Client Alert
PATH Act Amends Rules Relating to REITs and FIRPTA
December 24, 2015
By Andrew Short, Kristen Winckler, Joshua Milgrom, Stephen Grace & Matthew Tippett
On December 18, 2015, President Barack Obama signed the Protecting Americans from Tax Hikes Act of 2015 (the “Act”) into law. The Act makes significant changes to provisions of the Internal Revenue Code of 1986, as amended (the “Code”) with respect to real estate investment trusts (“REITs”) and the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”), and permanently extends some provisions that have been the subject of frequent extender legislation in prior years. This client alert sets forth a brief discussion of the provisions in the Act that impact REITs and FIRPTA.
Application of FIRPTA to Pension Funds
Under pre-Act law, foreign pension funds were subject to U.S. federal income taxation on the disposition of U.S. real property interests (“USRPIs”) under FIRPTA, while U.S. pension funds were generally exempt from U.S. taxation on capital gains. Foreign pension plans were forced to engage in sophisticated structuring to minimize U.S. tax.
The Act eliminates the disparate tax treatment between domestic and foreign pension funds and provides that qualified foreign pension funds are exempt from FIRPTA. Accordingly, qualified foreign pension plans will no longer be subject to FIRPTA on gain from the sale or disposition of USRPIs held directly, or indirectly through a partnership, or on capital gains distributions of a REIT attributable to such dispositions.
A qualified foreign pension fund is defined as any trust, corporation, or other organization or arrangement: (1) created outside the U.S., (2) established to provide retirement or pension benefits to current or former employees, (3) which does not have a single participant or beneficiary owning more than 5% of its assets, (4) subject to government regulation and annual reporting in its home country, and (5) where contributions to the entity are deductible or excluded from income or taxation on such entity that is deferred or taxed at a reduced rate.
The Act alleviates the disparate treatment of foreign pensions investing in U.S. real estate, but does not alter the rules that can impose U.S. net income tax on rent, interest, and other real estate related income, which will continue to merit consideration when structuring U.S. real estate investments.
Effective Date: This change is effective for dispositions and distributions on or after December 19, 2015.
Withholding Rate on FIRPTA Distributions
FIRPTA withholding is imposed at a rate of 10% on gross proceeds of sales, notwithstanding the fact that the actual amount of tax due may exceed (or be less than) the amount withheld.
The Act increases the rate of FIRPTA withholding from 10% to 15%. The prior 10% withholding rate remains effective where the transferee acquires a personal residence and the purchase price does not exceed $1 million.
Effective Date: The increased rate of FIRPTA withholding is effective for dispositions occurring 60 days after December 18, 2015.
Tax-Free Spinoffs Involving REITs
Operating businesses with significant real estate assets have used the tax-free spin-off under Code Section 355, combined with the REIT provisions to tax-efficiently separate real estate from the operating business. The tax-free distribution of real estate assets involving REITs has been perceived as an abuse of the general Code Section 355 requirement that both entities in a spin-off satisfy an active business test.
The Act prevents tax-free spin-offs when either the distributed or distributing entity is a REIT, with exceptions if (1) both the distributing and distributed entities qualify for REIT status immediately after the spin, or (2) a REIT spins-off its taxable REIT subsidiary (“TRS”). Additionally, the Act prohibits a corporation from making a REIT election within 10 years from the date of the tax-free spinoff.
Effective Date: These restrictions are effective for distributions made on or after December 7, 2015. However, the restrictions do not apply to any distribution pursuant to a transaction described in a ruling request submitted to the Service on or before December 7, 2015.
Taxable REIT Subsidiaries
The purpose of the TRS limit is to ensure that REITs focus primarily on the real estate business. In 2008, the TRS asset exception was amended to increase the value of TRS shares a REIT can hold from 20% to 25% of total REIT assets. The Service was concerned that allowing 25% of a REIT’s assets, by value, to be stock in TRSs enabled REITs to have significant non-real estate assets.
The Act will reduce the limitation back to 20%.
Effective Date: This change is effective for tax years beginning after December 31, 2017.
Application of FIRPTA to Publicly Traded REITs
Gain derived from the disposition of stock in a U.S. Real Property Holding Corporation is taxed under FIRPTA as income effectively connected with the conduct of a U.S. trade or business. Under pre-Act law, a foreign person owning 5% or less, actually or constructively, of publicly traded REIT stock was not subject to FIRPTA on the sale of the REIT stock or upon the receipt of a REIT capital gain dividend. Gain on the sale of stock of a “domestically controlled” REIT (defined as a REIT less than 50% owned by foreign persons during the applicable testing period) was also not subject to FIRPTA. In practice, determining whether a publicly traded REIT was domestically controlled was difficult due to the lack of information necessary to determine the domestic or foreign status of small investors.
The Act increases the maximum ownership permitted under the exemption from FIRPTA for publicly traded REITs from 5% to 10%. Subject to restrictions, the Act further provides that stock in a REIT will not be taxed under FIRPTA if it is held by a qualified shareholder, which includes a publicly traded “qualified collective investment vehicle,” such as a designated qualified collective investment vehicle or foreign publicly traded partnership located in a jurisdiction which has a comprehensive income tax treaty with the U.S.
The Act also provides greater certainty in determining whether a publicly traded REIT is domestically controlled by creating the presumption that all shareholders holding less than 5% of a REIT are U.S. persons unless the REIT has actual knowledge to the contrary. A REIT can presume that stock held by another qualified investment entity will be treated as held by a foreign person unless such qualified investment entity is domestically controlled.
Effective Date: These changes are effective for dispositions and distributions on or after December 18, 2015.
RICs Treated as Qualified Investment Entities
For purposes of FIRPTA, qualified investment entities are treated more favorably than other entities. Regulated investment companies (“RICs”) with significant real estate holdings were treated as “qualified investment entities” under pre-Act law, although the inclusion expired on December 31, 2014 (this provision had previously expired in 2007, 2009, 2011, and 2013, but was extended each time).
The treatment of such RICs as a “qualified investment entities” is made permanent under the Act.
Effective Date: This provision is effective as of January 1, 2015. However, the inclusion of RICs as qualified investment entities does not apply to withholding obligations on payments made in 2015 on or before December 18.
Prohibited Transaction Safe Harbors
REITs may be subject to a prohibited transaction tax (“PTT”) if the REIT engages in frequent property sales. The PTT is imposed at the rate of 100% on the net income derived from such sales. A safe-harbor applies if, among other requirements, the tax basis or fair market value of the property sold by the REIT in any given year does not exceed 10% of the aggregate tax bases, or aggregate fair market values of all of the REIT assets as of the beginning of the year.
The Act expands the safe harbor, allowing a REIT to sell property with an aggregate tax basis or fair market value up to 20% of its aggregate tax bases or aggregate fair market value in one year, so long as the REIT does not sell property with a tax basis or fair market value exceeding 10% of the REIT’s aggregate tax basis or aggregate fair market value over a three year period.
Effective Date: This provision applies to taxable years beginning after enactment of the Act.
Preferential Dividends
REITs have incurred significant compliance costs to avoid “preferential dividends.” A dividend is preferential unless it is distributed pro rata, with no preference to any share of stock compared to other shares of the same class of stock. A REIT is not entitled to the dividends paid deduction for a preferential dividend and the payment of preferential dividends can result in a loss of REIT status. Similar preferential dividend rules apply to RICs, but not to publicly offered RICs.
The Act repeals the preferential dividend rule for publicly offered REITs, defined as a REIT required to file annual and periodic reports with the SEC under the Securities Exchange Act of 1934.
The Act grants the Secretary the authority to provide an alternative remedy to a REIT that pays a preferential dividend. The remedy would be available to a REIT if the Service determines that the preferential dividend was inadvertent, or due to reasonable cause and not willful neglect. This provision provides the Secretary with the opportunity to allow REITs to correct inadvertent preferential dividends without jeopardizing REIT status.
Effective Date: The repeal of the preferential dividend rule and the availability of alternative remedies for publicly offered REITs are applicable to distributions in tax years beginning after December 31, 2015.
Designation of Dividends by REITs
A REIT that recognizes a net capital gain for a taxable year may designate dividends as capital gain dividends, and shareholders will be taxed on such dividends as if they recognized such capital gain on the sale or exchange of a capital asset held for more than one year. A REIT may also designate dividends as qualified dividend income, which will be taxed at the same rate as capital gains.
The Act provides that the aggregate amount of REIT dividends that can be designated as capital gain dividends or qualified dividends for a taxable year cannot exceed the total amount of dividends paid by such REIT for such year.
Effective Date: This provision is effective for taxable years beginning after December 31, 2015.
Debt Qualifying as Real Estate Assets
Under pre-Act law, debt instruments of publicly offered REITs and interests in mortgages on interests in real property generally were not qualified real estate assets.
The Act allows debt instruments of publicly offered REITs, and interests in mortgages on interest in real property to be treated as qualified real estate assets for purposes of the 75% asset test and the 95% income test. However, income from debt instruments of publicly offered REITs will not qualify for the 75% income test, unless the income qualified as good 75% income under pre-Act law and may not account for more than 25% of a REIT’s assets by value.
Effective Date: This provision is effective for taxable years beginning after December 31, 2015.
Personal Property
For purposes of the 75% income test, rents attributable to personal property leased in connection with real property was treated as good REIT income so long as the rent allocable to such personal property did not exceed 15% of the total rent attributable to both the real and personal property. However, personal property was not considered a good REIT asset for purposes of the 75% asset test.
The Act conforms the 75% asset test with the 75% income test. Personal property leased with real property will be treated as real property for purposes of the 75% asset test to the extent that rents attributable to such personal property are treated as rents from real property for purposes of the 75% income test. In addition, income from an obligation secured by a mortgage on real property and personal property will be treated as qualifying under the 75% income test, so long as the value of personal property does not exceed 15% of the total fair market value of the real property and personal property. Such mortgages will also be considered a real estate asset for purposes of the 75% asset test.
Effective Date: This change is effective for taxable years beginning after December 31, 2015.
Hedging Provisions
Income earned by REITs from clearly identified hedging transactions that: (1) hedge any indebtedness incurred or to be incurred by the REIT to acquire or carry real estate assets, or (2) manage risk of currency fluctuations relating to any item that qualifies for the 95% or 75% income tests is excluded from gross income for purposes of the 75% and 95% income tests.
The Act adds an additional category of excluded hedging income. If a REIT enters into a qualifying hedge but disposes of the underlying property, the REIT can enter into a hedge of the original qualifying hedge, and income from the subsequent hedge will not be included in income for purposes of the 75% and 95% income tests.
Effective Date: This change is effective for taxable years beginning after December 31, 2015.
REIT Earnings and Profits
A REIT’s current earnings and profits is not reduced by any amount unless the REIT can deduct such amount from its current year’s taxable income. A REIT with items that are deductible from taxable income in years prior to the year taken into account for earnings and profits would have effectively increased current earnings and profits, and thereby increased includible dividends, and reduced return of capital.
The Act conforms tax deductibility with deductibility for computing earnings and profits. The Act also clarifies that on the sale or exchange of real property, earnings and profits for purposes of computing the dividends paid deduction is increased by the amount of includible gain for such tax year.
Effective Date: This change is effective for taxable years beginning after December 31, 2015.
RICs and REITs Under FIRPTA
The so-called FIRPTA “cleansing rule” provided that an interest in a corporation was not a USRPI if, as of the date of disposition, the corporation owned no USRPIs and all USRPIs held by such corporation during the applicable testing period were disposed of in transactions in which the full amount of gain was subject to U.S. tax.
RICs and REITs do not pay corporate level tax on gain if such amount is distributed to shareholders. The Act codifies that the cleansing rule is only applicable if neither the corporation nor any predecessor of the corporation was a RIC or REIT at any time during the applicable testing period.
Effective Date: This change is effective for dispositions on or after December 18, 2015.
Dividends Received Deduction
Code Section 245 allows a dividends-received deduction (“DRD”) for domestic corporations that receive dividends from certain foreign corporations. To be eligible for the DRD, the earnings from which the dividend is paid must have been previously subject to U.S. tax as effectively connected income or paid to such foreign corporation by an 80% owned domestic corporation.
The Act clarifies that, for purposes of determining whether dividends from a foreign corporation are eligible for a DRD, dividends paid by RICs and REITs to the foreign corporation are not treated as dividends from domestic corporations.
Effective Date: This change is effective for dividends received on or after December 18, 2015.
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