On December 18, President Obama signed the Protecting Americans from Tax Hikes (PATH) Act of 2015 (the “Act”) into law. The Act provides for a number of favorable and flexible REIT-specific tax provisions, and implements substantial reforms to the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), many of which are likely to facilitate a significant amount of foreign capital investment in U.S. real estate. The Act also extends, and in certain cases, makes permanent, a number of tax relief provisions that expired at the end of 2014. This alert addresses the most relevant provisions of the Act that are important to REITs and their shareholders, as well as the FIRPTA reforms.
REIT-Specific Tax Provisions of the Act
1. Restriction on Tax-free Spinoffs Involving REITs
Many public non-REIT companies have explored (and in certain instances, consummated) tax-free spinoffs of their real estate into newly formed REITs in an effort to “unlock” the value of their real estate. The Act essentially disallows tax-free treatment for such spinoffs. More specifically, under the Act, a spinoff involving a REIT will qualify for tax-free treatment only if either (i) immediately after the distribution both the distributing and controlled corporation are REITs, or (ii) a REIT distributes to its shareholders the stock of a taxable REIT subsidiary (TRS) of which the REIT has owned at least 80 percent during the three-year period ending on the date of the distribution. In addition, neither a distributing nor a controlled corporation is permitted to elect to be treated as a REIT for at least 10 years following a tax-free spinoff transaction. These rules apply to distributions made on or after December 7, 2015, but shall not apply to any distribution pursuant to transactions subject to ruling requests submitted to the IRS on or before such effective date, which request has not been withdrawn and with respect to which a ruling has not been issued or denied in its entirety as of such date.
2. Reduction of TRS Percentage Limitation
Effective for taxable years beginning after 2017, the Act reduces the percentage of the value of the gross assets a REIT may hold as securities in TRSs from 25 percent to 20 percent. It should be noted that prior to July 30, 2008, the percentage limitation was 20 percent.
3. Prohibited Transaction Safe Harbor Rules
A REIT is subject to a 100 percent tax on net income from a sale of property if, based on the relevant facts and circumstances, such sale involves property held as inventory or held primarily for sale to customers in the ordinary course of business (a “prohibited transaction”) unless such sale qualifies under the safe harbor.
The current safe harbor exception provides that a sale of “inventory” property may avoid being a prohibited transaction if it meets several requirements, including: (a) the REIT did not make more than seven sales of such “property” during the year (“Seven Sales Rule”), or (b) either (i) the aggregate adjusted bases of all such “properties” sold during the year does not exceed 10 percent of the aggregate bases of all of the REIT’s assets as of the beginning of the year, or (ii) the fair market value of all such “properties” sold during the year does not exceed 10 percent of the fair market value of all of the REIT’s assets as of the beginning of the year (“10 Percent Rule”).
The Act modifies the 10 Percent Rule such that a REIT now has the option to calculate the 10 percent threshold over a three-year average, with a maximum of 20 percent in any particular year, or to use the current safe harbor methodology. This modification could, under certain circumstances, increase the amount of proceeds that a REIT may generate on such sales in a given year without jeopardizing the qualification of the applicable sales under the safe harbor, provided the applicable 10 percent limitation is still met at the end of the applicable three-year period. Further, this alternative averaging test is effective for taxable years beginning after the date of enactment. Additionally, the Act removes the inference that the property sold be considered “inventory” property. Such clarification of the safe harbor takes effect as if included in the Housing Assistance Tax Act of 2008 except with respect to timber sales, in which case, the non-applicability of such inference applies as of the date of enactment of the Act.
4. Repeal of the Preferential Dividend Rule for Publicly Offered REITs
REITs are entitled to a deduction for dividends paid to shareholders (the “dividends paid deduction,” or DPD) so long as the dividend is not a “preferential dividend.” Further, preferential dividends do not count toward satisfying the requirement that REITs distribute at least 90 percent of their taxable income (the “90 percent distribution requirement”) each tax year. A dividend is considered preferential unless it is distributed pro rata to shareholders, with no preference to any share of stock as compared with other shares of the same class, and with no preference to one class compared with another except to the extent the class is expressly entitled to such preference.
In 2010, the preferential dividend rule was repealed for publicly offered regulated investment companies (RICs). Effective for distributions in taxable years beginning after 2014, the Act conforms the preferential dividend rule treatment of REITs to that of RICs. The preferential dividend rule will no longer apply to “publicly offered REITs,” including all public listed REITs and public non-listed REITs that are required to file annual and periodic reports with the Securities and Exchange Commission (SEC) under the 1934 Securities Exchange Act.
In the past, the preferential dividend rule was a notorious “trap for the unwary,” where even a minor or seemingly trivial “foot-fault” could jeopardize REIT status. Accordingly, the repeal of such rule with respect to “publicly offered REITs” is an extremely welcome development for both practitioners and investors alike.
5. IRS Authority to Cure Certain Inadvertent Preferential Dividends
The Act provides the IRS with authority to cure failures of the preferential dividend rule for non-publicly offered REITs that are inadvertent or due to reasonable cause and not due to willful neglect, rather than treat the dividend at issue as not qualifying for the REIT’s dividend paid deduction and not counting toward satisfying the 90 percent distribution requirement. This introduces a more practical approach to resolving certain preferential dividend failures for non-publicly offered REITs. This provision applies to distributions in tax years beginning after 2015.
6. Limitations on Designation of Dividends by REITs
The Act provides that the aggregate amount of dividends designated by a REIT as a capital gain dividend or a qualified dividend may not exceed the dividends paid by the REIT with respect to such year. For these purposes, dividends paid after the close of the taxable year are treated as paid with respect to such year. This provision applies to distributions in tax years beginning after 2015.
7. Debt Instruments of Publicly Offered REITs
The Act classifies debt instruments issued by publicly offered REITs as “nonqualified publicly offered REIT debt instruments,” which nonetheless count as real estate assets for purposes of the 75 percent asset test. However, the amount of such “nonqualified publicly offered REIT debt instruments” a REIT may own is limited to 25 percent of the value of the investing REIT’s gross assets. Income from, including any gain on the sale of, such debt instruments issued by publicly offered REITs is treated as qualifying income for purposes of the 95 percent income test but not the 75 percent income test. The definition of a “publicly offered REIT” is the same as discussed above. Thus, these new rules allow for a REIT to hold debt instruments in public listed REITs and public non-listed REITs.
The Act also provides that mortgages on interests in real property will be considered real estate assets for purposes of the 75 percent asset test. Law prior to the Act provided only that mortgages on real property may be so included.
These provisions are effective for tax years beginning after 2015.
8. Leases and Loans Involving Ancillary Personal Property
The Act provides that certain ancillary personal property that is leased with real property is treated as a real estate asset for purposes of the 75 percent asset test if rents attributable to such property do not exceed 15 percent of the total rent associated with such leased property. In addition, certain other property that, together with real property, secures a mortgage obligation is treated as a real estate asset for purposes of the 75 percent asset and all of the interest generated by such mortgage is qualifying income for purpose of the 75 percent income test if the fair market value of the personal property does not exceed 15 percent of the total fair market value of the real and personal property securing the obligation. The provision is effective for tax years beginning after 2015.
9. Hedging
Under current law, income from certain qualifying hedging transactions is not included in a REIT’s gross income for purposes of the relevant income tests. The Act expands the scope of qualifying hedging transaction to include (1) hedges entered into to counteract a qualifying hedge (e.g., previously acquired hedges of a REIT entered into to manage risk associated with extinguished liability or property that has been disposed of); and (2) hedges for which the hedge identification and curing regulations under section 1221 apply. The provision is effective for tax years beginning after 2015.
10. Modification of REIT Earnings and Profits Rules
Current law provides that current (but not accumulated) REIT earnings and profits (E&P) for any tax year are reduced only by amounts that are allowable in computing taxable income for the current tax year. The Act modifies this rule to provide that current REIT E&P may be reduced only by amounts allowable in computing taxable income during the current year and prior years. This provision applies solely for purposes of determining the tax treatment of a REIT distribution to its shareholders (i.e., whether such distribution is taxed as a dividend, return of capital, or capital gain if a distribution exceeds a shareholder’s stock basis).
Effectively, this rule causes E&P to be calculated similarly to REIT taxable income, and as a result attempts to prevent mismatches between the two that can result in a number of adverse tax consequences for both REITs and their shareholders. Accordingly, the Act provides long-awaited consistency to REIT E&P calculations.
The Act also makes a conforming change to a similar rule that increases a REIT’s E&P solely for purposes of the DPD by the total amount of gain recognized on the sale of property.
This provision is effective for tax years beginning after 2015.
11. Treatment of Certain Services Provided by TRSs
The Act allows a REIT’s TRS to provide certain services to the REIT, such as marketing and development, that are generally done by a third-party independent contractor without subjecting the REIT to the 100 percent prohibited transactions tax. The provision also expands the 100 percent excise tax on non-arm’s-length transactions to include services provided by the TRS to its parent REIT.
This provision is effective for tax years beginning after 2015.
FIRPTA Provisions of the Act
1. Repeal of FIRPTA for Interests Held by Foreign Retirement or Pension Funds
The Act completely exempts from FIRPTA any U.S. real property interest held by a qualified foreign pension fund. In order to so qualify, the foreign pension fund must be exempt from tax or subject to a reduced rate of tax in its resident jurisdiction, or contributions to such fund must be tax-deductible in the fund’s resident jurisdiction. Additionally, the fund must adhere to certain “U.S.-based” criteria; specifically, the purpose of the fund must involve the administration and provision of retirement or pension benefits to employees, no single participant may hold the right to more than 5 percent of the fund’s assets or income, and the fund must be subject to local government regulation, including rules requiring the fund toreport annually to local tax authorities regarding its beneficiaries. This provision applies to dispositions and distributions made after the date of enactment of the Act.
This reform reflects a clear desire to put U.S. and foreign pension funds on equal footing with respect to real estate investments in the U.S., and is likely to result in a significant increase of foreign capital investments into the U.S. real estate market. Particularly for foreign pension funds, this provision should significantly reduce the once nearly stifling effect of FIRPTA on foreign investment in U.S. real estate.
2. Increased Threshold for Publicly Traded REIT Stock
Prior to the enactment of the Act, foreign investors owning 5 percent or less of a REIT, of which any of the classes of stock is traded on an established securities market, were not subject to FIRPTA upon a sale of the REIT’s stock or the receipt of a capital gain dividend from the REIT. The Act increases from 5 percent to 10 percent the maximum stock ownership a shareholder may hold in a publicly traded REIT to avoid having that stock treated as a U.S. real property interest on disposition. Also, the Act contains a complex system of rules to allow certain foreign publicly traded entities (corporations and partnerships) formed in jurisdictions that have a comprehensive income tax treaty with the U.S. and have an agreement for the exchange of information with respect to taxes with the U.S. and “qualified collective investment vehicles,” to own and dispose of any amount of stock in a publicly traded REIT, without triggering FIRPTA. However, if any such entities (described in the preceding sentence) have investors that hold more than 10 percent of such stock or interests, the FIRPTA exemption will be reduced by the proportionate ownership of such holder. These provisions apply to dispositions and distributions on or after the date of enactment of the Act. The increased limitation for foreign “portfolio investors” and expansion to certain types of entities (discussed above) is likely to attract additional foreign capital in publicly traded REITs.
3. “Domestically Controlled” Presumptions
Under current law, gain resulting from the sale or disposition of stock of a “domestically controlled” qualified investment entity (i.e., a REIT or RIC, more than 50 percent of the stock of which is owned by U.S. persons), is not subject to FIRPTA. Typically, many publicly traded REITs have difficulty taking advantage of this FIRPTA exception because of lack of information regarding the U.S. or foreign status of their less than 5 percent shareholders. The Act provides new presumption rules for purposes of determining whether a REIT or RIC is “domestically controlled.” First, shareholders owning less than 5 percent of stock in a qualified investment entity (e.g., a REIT or RIC) that is regularly traded on an established U.S. securities market will be treated as U.S. persons, absent actual knowledge of the qualified investment entity to the contrary. Also, REIT or RIC stock owned either by a publicly traded REIT or a RIC meeting certain requirements, will be presumed to be held by a foreign person unless the “upper-tier” REIT or RIC is domestically controlled, in which case, such stock will be treated as held by a U.S. person. Additionally, any stock in a RIC or REIT that is held by a RIC or REIT that is not publicly traded will be treated as held by a U.S. person only in proportion to the stock of the upper-tier RIC or REIT that is held (or treated as held) by a U.S. person. This provision takes effect on the date of enactment of the Act.
4. Increased Rate of FIRPTA Withholding on Dispositions of U.S. Real Property Interests
The Act increases the rate of withholding on dispositions of U.S. real property interests (other than the sale of a personal residence where the amount realized is $1 million or less) from 10 percent to 15 percent. Such increased rate is designed to collect a greater amount of the potential tax owed. This provision is effective for dispositions occurring 60 days after the date of enactment of the Act.
5. Interests in RICs and REITs Not Eligible for “Cleansing Rule”
Currently, under the so-called “cleansing rule,” a corporation, the disposition of the stock of which would give rise to FIRPTA gain, may “cleanse” itself of its U.S. real property interest designation by disposing of all of its real estate assets in a taxable transaction. The Act essentially excludes RICs and REITs from eligibility for the “cleansing rule.” This provision applies to dispositions on or after the date of enactment of the Act.
6. Certain Dividends Received From Foreign Corporations Attributable to RICs and REITs
Dividends received by U.S. corporations from foreign subsidiaries are generally not eligible for a dividend received deduction unless the dividend is attributable to (i) income effectively connected with a U.S. trade or business, or (ii) any dividend received (directly or through a wholly owned foreign corporation) from an 80 percent or more controlled U.S. subsidiary (the “look through rule”). The Act provides that for purposes of the look through rule, dividends from RICs and REITs are not treated as dividends from domestic corporations. As a result, under the Act, dividends received by U.S. corporations from a wholly owned foreign subsidiary that are attributable to a dividend received from a U.S. RIC or REIT will not be eligible for a dividend received deduction. This provision applies to dividends received from RICs and REITs on or after the date of enactment of the Act.