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New Regulations Impact Tax Considerations for Foreign Investment in Real Estate

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Key Takeaways:

  • While foreign investors are typically taxed on gain from the sale of U.S. real property interests (which include interests in most equity REITs), they are generally exempt from tax on gain from the sale of interests in “domestically controlled” REITs
  • Proposed regulations would change the ownership attribution rules for determining whether a REIT is domestically controlled
  • As a result, real estate industry participants should review their ownership structures to verify tax consequences for foreign investors


On December 29, 2022, the Treasury Department and the Internal Revenue Service (IRS) published proposed regulations (the Proposed Regulations) under Section 897 of the Internal Revenue Code of 1986, as amended (the Code), which would significantly change the current interpretation of when a REIT is considered “domestically controlled” and thus when gains from the sale of such REIT interests may be exempt to foreign investors. The Proposed Regulations also address the treatment of qualified foreign pension funds (QFPFs) and certain other entities for purposes of the exemption from taxation for foreign governments under Section 892. On the same day, the Treasury Department and the IRS also issued final regulations (the Final Regulations) clarifying when an entity is considered a QFPF for purposes of the Foreign Investment in Real Property Tax Act (FIRPTA).

Domestically Controlled REITs

Under FIRPTA, foreign investors generally are taxed on gain from the disposition of United States real property interests (USRPIs) as if such gain were effectively connected with a U.S. trade or business of the foreign investor. However, interests in a domestically controlled “qualified investment entity” are not USRPIs. The term “qualified investment entity” includes all REITs and some regulated investment companies (RICs). Accordingly, gain on the disposition of stock in a domestically controlled REIT (DREIT) is not subject to FIRPTA (the DREIT Exception). To be “domestically controlled,” a REIT must at all times during a specified testing period have less than 50% of the value of its stock held directly or indirectly by foreign persons.

The Proposed Regulations would change current practice regarding the determination of whether a REIT is “domestically controlled” for purposes of the DREIT Exception. To determine the percentage of foreign ownership, the Proposed Regulations create the concepts of “non-look-through persons” and “look-through persons.” Under the Proposed Regulations, only a “non-look-through person” is treated as holding directly or indirectly stock of a REIT, and stock of a REIT held by or through a “look-through person” is treated as held proportionately by the look-through person’s ultimate owners that are non-look-through persons. This rule generally requires that intermediate owners in a chain of ownership that are themselves “look-through persons” be disregarded and that ownership be traced to the first persons in such chain that are “non-look-through persons.”

The Proposed Regulations define “non-look-through person” to include individuals, domestic corporations (other than “foreign-owned domestic corporations” (discussed below), S corporations, and non-public REITs or RICs) and foreign corporations. A “look-through person” is defined as any other person and includes a REIT or a RIC (except in certain situations involving publicly traded REITs, as described below), an S corporation, a domestic or foreign non-publicly traded partnership, and a domestic or foreign trust.

Although domestic C corporations are generally considered “non-look through persons” under the Proposed Regulations, there is one major exception. A domestic C corporation will be treated as a look-through person if (i) its stock is not publicly traded and (ii) foreign persons hold (directly or indirectly) 25% or more of the fair market value of the corporation’s outstanding stock. This is a significant change from current practice and will disallow structures in which a 25% or more foreign-owned domestic corporation is used as an intermediary shareholder in order to qualify a lower-tier REIT as a DREIT (what is sometimes referred to as “synthetic DREIT”).

The Proposed Regulations set forth special rules applicable to persons who own stock in publicly traded REITs. First, a person that holds less than 5% of a class of U.S. publicly traded REIT stock that is deemed to be a U.S. person under Section 897(h)(4)(E)(i) is treated as a “non-look-through person” that is a U.S. person, unless the REIT has actual knowledge that such person is a foreign person. This rule applies notwithstanding the other proposed provisions. For example, a QFPF holding less than 5% of a public REIT’s stock will be treated as a U.S. person absent actual knowledge of its status as a foreign person. Second, a publicly traded REIT (which, under Section 897(h)(4)(E)(ii) is deemed to be held by either a foreign or domestic person based on whether the public REIT is or is not domestically controlled, respectively) is a “non-look through person” for purposes of determining whether any private REITs that it owns will meet the DREIT Exception.

The Proposed Regulations also would clarify that, except as discussed above in the context of a publicly traded REIT, a QFPF is a foreign person for purposes of the DREIT Exception. Section 897(l) provides that a QFPF is not treated as a “nonresident alien individual or foreign corporation” for purposes of FIRPTA, but it does not provide that it is not a “foreign person” for purposes of the DREIT Exception. Further, if a QFPF were not to be considered a foreign person for purposes of the DREIT exception, then majority ownership of a REIT by a QFPF would allow other foreign investors of such REIT to avoid FIRPTA. The IRS reasoned that it would be inconsistent with the intent of the QFPF exception for it to benefit other foreign shareholders by allowing a REIT that would otherwise not be a DREIT to so qualify. Before the Proposed Regulations, some believed that a technical reading of the Code produced a contrary conclusion.

The Proposed Regulations under Section 897 will be effective on or after the date that such Proposed Regulations are published as final regulations in the Federal Register. However, these Proposed Regulations may be relevant to determine whether a REIT is domestically controlled before the date that such Proposed Regulations are finalized because of the testing period for determining DREIT status (generally, a five-year look back). If gains are realized after the Proposed Regulations under Section 897 are finalized with respect to interests in a REIT that would have been a DREIT but for foreign-owned corporations being shareholders during the testing period, such gains will not be exempt from FIRPTA because of the DREIT Exception regardless of whether such ownership existed only prior to the finalization of such Proposed Regulations. Further, as noted in the Preamble to the Proposed Regulations, the IRS reserves the right to challenge taxpayers taking a contrary position to the Proposed Regulations regarding DREIT Status with respect to dispositions of REIT shares occurring prior to the finalization of such Proposed Regulations.

Foreign Government Exception

Section 892(a)(1) exempts from U.S. taxation certain income derived by a foreign government (the 892 Exemption). The 892 Exemption does not apply to income derived from the conduct of commercial activities or received by or from a controlled commercial entity. A United States real property holding corporation (USRPHC)  is treated as engaged in commercial activity by default and, therefore, is a controlled commercial entity if it is controlled by a foreign government. Thus, any income from such a USRPHC is not eligible for the Section 892 Exemption.

The Proposed Regulations provide that a QFPF or a corporation controlled by a QFPF will not be treated as a controlled commercial entity for purposes of the 892 Exemption solely by reason of being a USRPHC. The Proposed Regulations also provide that, if a corporation controlled by a foreign government is a USRPHC solely by reason of its direct or indirect ownership interest in one or more other corporations that are not controlled by a foreign government, then such corporation is not a controlled commercial entity. These Proposed Regulations would provide certainty that a QFPF or other corporation controlled by a foreign government and whose only assets are minority interests in REITs or other entities will not be a controlled commercial entity, and therefore would be exempt from U.S. tax. It is not clear, however, whether a foreign corporation that holds non-controlling interests in underlying entities (like investment funds) that are treated as partnerships for tax purposes will also be able to rely on this exemption.

The Proposed Regulations under Section 892 will be effective on or after the date that they are published as final regulations in the Federal Register, but that taxpayers may rely on the Proposed Regulations under Section 892 until they are adopted as final in the Federal Register.

Qualified Foreign Pension Funds

A QFPF or any entity all of the interests of which are held by a QFPF (a qualified controlled entity, or QCE) is not subject to tax under FIRPTA. The Final Regulations clarify the conditions for an entity to be considered a QFPF eligible for the FIRPTA exemption.

Under previously issued proposed regulations, the Treasury Department and the IRS provided a QFPF or QCE must satisfy additional criteria set forth in the proposed regulations to be a “qualified holder” and eligible for the exemption. To be a qualified holder, the QFPF or QCE must either: (1) have owned no USRPIs on the date it became such and remained qualified as a QFPF or QCE since that date or, (2) if it held USRPIs, remained a QFPF or QCE during the entirety of an up to 10-year testing period (the qualified holder rule). Although the subject of much commentary, the Final Regulations kept the qualified holder rule, adding only a limited safe harbor.

In addition, the Final Regulations provided clarity by adding a definition of retirement and pension benefits and clarifying the scope of ancillary benefits. This clarification is helpful because a QFPF must provide only retirement, pension and ancillary benefits to so qualify, and can only provide a limited amount of ancillary benefits. The revised definition of ancillary benefits clarifies that, in addition to benefits payable upon the diagnosis of a terminal illness, medical benefits, or unemployment benefits, ancillary benefits also include incidental death benefits (for example, funeral expenses), short-term disability benefits, life insurance benefits, and shutdown or layoff benefits.

The Proposed Regulations and Final Regulations provide helpful guidance for structuring foreign investments in real estate. Real estate sponsors, REITs and other real estate industry participants should review their existing joint venture, private REIT and fund structures in light of these new regulations. Most notably, close attention should be paid to the ownership of any DREIT to ensure such REIT will continue to meet the requirements to be a DREIT, particularly if such REIT is directly or indirectly owned by any domestic corporations. Additionally, it will be important to review all agreements that relate to a direct or indirect investment in a DREIT for compliance with covenants that relate to DREIT status.

V&E’s Tax group has substantial experience in structuring foreign investments in real estate. For additional information about the impact of these new regulations, please contact Chris Mangin, Ron Nardini, Paige Anderson or any other member of the group.

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.