REIT Reforms Under the PATH Act
June 20, 2017
Under the PATH Act, significant reforms are impacting real estate investment trusts (REITs). These reforms include the treatment of preferential dividends, prohibited transactions and hedging. Also discussed is how taxable REIT subsidies are impacted and the substantial changes made to the provisions concerning foreign investment in US real estate.
DP: The 2015 Protecting Americans from Tax Hikes Act, the PATH Act, it’s been in the news quite a bit lately and it includes some significant reforms impacting real estate investment trusts, or REITs for short. What are some of these?
EA: Let’s start with preferential dividends. The act repeals the rule for publically offered REITs. Prior to this change a preferential dividend resulted in a REIT not being entitled to a dividend paid deduction for non-pro-rata dividends, a REIT publically offered, if it is required to file annual and periodic reports with the Securities and Exchange Commission. This new rule applies retroactively to distributions in tax years beginning after 2014.
EA:For non-publically traded REITs the legislation provides the secretary of the treasury authority to provide an appropriate remedy in lieu of a disallowance of the dividends paid deduction to cure the failure of the REIT to comply with the preferential dividend requirements. This provision applies to distributions in tax years beginning after 2015.
DP: Now tell us a little bit about prohibited transactions.
EA:Generally a REIT may be subject to a prohibited transaction and it’s taxed at 100% of the net income derived from this transaction. Generally a prohibitive transaction is a sale or other disposition of property by the REIT that is “stock and trade or other property that would be inventory or property held for the sale to customers.” There’s a safe harbor that applies if the tax basis or fair market value of the asset sold by the REIT in any given year does not exceed 10% of the aggregate tax basis or fair market value of all of the REIT’s assets as of the beginning of the year. The act expands the safe harbor allowing a REIT to sell property with an aggregate tax basis or fair market value up to 20% of its aggregate tax basis or aggregate fair market value in one year so long as the REIT does not sell property with a tax basis or fair market value exceeding 10% of the REIT’s aggregate tax basis or aggregate fair market value over a three year period.
DP: Ok, now does the act attempt to prevent a mismatch between E&P and taxable income?
EA:I’m glad you ask that. Yes it does, but only for purposes of determining the tax treatment to the shareholders. This change is designed to avoid duplicate taxation to the shareholders, but only applies for this purpose, which means that your deduction for dividends paid will be different for earning and profits purposes for your shareholders versus what you would report on your tax return.
DP: Ok. Now how are taxable REIT subsidies impacted?
EA: The percentage of total assets of a REIT attributed to a securities of a taxable REIT subsidiary was decreased from 25% to 20%.
DP: Ok. Now, Michael if you could, tell our listeners a little bit debt instruments.
EA:Well, interestingly enough, they changed the rules so now debt instruments of a publically offered REIT and interest in mortgages on interest in real property can now be treated as qualified real estate assets for purposes of the 75% asset test and the 95% income test. However, income from the debt instrument of a publically offered REIT does not qualify for the 75% income test unless the income qualified is good 75% income under the pre-act law and may not account for more than 25% of a REIT’s assets by value.
DP: Ok. And personal property?
EA:The REIT asset test has been changed to provide symmetry between the income and asset test. Prior to this there was a disconnect between the two rules in connection with personal property leased. If personal property leased with real property by a REIT it’s treated as real property for purposes of the 75% asset test to the extent that the rent from the personal property qualifies as rent from real property under the current rules.
DP: OK now, touch on hedging if you could.
EA:There’s an additional category of excluded hedging income. The REIT rules are now expanded to include terminations of hedges in connection with liabilities that are being extinguished or property that is being sold.
DP: And Michael, any final thoughts on this topic.
EA:Yes, I have a few thoughts. There were some substantial changes made to the provisions concerning foreign investment in US real estate. These new rules encourage foreign investment in US real estate and consequently are extremely important. First the legislation exempts foreign pension funds from taxation under FIRPTA. Second the PATH act doubles the size of holdings of a publically traded REIT that are exempt from FIRPTA from 10% from 5%. And lastly, the withholding rate on purchases of US real estate from foreign persons was increased from 10% to 15%. In connection with the non-foreign provisions I’d like to mention that if a C-Corporation converts to an S-Corporation, or REIT by extension, any gain now recognized within 5 years is subject to an entity level tax. This rule makes the temporary legislation permanent. And lastly, the act prevents tax free spin offs, when either a distributed or distributing entity is a REIT with certain exceptions. This provision was targeted to prevent large corporations from reducing their tax bills by spinning out their real estate in section 355 transactions.
DP: Well Michael, thank you very much for your expertise and this great insight. And thank you for listening to the EisnerAmper Podcast Series. Visit EisnerAmper.com for more information on this, and a host of other topics, and join us for our next EisnerAmper podcast when we get down to business.