On December 28, 2022, the IRS issued proposed regulation REG-100442-22, which may change real estate investment trusts’ (REITs) domestically controlled status. This change could cause non-U.S. investors in these structures to pay potentially significant U.S. tax on any gains realized upon sale of their stock. While still under review, the proposed regulations also suggest the IRS may begin using these new guidelines before they become final.
What Guidance is Currently Followed to Determine If a REIT Is Domestically Controlled?
A 2009 Private Letter Ruling concluded that a REIT owned by two U.S. corporations was domestically controlled, as the corporations were the taxpayers, regardless of the ownership within those corporations. While private letter rulings are not law or binding, this ruling has been widely used as the only guidance for how the IRS views domestic control in these situations.
Let’s look at an example under current law. A REIT owned 50% by one U.S. individual and 50% by a U.S. domestic C corporation qualifies as a domestically controlled REIT, regardless of the ownership of the corporation. This REIT is controlled 100% by U.S. taxpayers, easily satisfying the domestically controlled testing. Therefore, under current law, any non-U.S. investor that sells its stock of the corporation is exempt from U.S. tax on the gains. This is a significant tax benefit to foreign investors.
How Does Section 897 Impact REIT Foreign Investors?
Under Sec. 897 currently, a nonresident individual or foreign corporation invested in the REIT is taxed when a Qualified Investment Entity (QIE) makes a distribution from a gain on a sale or disposition of a U.S. real property interest, including stock issued by a U.S. real property holding corporation.
Sec. 897(h)(2), however, offers foreign investors an exception — stating that ownership of a domestically controlled QIE is not considered a U.S. real property interest, and therefore is not subject to tax under Sec. 897. It’s important to understand the definitions of each.
A domestically controlled QIE is one in which:
- Less than 50% of the fair market value of its stock is directly or indirectly owned by foreign persons at all times during the testing period.
The testing period is defined as the shorter of either:
- The five-year period ending on the date of the disposition or distribution, or
- The period during which the QIE was in existence.
- NOTE this five-year testing window essentially makes the proposed regulations retroactive in testing on any future transactions, as REITs that use these structures might not qualify as domestically controlled.
What is the Potential Impact of the Proposed Regulations to Foreign Investors and Sec. 897?
The proposed regulations provide that a “limited look-through test” would apply to determine overall domestic ownership. Each direct and indirect investor is defined as either a “look-through person” or a “non-look-through person.” To determine if the QIE is controlled by greater than 50% U.S. investors, the proposed regulations would only include non-look-through persons in that determination.
A look-through person includes:
- S corporations
- Nonpublicly traded partnerships (domestic or foreign)
- Trusts (domestic or foreign)
- Any nonpublicly traded domestic C corporation (foreign owned domestic) if foreign persons hold directly or indirectly 25% or more of the fair market value of the nonpublic domestic C corporation’s outstanding stock
A non-look-through person includes:
- Domestic C corporations (other than foreign owned domestic corporations)
- Foreign corporations (including foreign governments)
- Non-taxable holders (such as tax-exempt entities under Section 501(a))
- International organizations
- Publicly traded partnerships (both domestic and foreign)
- Qualified foreign pension funds (QFPF) and
- Qualified controlled entities (QCEs)
Any non-look-through person would consider 100% of their shares as either domestic or foreign, without looking through to any of its investors. For example, the IRS would consider a domestic C corporation that had foreign owners, but not enough ownership to rise to the level of a foreign owned domestic corporation, to be 100% domestically owned, despite the foreign owners.
Let’s go back to our previous example of a REIT owned 50% by U.S. individuals and 50% by a domestic C corporation. However, now assume the domestic corporation is owned 50% by U.S. individuals and 50% by non-U.S. investors. In this scenario, because the corporation is owned by more than 25% non-U.S. investors, it would be considered a look-through person. In this case, though, the REIT would still be domestically controlled, as U.S. persons own 75% (50% direct and 25% indirectly through the corporation). The non-U.S. persons would still be exempt from taxation upon selling their stock.
However, if we assume the U.S. corporation is owned 100% by non-U.S. investors — a very common structure for REITs — we now fail the testing, as our REIT is owned 50% by U.S. persons and 50% by non-U.S. persons. Since the REIT is not owned by more than 50% U.S. taxpayers, the exception does not apply. Our foreign investors would be subject to tax on any gain on the sale of their interest.
The IRS is currently in the process of reviewing comments on these proposed regulations. Affected REITs should review their existing structure to determine if the proposed regulations detrimentally impact their non-U.S. investors.
Contact Dave Charles at firstname.lastname@example.org, Dave Sobochan at email@example.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.