IRS Issues Section 892 Final Regulations Impacting Foreign Government Investment in U.S. Real Estate

On December 12, 2025, the United States Department of the Treasury (“Treasury”) and the Internal Revenue Service released final regulations (the “Final Regulations”) under Section 892 of the Internal Revenue Code of 1986, as amended (the “Code”). Among other things, the rules finalize changes regarding when a foreign government is considered to be engaged in commercial activity by modifying the U.S. real property holding corporation (“USRPHC”) per se rule and clarifying the method for applying the minority interest exception to such rule. The Final Regulations generally adopt the approaches set forth in proposed regulations issued in 2011 and 2022 (together, the “Proposed Regulations”), which were themselves aimed at modifying temporary regulations issued in 1988 (the “Temporary Regulations”), and are effective beginning December 15, 2025.

Background

Under Section 892 of the Code, foreign governments are generally exempt from U.S. income taxation on certain qualified investment income, but the exemption does not apply to income earned by a foreign government that is derived from commercial activity or received from a “controlled commercial entity” (“CCE”). Under the Temporary Regulations, any USRPHC, or any foreign corporation that would be a USRPHC if domestic, was treated as per se engaged in commercial activity, with CCE status attaching if the foreign government held (directly or indirectly) 50% or more of the total interests in such entity (by vote or value) or any other interest that provided the foreign government with “effective practical control” of the entity (the “Per Se Rule”). As a result, dividends and gains attributable to such CCE were not eligible for the Section 892 exemption and were instead subject to withholding tax or taxation under the FIRPTA regime.

The Proposed Regulations introduced an exception to the Per Se Rule for corporations that would be USRPHCs “solely by reason of” their ownership of a direct or indirect interest in one or more other corporations that were not controlled by the relevant foreign government (the “Minority Interest Exception”). Comments to the Proposed Regulations asserted that there were two possible interpretations of this exception. Under the “Balance Sheet Method” any direct or indirect ownership interests in corporations not controlled by the foreign government would be removed from the tested entity’s balance sheet before performing the asset test under Section 897 to determine whether the entity is a USRPHC. The “Good Asset Method” instead would treat such minority interests as non-U.S. real property interests (“USRPIs”) for purposes of the asset test under Section 897.

To illustrate the difference between the two methods, assume that the tested corporation holds (a) $30 of direct USRPIs, (b) $25 of non-real property assets, and (c) a $45 minority interest in a USRPHC. Under the “Balance Sheet Method,” the minority interest is ignored entirely. The corporation would be treated as holding 54.5% USRPIs ($30 / ($30 + $25)) and would not be eligible for the Minority Interest Exception. Under the “Good Asset Method,” the minority stake is included in the denominator of the above ratio; the corporation would be treated as holding 30% USRPIs ($30 / ($30 + $25 + $45)) and therefore would be eligible for the Minority Interest Exception.

The Final Regulations

The Final Regulations deviate from the Temporary Regulations in that they limit the Per Se Rule to domestic corporations that are USRPHCs and exclude foreign corporations from automatic CCE status, regardless of whether such foreign corporation would be a USRPHC if domestic. In addition, the Final Regulations retain the Minority Interest Exception introduced in the Proposed Regulations. The Treasury noted that, although it believed that the change in the Per Se Rule rendered the Minority Interest Exception unnecessary, it was retained largely to respect taxpayer reliance on the Proposed Regulations, but also because, in the Treasury’s view, the exception appropriately allows foreign governments to use domestic holding companies for investments that could otherwise be made directly or with foreign holding companies.

The Final Regulations also mandate the “Balance Sheet Method” and reject the alternative “Good Asset Method” for purposes of applying the Minority Interest Exception. Because the “Good Asset Method” treats minority interests in noncontrolled USRPHCs as “good assets” included in the denominator but excluded from the numerator, a tested corporation could dilute the percentage of “bad assets” by increasing its minority stakes in noncontrolled USRPHCs. As such, the Treasury was concerned that use of the “Good Asset Method” could shelter from FIRTPA entities that would be a USRPHC for reasons other than minority interests, such as direct USRPIs and controlled USRPHCs, which would be inconsistent with the “solely by reason of” requirement of the exclusion from the Per Se Rule.

In addition, although the Final Regulations do not expressly address when a U.S. corporation is treated as a non-commercial entity, their structure supports an inference that certain passive U.S. corporations may fall outside commercial entity status. By confining the Per Se Rule to domestic corporations that are USRPHCs, the Final Regulations suggest that a U.S. corporation that is not a USRPHC and that merely holds passive investments, without itself conducting an active trade or business, may not be treated as engaged in commercial activity solely by reason of its domestic status. Accordingly, eligibility for the Section 892 exemption with respect to dividends and interest from controlled U.S. corporations may turn on a facts-and-circumstances analysis of the U.S. corporation’s activities, rather than ownership percentage alone.

Implications

The Final Regulations provide clarity for foreign governments investing directly or indirectly in real estate in the United States. The narrowing of the Per Se Rule and the retention of the Minority Interest Exception solidifies the additional flexibility introduced by the Proposed Regulations for structuring U.S. real estate investments. Foreign government-related investors in U.S. real estate and real estate asset managers whose investor base includes Section 892 investors should consult with their tax advisors regarding the application of the Final Regulations to their investments and businesses.

This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.