IRS Proposes to Withdraw Look-Through Rule for Domestically Controlled REITs

Under the Foreign Investment in Real Property Tax Act (FIRPTA), gain recognized by a foreign person on a disposition of a U.S. real property interest (USRPI) is treated as effectively connected income and taxed at regular U.S. rates. Generally, stock in a REIT that is a United States real property holding corporation is a USRPI. However, stock in a domestically controlled REIT (DREIT) is not a USRPI, and therefore gain on sale of such stock is not subject to tax under FIRPTA. A REIT will be a DREIT if, during the applicable testing period (generally, the prior 5 years), foreign persons owned, directly or indirectly, less than 50% of the value of its stock.

The 2024 Final Regulations sought to interpret the meaning of “directly or indirectly” in this context. Among other things, the 2024 Final Regulations require REITs to “look through” any non‑public domestic C corporation shareholder to its direct and indirect shareholders if foreign persons own 50% or more of that corporation, directly or indirectly (the Look-Through Rule). The REIT then must determine its domestically controlled status based on whether those direct and indirect shareholders of the domestic C corporation are U.S. or foreign persons. The Proposed Regulations would eliminate the Look-Through Rule and treat all domestic C corporations as “non‑look‑through persons”; that is, as U.S. persons.

The Treasury and the IRS, citing the extensive comments requesting withdrawal (including comments from the American Bar Association drafted, in part, by V&E attorneys (link)), state that they have concluded that reading “indirectly” to require looking through domestic C corporations is not the best interpretation of the DREIT regime. They also note the Look-Through Rule created legal uncertainty and impracticable tracing burdens that could deter investment in U.S. real estate.

The Proposed Regulations would apply to transactions on or after the date they are finalized. However, taxpayers would be allowed to apply the regulations to transactions occurring on or after the effective date of the 2024 Final Regulations (April 25, 2024), but before finalization of the Proposed Regulations. Taxpayers are also permitted to rely on the Proposed Regulations pending finalization.

If finalized, the Proposed Regulations would simplify the domestically controlled analysis for REITs. Domestic C corporations — regardless of foreign ownership — would again be treated as U.S. shareholders for purposes of the “domestically controlled” analysis. And, because such final regulations could be applied effectively retroactive to the day the Look-Through Rule was effective, for all practical purposes, the final regulations will have the effect of eliminating the Look-Through Rule in its entirety — retroactively and prospectively. This is likely to be welcome relief for REITs and REIT shareholders that were adversely impacted by the Look-Through Rule, as well as those sponsors and investors looking to establish new DREITs.