal property is leased with real property by a REIT, it will be treated as real property for purposes of the 75% REIT asset test to the extent the rent from such personal property qualifies as rent from real property under the current rules. Under current rules, rent attributable to personal property is qualified real estate income as long as 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. 
  • The Act expands the REIT rules relating to hedging transactions to include terminations of hedges in connection with liabilities that are being extinguished or property that is being sold. 
  • The Act contains a provision designed to avoid a mismatch between the earnings and profits of a REIT and its taxable income. However, this only applies for purposes of determining the tax treatment of the distribution in the hands of the REIT shareholder.
  • Under the Act, a TRS is now permitted to perform certain services in connection with development and marketing of REIT real property without subjecting the REIT to the 100% prohibited transactions tax. However, the Act also expands the 100% excise tax under Code Section 482 to include any non-arm’s length transaction where a TRS provides services to its parent REIT.

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