On April 24, 2024, the IRS issued final regulations regarding when a real estate investment trust (“REIT”) qualifies as a “domestically controlled REIT” (“D-REIT”).
While the final regulations generally follow the proposed regulations on this topic that were issued on December 28, 2022, the final regulations respond to comments received from taxpayers. The final regulations (i) provide a 10-year “transition rule” that grandfathers current structures, subject to certain requirements, and thus allows certain entities to continue to be treated as D-REITs for ten years and (ii) narrow the scope of the “look through” rule, pursuant to which REIT stock owned by certain U.S. corporations is treated as owned by the corporations’ own shareholders.
The discussion below describes the final regulations and the relevant issues in more detail:
- General Background:
- A D-REIT is defined generally as a REIT that has been less-than-50% owned (directly or indirectly) by non-U.S. persons at all times during a “look-back period” equal to the shorter of: (i) five years, or (ii) the period since the REIT was formed.
- If a REIT qualifies as a D-REIT, then its stock is not treated as an asset subject to the U.S. tax rules relating to investments in real estate known as FIRPTA (i.e., the non-U.S. persons that own the minority stake in the D-REIT can sell their D-REIT stock without having to pay U.S. income tax in respect of gains realized or having to file a U.S. tax return, as would normally be required under FIRPTA when a non-U.S. person sells stock in certain U.S. corporations that are heavily invested in real estate).
- The question that the proposed regulations address is when REIT stock is treated as owned “indirectly” by non-U.S. persons for purposes of the 50% threshold discussed above.
- Specifically, in Private Letter Ruling 200923001 (February 26, 2009), which is non-precedential guidance, the IRS approved a structure in which REIT stock owned by a U.S. corporation was treated as owned by a U.S. person ̶ even though the U.S. corporation itself was owned by non-U.S. shareholders that apparently had chosen to hold their stock in the REIT through the U.S. corporation in order to establish domestic control and cause the REIT to qualify as a D-REIT.
- Following the issuance of the Private Letter Ruling, this structure, or some variation of it, was widely used by foreign investors who were willing to place up to 51% of their REIT stock into a U.S. corporation in order for the remaining 49% to be exempt from FIRPTA.
- The IRS issued no additional private letter rulings approving similar structures, and there had been some question as to whether Private Letter Ruling 200923001 continued to represent the IRS’s current position.
- The Proposed Regulations:
- On December 28, 2022, the IRS issued proposed regulations that created a 25% look-through rule, under which stock in a REIT held by a non-publicly-traded U.S. corporation would be treated as held indirectly by the corporation’s own shareholders (effectively treating the U.S. corporation as a conduit for these purposes) if at least 25% of the corporation’s stock (by value) was held by non-U.S. persons ̶ i.e., the proposed regulations clearly reject a strategy of using foreign-owned domestic corporations as a means of creating domestic control for purposes of the D-REIT rules.
- The proposed regulations would have applied to all sales of REIT stock occurring after their finalization, regardless of when the relevant REIT was formed.
- The IRS also stated in the preamble to the proposed regulations that it reserved the right to take the position that the 25% look-through rule could apply during the “look-back period” described above ̶ for example, if REIT stock were sold the day after the proposed regulations were finalized, the IRS reserved the right to argue that the look-through rule should apply for purposes of measuring control of the REIT during the look-back period described above.
- While perhaps not objecting to the application of the look-through rule on a purely prospective basis, many taxpayers objected to the fact that the proposed regulations had no grandfathering for structures already in place, and objected to the notion that the look-through rule might apply to look-back periods spanning times before the finalization of the proposed regulations.
- The proposed regulations also contained various rules relating to the treatment of foreign sovereign investors, which were not addressed in the current final regulations, but which are to be addressed separately.
- The Final Regulations:
- The final regulations continue to impose a look-through rule on D-REIT structures going forward, but they very helpfully have offered a ten-year transition rule, whereby pre-existing structures effectively are grandfathered for ten years, subject to certain conditions, which are:
- First, the D-REIT looking to benefit from the ten-year transition rules cannot increase its ownership in U.S. real property interests by 20% or more (so there is a limit to how much you can bulk up holdings and still be grandfathered).
- For these purposes, U.S. real property interests held by a REIT on the date of the final regulations are filed with the federal register (the “application date”) are valued at their recorded values as of the close of the most recent quarter in the REIT’s taxable year before the application date. U.S. real property interests purchased later are valued at their fair value at the time of acquisition.
- This may be relevant for REITs that are developing properties and would be expected to make additional investments over time, or Up-REIT arrangements where the REITs might acquire additional real estate investments by reason of the exchange of OpCo partnership units for REIT shares.
- There also is an exception for purchases entered into pursuant to a commitment that was binding before the application date.
- Second, the amount of REIT stock held by corporations, individuals and other “non-look-though persons” cannot increase by 50 percentage points, by value (so there’s a limit to how much new investors can buy into, or exchange into, a pre-existing grandfathered structure).
- For these purposes, if a REIT has issued a publicly-traded class of stock, all less-than-5% holders of such stock are treated effectively as a single public shareholder (so that trades among such shareholders are ignored).
- First, the D-REIT looking to benefit from the ten-year transition rules cannot increase its ownership in U.S. real property interests by 20% or more (so there is a limit to how much you can bulk up holdings and still be grandfathered).
- The final regulations replace the 25% look-through rule with a look-through rule that applies only to a “foreign-controlled domestic corporation,” which is a U.S. corporation more-than-50% owned by non-U.S. persons.
- The final regulations continue to impose a look-through rule on D-REIT structures going forward, but they very helpfully have offered a ten-year transition rule, whereby pre-existing structures effectively are grandfathered for ten years, subject to certain conditions, which are:
If you have any questions about the foregoing, please do not hesitate to contact any members of the Cleary U.S. Group.
