Originally Published in the June 2023 Edition of Practical Tax Strategies, a Thomson Reuters Publication.
The qualification of real estate investment trusts (REITs) and registered investment companies (RICs) as domestically controlled qualified investment entities is set to undergo significant changes with the introduction of proposed regulations. These regulations, issued by the IRS and Treasury on 12/29/2022, have implications for sponsors and non-U.S. investors in real estate funds, private equity funds, and other tax structures involving REITs.
Overview of Regulatory Position Prior to Proposed Regulations
Under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), any gain or loss from the sale or disposition of a U.S. real property interest (USRPI) by a non-U.S. investor is considered income connected with a U.S. trade or business. A domestically controlled qualified investment entity (QIE), such as a domestically controlled REIT (DC REIT), is not considered a USRPI. However, distributions from a DC REIT attributable to net capital gain from sales of USRPIs are still subject to tax under FIRPTA.
The determination of whether a REIT qualifies for DC REIT status has been unclear. The Proposed Regulations shed light on this issue.
Proposed Regulations
Look-through Rule for Foreign-Owned Domestic Corporations
According to the Proposed Regulations, foreign-owned domestic corporations are treated as flow-through entities for determining DC REIT status. A foreign-owned domestic corporation is defined as a non-publicly traded domestic C corporation with 25% or more of its outstanding stock owned directly or indirectly by non-U.S. persons. The aggregate ownership of non-U.S. persons in a non-publicly traded domestic C corporation is considered to determine if it meets the 25% ownership threshold.
The purpose of this rule is to prevent non-U.S. investors from using U.S. corporations to create DC REITs that would exempt them from tax under FIRPTA.
Treatment of Qualified Foreign Pension Funds (QFPFs) and Qualified Controlled Entities (QCEs)
The Proposed Regulations clarify that QFPFs and QCEs will always be treated as "foreign persons" when determining DC REIT status. QFPFs are pension funds while QCEs are entities whose interests are held by QFPFs. Both QFPFs and QCEs are exempt from FIRPTA.
This change primarily affects non-U.S. investors who don't qualify as QFPFs or QCEs, as they may no longer be exempt from tax under FIRPTA if the REIT fails to qualify as a DC REIT.
Practical Application of Proposed Regulations
Sponsors and investors in real estate funds and other investment structures involving DC REITs should carefully analyze the impact of the Proposed Regulations on their funds or investment structures.
For sponsors, it is crucial to examine the ownership structure of DC REITs with significant non-U.S. ownership. Additional information and certifications may be required to determine beneficial ownership.
Fund documents, including side letters and subscription documents, may need to be reviewed to ensure accuracy in light of the Proposed Regulations. Transfer and redemption restrictions may also be necessary to maintain DC REIT qualification.
Some real estate funds may not be affected by the Proposed Regulations if they rely on direct shareholding by U.S. taxable and tax-exempt investors.
As for QFPFs and QCEs, their treatment as "foreign persons" may impact non-U.S. investors who don't qualify for these exemptions.
Conclusion
The introduction of the Proposed Regulations brings significant changes to the qualification of REITs as DC REITs. Sponsors and investors should carefully assess the impact on their funds and investment structures.
It is important to note that the Proposed Regulations may apply retroactively. Sponsors should consider the possible retroactivity and the IRS's ability to challenge positions contrary to the Proposed Regulations.
The effective date of the Proposed Regulations is the date of publication as final in the Federal Register. However, they may have implications for determining DC REIT status during periods before their finalization.
By staying informed and proactively addressing these changes, sponsors and investors can navigate the evolving landscape of domestically controlled REITs.
Vasudha Anil Kumar is an Associate in Linklaters LLP’s U.S. Tax Group and Max Levine is a Partner and the Head of Linklaters LLP’s U.S. Tax Group. The authors are grateful to their colleague, Gabriel Grossman, for his comments to this article.
