IRS Releases Final Regulations Impacting FIRPTA Exemption for Domestically Controlled REITs

Key Takeaways:

• The government declined to adopt near-unanimous commentary on the proposed regulations recommending that the domestic C corporation “look-through” rule be withdrawn.

• For purposes of determining whether a REIT must “look-through” a domestic C corporation in testing for domestically controlled REIT status, the “25% or greater” threshold from the proposed regulations is increased to a “more than 50%” threshold in the final regulations.

• The final regulations impose an “actual knowledge” exception to treating publicly traded domestic C corporations as not subject to the “look-through” rule.

• The final regulations addressed retroactivity concerns by providing a ten-year transition rule for all REITs in existence as of April 25, 2024, pursuant to which (1) the “look-through rule” will not apply, and (2) application of the look-through rule is prospective only from the end of the transition period.

• The ten-year transition rule may end early for a REIT that acquires significant assets or undergoes significant changes in ownership.

• REITs may voluntarily certify, but are not required to certify, to their shareholders as to the REIT’s “domestically controlled” status.

On April 24, 2024, the Treasury Department (“Treasury”) and the Internal Revenue Service (IRS) released final regulations (“Final Regulations”) under Section 897 of the Internal Revenue Code of 1986, as amended, addressing when a real estate investment trust (“REIT”) is considered domestically controlled. With some modifications, the Final Regulations largely adopt the framework of the proposed regulations (see REG-100442-22) (“Proposed Regulations”), although they do not address Proposed Regulations under Section 892 with respect to the foreign government exemption. The Treasury and the IRS indicated such proposals will be addressed in a separate rulemaking.

Domestically Controlled REITs

The Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) treats gain recognized by a foreign person on the disposition of a United States real property interest (“USRPI”) as income effectively connected with a U.S. trade or business and thus subject to the regular U.S. federal income tax (see Section 897(a)(1)). However, Section 897(h)(2) provides that interests in a domestically controlled REIT are not USRPIs. Accordingly, gain recognized on the sale of shares in a domestically controlled REIT (“DREIT”) is exempt from FIRPTA. For a REIT to be domestically controlled, less than 50% of the value of its stock must, at all times during the specified testing period (generally a five-year lookback), be held directly or indirectly by foreign persons. Stated another way, more than 50% of a REIT’s stock must be held by U.S. persons for it to qualify as a DREIT.

The Proposed Regulations

The Proposed Regulations provided rules for determining whether stock of a REIT is considered to be held “directly or indirectly” by foreign persons for purposes of determining whether such entity is domestically controlled. To determine the percentage of foreign ownership, the Proposed Regulations created the concept of “non-look-through persons” and “look-through persons.” A non-look-through person includes individuals, most domestic C corporations, publicly traded partnerships, foreign corporations and estates. A look-through person is defined as any other person and includes REITs (except for certain publicly traded REITs), regulated investment companies, domestic and foreign non-publicly traded partnerships, and domestic and foreign trusts. In an exception to the general treatment of domestic C corporation as “non-look-through persons,” the Proposed Regulations treated non-publicly traded domestic C corporations as “look-through persons” if foreign persons hold (directly or indirectly) 25% or more of the fair market value of the corporation’s outstanding stock. This represented a significant change from practice prior to the issuance of the Proposed Regulations.

The Proposed Regulations also provided special rules applicable to persons owning shares in publicly traded REITs. Specifically, they provided that a person holding less than 5% of the stock of a U.S. publicly traded REIT at all times during the specified testing period would be treated as a U.S. person that is a “non-look-through person” with respect to that stock, unless the REIT has actual knowledge that such person is not a U.S. person. The Proposed Regulations also clarified that, except as described above in the case of a publicly traded REIT, a qualified foreign pension fund (“QFPF”) is a foreign person for purposes of determining whether a REIT is “domestically controlled,” notwithstanding the QFPF’s exception from taxation under FIRPTA.

The Proposed Regulations would have applied to transactions occurring on or after the date that the regulations are published as final regulations in the Federal Register. The preamble, however, noted that the Proposed Regulations could be relevant for determining whether a REIT is domestically controlled before the finalization date because the specified testing period for a transaction after the finalization date may include periods before that date. This sounded alarm bells for practitioners worried about the effect such a proposed applicability date could have on REITs that entered into structures with the expectation that whether a REIT is domestically controlled would be determined under the law existing prior to the issuance of the Proposed Regulations.

The Final Regulations

The Final Regulations became effective when published in the Federal Register on April 25, 2024 (the “Effective Date”). Although acknowledging comments requesting that the domestic corporation look-through rule be withdrawn, the Treasury and the IRS stated that they nonetheless believed it necessary to provide guidance regarding the meaning of “indirect” for purposes of determining whether a REIT is “domestically controlled.” Further, the preamble to the Final Regulations emphasizes that the Treasury and the IRS are focused on whether there is “foreign control” of a REIT. However, the Treasury and the IRS agreed with commentators that this rule should be narrowed to address compliance concerns and more closely align the rule with the DREIT exception’s focus on foreign control. As such, the Final Regulations increased the foreign-ownership percentage threshold for such corporations from 25% or more to greater than 50% (such corporation, a foreign-controlled domestic corporation).

The Final Regulations adopted the rule in the Proposed Regulations treating a QFPF as a foreign person for purposes of the DREIT exception without change. The Final Regulations also generally kept the rule treating shareholders owning less than 5% of a publicly traded REIT’s stock as U.S. persons; however, the Final Regulations provide that this rule does not apply if the REIT has actual knowledge that such person is a foreign person or a foreign-controlled domestic corporation. The Final Regulations add similar exceptions to the treatment of public domestic corporations or publicly traded partnerships as “non-look-through persons” if the REIT has actual knowledge that the corporation or publicly traded partnership is foreign-controlled.

Importantly, the Final Regulations addressed significant concerns regarding the retroactive effect of the Proposed Regulations. Reversing course, the Treasury and the IRS determined that the domestic corporation look-through rule should be prospective in nature only. Accordingly, the Final Regulations provide that, for a 10-year period, existing structures are exempt from the domestic corporation look-through rule, provided certain requirements are met. Specifically, the 10-year transition period will end with respect to a REIT if either (1) the REIT acquires, directly and indirectly, USRPIs after the Effective Date 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 the Effective Date or (2) the REIT undergoes an ownership change such that the direct or indirect ownership of the REIT by “non-look-through persons” has increased by more than 50% in the aggregate as compared to the ownership on the Effective Date. With respect to the first of these rules, a REIT is permitted to use the asset values it uses for REIT testing purposes. With respect to the second, to simplify the ownership determination where the REITs is publicly traded, transfers by any person (regardless of their status as a non-look-through person) that owns less than a 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 will nonetheless be prospective only from the date the benefit of the transition rule was lost.

The Final Regulations also address uncertainty surrounding the procedures by which a DREIT may certify that an interest in its stock is not a USRPI and thus not subject to FIRPTA withholding tax upon disposition. Under Treasury Regulations Sections 1.897-2(h)(1) and 1.1445-2(c)(3), upon request of a foreign shareholder, a domestic corporation must provide a statement of its determination as to whether its stock constitutes a USRPI. Section 1.897-2(h)(1) does not apply to DREITs, which resulted in uncertainty regarding the availability of such procedure to DREIT shareholders. In response to the uncertainty, the Final Regulations provide that while a DREIT is not required to do so, a DREIT may voluntarily provide a statement to its shareholders certifying that its stock is not a USRPI because the REIT is domestically controlled, which shareholders may furnish to transferees of their DREIT stock.

Implications

The Final Regulations provide much-needed certainty for structuring foreign investments in real estate following the issuance of the Proposed Regulations. Although somewhat narrower in scope than the Proposed Regulations, the Final Regulations solidify the approach of the Proposed Regulations with respect to determining whether a REIT is domestically controlled. While the addition of the transition rule provides comfort, REITs and other real estate industry practitioners should still carefully review their ownership structures to determine the impact of the updated domestic corporation look-through rule and verify any tax consequences for foreign investors. Specifically, we expect the Final Regulations to have the following implications, among others:

• Practical end to “synthetic” DREIT structures on a go-forward basis.

• Challenges in maintaining the benefit of the transition rule with respect to DREIT structures that are not static (that is, structures in which the business plan contemplates continual capital raising and asset acquisition).

• REIT shareholders negotiating to contractually require REITs to certify as to their domesticity under the “voluntary” procedures of the Final Regulations.

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.