Summary

On April 25, 2024, the IRS and Treasury Department published final regulations for determining whether qualified investment entities (QIEs), which include real estate investment trusts (REITs), are considered domestically controlled for purposes of the Foreign Investment in Real Property Tax Act (FIRPTA) rules of IRC Section 897. The final regulations finalize portions of the proposed regulations published on December 29, 2022, along with some changes discussed below. 

The proposed regulations set forth a rule under which, for purposes of determining whether the REIT is domestically controlled, the REIT would have to look through to the owners of a 25 percent or more foreign-owned domestic C corporation in order to make the determination. Many commentators on the proposed regulations asked the Treasury Department to withdraw the proposed look-through rule. While the final regulations retain a look-through rule, in response to these comments, the final regulations increase the amount of foreign ownership required in order for the look-through to be applied to a non-publicly listed domestic C corporation from 25 percent or more to greater than 50 percent. The increase from 25 percent to greater than 50 percent may be helpful for determining and maintaining the domestically controlled REIT status of some REITs that would have otherwise been adversely affected by the proposed rules. However, in practice, the change does not offer much relief for real estate funds and joint ventures seeking to use a domestic C corporation in their structures to ensure a REIT qualifies as domestically controlled, because the stock in such a corporation has historically been predominantly owned by foreign persons. 

The final regulations also provide a new transition rule that exempts existing structures from the final look-through rule for a 10-year period, provided that such REITs do not acquire a significant amount of new U.S. real estate or undergo significant changes in shareholder ownership. 

Background

Under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), a non-U.S. person’s sale or disposition of a United States real property interest (USRPI) is generally subject to U.S. federal income tax and a tax return reporting requirement. Under FIRPTA, the purchaser of a USRPI from a non-U.S. person is generally required to withhold tax equal to 15 percent of the seller’s amount realized on the sale. USRPIs include stock in a U.S. corporation whose assets are largely comprised of other USRPIs. Thus, stock in a REIT is generally a USRPI. However, stock in a domestically controlled REIT is not treated as a USRPI and thus the sale of shares of a domestically controlled REIT by a foreign person is not subject to U.S. taxation under FIRPTA. This exception allows foreign investors in a REIT to sell shares of the REIT without the gain being subject to U.S. federal income tax. A REIT is considered to be domestically controlled if less than 50 percent of the value of the REIT shares is held “directly or indirectly” by foreign persons for at least five years prior to the date of disposition (or, if shorter, the period during which the REIT was in existence). 

Final domestic C corporation look-through rule

The final regulations apply look-through treatment to a non-public domestic C-corporation if foreign persons hold directly or indirectly more than 50 percent of the fair market value of that corporation's outstanding stock. In determining domestically controlled REIT status, the final regulations adopt the general approach provided in the proposed regulations of dividing owners of REIT shares into two categories: “look-through persons” and “non-look-through persons”. The ultimate non-look through owners of look-through persons are treated as proportionally owning the REIT shares owned directly or indirectly by the look-through persons. A look-through person includes non-publicly traded partnerships and REITs, certain RICs, trusts, S corporations, and – notably – non-publicly traded domestic C corporations that are more than 50% owned, directly or indirectly, by foreign persons. The final regulations refer to a C corporation that is more than 50% owned by foreign persons as a “foreign-controlled domestic corporation”.

Transition rule

The final regulations exempt existing structures from the domestic C corporation look-through rule for a 10-year period, provided that certain requirements are met. The requirements are intended to ensure that the final domestic C corporation look-through rule does not apply to existing business arrangements, but only to the extent the REIT does not acquire a significant amount of new USRPIs or undergo a significant change in its ownership. Specifically, the 10-year transition period will end with respect to a REIT if either:  

1. the REIT acquires, directly and indirectly, USRPIs after April 24, 2024, with a fair market value of 20% or more of the fair market value of the USRPIs held directly and indirectly by the REIT as of April 24, 2024, or 
2. the REIT undergoes an ownership change such that the direct or indirect ownership of the REIT by “non-look-through persons” increases by more than 50% in the aggregate as compared to the ownership by such non-look-through persons on April 24, 2024.   

A REIT is permitted to use the asset values that it uses for quarterly REIT testing purposes in applying these rules. In addition, to simplify the ownership determination, where the REIT's stock is publicly-traded, transfers by any person (regardless of their status as a non-look-through person) that owns a less than 5% interest in the REIT’s stock will be disregarded, unless the REIT has actual knowledge of that person’s ownership. If a REIT loses the benefit of the transition rule for either of the reasons stated above, the domestic corporation look-through rule only applies prospectively and thus does not apply to any portion of a testing period during which the transition rule was applicable. 

Observations and next steps

The final regulations will have a significant impact on structuring of foreign investment in REITs and are likely to make it difficult for foreign investors in private REITs to do so without being subject to tax under FIRPTA and associated U.S. tax return filing requirements upon a disposition of their interest in in the stock of either the REIT itself or a domestic C corporation that has invested in the REIT. Additionally, while the transition rule provides a long runway to unwind existing investment structures, meeting the requirements of the transition rules may be difficult for existing real estate funds or joint ventures that are in the early stages of acquiring real estate assets with newly raised capital.    

Real estate funds and joint ventures utilizing REITs should review the impact of these final regulations on their current structure and address the application of the transition rule.

If you have any questions on these final regulations, please contact Stephen Lee or your Citrin Cooperman advisor.