Impact of Final Regulations relating to Domestically Controlled REITs on Investors and Sponsors

Originally Published in the Third Quarter 2024 Edition of the Real Estate Taxation Journal, a Thomson Reuters Publication.

On April 24, 2024, the IRS and the U.S. Department of Treasury (“Treasury”) issued final regulations relating to the qualification of a real estate investment trust (“REIT”) or a registered investment company (“RIC”) as a domestically controlled qualified investment entity (the “Final Regulations”).¹The Final Regulations finalize, with changes, the proposed regulations issued on December 29, 2022 (the “Proposed Regulations”).² The Final Regulations generally (i) limit the scope of the “look-through rule” of the Proposed Regulations, which treats certain “foreign-owned domestic corporations” as flow-through entities for purposes of determining if a REIT owned, in part, by a “foreign-owned domestic corporation” qualifies as a domestically controlled REIT (“DC REIT”), and (ii) apply only prospectively (subject to a ten-year transition period for existing REITs that continue to meet certain requirements). The Final Regulations may impact sponsors and non-U.S. investors in real estate funds, private equity funds and other tax structures involving REITs.

Overview of Regulatory Position Prior to Proposed Regulations

Pursuant to the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”), any gain or loss of a non-U.S. investor from the sale or other disposition of a U.S. real property interest (“USRPI”) is considered to be income that is effectively connected with the conduct of a U.S. trade or business._³

A USRPI includes any non-creditor interest in a U.S. real property holding corporation (“USRPHC”), i.e., a U.S. entity that is treated as a corporation for U.S. federal income tax purposes (a “U.S. corporation”) with 50 percent or more of the fair market value of its business assets consisting of interests in U.S. real estate and related assets.₄ A REIT is generally considered a USRPHC because of the composition of its assets.

However, an interest in a domestically controlled qualified investment entity (“QIE”), such as a domestically controlled REIT (previously defined as a “DC REIT”), is not a USRPI.⁵ Accordingly, any gain on the sale or disposition of stock in a domestically controlled QIE, such as a DC REIT, is not subject to tax under FIRPTA. However, distributions from a DC REIT that are attributable to net capital gain from the sales or exchanges of USRPIs (referred to as “capital gain dividends”) received by a non-U.S. person are still subject tax under FIRPTA.⁶

A domestically controlled QIE is any QIE in which less than 50 percent of the value of its stock was held directly or indirectly by foreign persons at all times during the shorter of (i) the five-year period ending on the date of the disposition or distribution, as applicable, or (ii) the period during which the QIE was in existence (the “five-year look-back period”).⁷

The Code and the Treasury Regulations had not clearly addressed how to determine “indirect” ownership for purposes of determining whether a REIT qualifies for DC REIT status. However, the Treasury Regulations have provided that the “actual owners of stock”, as determined under Treas. Reg. Sec. 1.857-8, must be taken into account.⁸ The actual owner of REIT shares is the person who is required to include the dividends received on the shares in gross income (i.e., the shareholder of record of the REIT).⁹

Further, the IRS issued a private letter ruling in 2009 (the “2009 PLR”) that provided that REIT stock owned by a non-U.S. person through a fully taxable U.S. corporation is to be treated as owned by such U.S. corporation, and not as owned “indirectly” by the non-U.S. person, for purposes of determining DC REIT status.¹⁰ Under the facts presented in the 2009 PLR, the REIT in question was held by two fully taxable U.S. corporations that were, in turn, partly owned by non-U.S. persons. The IRS referred to the “actual owners of stock” pursuant to Treas. Reg. Sec. 1.897-1(c)(2)(i) and held that the two fully taxable U.S. corporations that held interests in the REIT qualified as actual owners of stock, despite the fact that these U.S. corporations were held, in part, by non-U.S. persons. Therefore, the 2009 PLR determined that the REIT qualified as a DC REIT without an analysis of the ownership of the two U.S. corporations. However, because a private letter ruling may only be relied upon by the taxpayer to which it is issued, it is not binding precedent with respect to other taxpayers.

Proposed Regulations

First, pursuant to the Proposed Regulations, “foreign-owned domestic corporations” (“FODCs”) would have been treated as flow-through entities for purposes of determining DC REIT status (the “look-through rule”).¹¹ Under the Proposed Regulations, an FODC is any non-publicly traded U.S. corporation if non-U.S. persons hold directly or indirectly 25 percent or more of the value of its outstanding stock, after applying certain look-through rules.¹²

The preamble to the Proposed Regulations (the “Proposed Regulations Preamble”) noted that the Treasury and IRS believe reliance on Treas. Reg. Sec. 1.857-8 alone to determine DC REIT status is incorrect, as Treas. Reg. Sec. 1.857-8 is only intended to ensure that the beneficial owner of stock is taken into account when different from the shareholder of record.¹³ The Proposed Regulations Preamble did not directly address the potential inconsistency with the 2009 PLR, which also cited those regulations to support its conclusion.

Second, the Proposed Regulations clarified that a qualified foreign pension fund (“QFPF”) or a qualified controlled entity (“QCE”) would always be treated as a “foreign person” for purposes of determining the status of a REIT as a DC REIT.¹⁴ Under the FIRPTA rules, both a QFPF and a QCE are generally exempt from U.S. tax pursuant to FIRPTA.¹⁵

Third, the Proposed Regulations may have been relevant for determining DC REIT status during periods before the date on which the Proposed Regulations were finalized, to the extent the five-year look-back period for DC REIT status related to a transaction that occurred after the Proposed Regulations were finalized, but included periods before the date of finalization. As such, there was the potential that the Proposed Regulations could have been applied retroactively.

In sum, pursuant to the Proposed Regulations, a REIT would have been required to look through a fully taxable U.S. corporation that qualifies as an FODC, for purposes of determining DC REIT status, and this rule may have been applied retroactively.  

Interim Period between Proposed Regulations and Final Regulations

The IRS and Treasury received comment letters from the American Bar Association, real estate groups (including the American Investment Council and Nareit) and law firms that generally noted that the Treasury lacked the statutory authority to propose the look-through rule of the Proposed Regulations and cautioned that the look-through rule and its retroactive nature could have a chilling effect on non-U.S. investment in U.S. real estate held by REITs. 

Addressing these comments relating to the posture of the Proposed Regulations, David Berke of the IRS Office of Associate Chief Counsel (International) said, “[w]e are thinking through the comments received including whether to provide transitional relief…”16 Ultimately, as previewed, the Treasury and IRS did provide transitional relief in the Final Regulations.

Final Regulations

Look-Through Rule

The Final Regulations limit the look-through rule to situations where non-U.S. persons indirectly own a significant percentage of a REIT and increase the amount of non-U.S. ownership required to apply the look-through rule from “25 percent or more” to “more than 50 percent”. Accordingly, an FODC is any non-publicly traded U.S. corporation if non-U.S. persons hold directly or indirectly more than 50 percent of the fair market value of its outstanding stock, after applying certain look-through rules.17

Comment letters sent to the IRS and Treasury recommended that the look-through rule be withdrawn for two principal reasons. First, some commentators argued that the look-through rule is inconsistent with the Code, which does not contemplate look-through treatment for fully taxable U.S. corporations, except for certain constructive ownership rules such as those in Section 318.¹⁸ These constructive ownership rules are specifically referenced in certain sub-sections of Section 897,¹⁹ but are not referenced in the rules relating to determining whether a REIT qualifies as a DC REIT.²⁰ The preamble to the Final Regulations (the “Preamble”) notes that the look-through rule does not apply specific constructive ownership rules like those in Section 318, but rather, gives effect to the term “indirectly” for purposes of determining whether a REIT qualifies for DC REIT status. This is based on the policy of the exception for DC REITs, which is to ensure that United States persons directly and indirectly control a REIT that is “domestically controlled”. Thus, the fact that other sub-sections of Section 897 refer to Section 318 is irrelevant to determining the status of a REIT as a DC REIT.

Second, some commentators pointed to the inconsistency between the look-through rule and the 2009 PLR. The Preamble observes that the citation in a report by the Joint Committee on Taxation (the “JCT Report”)²¹ merely restates the holding in the ruling in its description of the then current law. The JCT Report does not express any view regarding the binding effect of the 2009 PLR or indicate that Congress endorsed a rule that prevents looking through U.S. corporations in all cases. Therefore, the Preamble does not address the merits of the 2009 PLR, but simply concludes that the JCT Report’s reference to the 2009 PLR does not affect the application of the look-through rule.

Therefore, the Treasury Department and the IRS did not adopt the recommendation to withdraw the look-through rule, but instead, limited the applicability of the look-through rule to situations where non-U.S. persons own a significant indirect ownership interest in a REIT.

Treatment of QFPFs and QCEs

The Final Regulations clarify that a QFPF or a QCE will be treated as a “foreign person” for purposes of determining a REIT’s status as a DC REIT, consistent with the approach in the Proposed Regulations.²² One commentator noted that because neither a QFPF nor a QCE is subject to tax under FIRPTA, there is no policy reason to treat a QFPF or a QCE as a foreign person for other rules, such as for purposes of determining whether a REIT qualifies for DC REIT status. The Preamble, however, rejects this argument and notes that the policy of the DC REIT rules seeks to determine whether control of the REIT is held directly or indirectly by United States or non-U.S. persons, as opposed to whether control is held by taxable persons.²³

Transition Rule

The Final Regulations introduce a transition rule, which exempts existing DC REIT structures from the look-through rule until April 24, 2034, provided that certain asset and ownership requirements are met (the “transition rule”).²⁴

First, an existing DC REIT seeking exemption from the look-through rule is prohibited from acquiring USRPI that, in the aggregate, exceed 20 percent of the total FMV of all of its USRPI as of April 25, 2024 (the “asset requirement”).²⁵ Because the asset requirement only limits the acquisition of USRPI, a REIT that is grandfathered under the transition rule and that employs both a debt and equity strategy may consider acquiring interests in mortgage loans, which are generally not considered to be USRPI.²⁶ Second, an existing DC REIT cannot have a significant change in ownership without becoming subject to the look-through rule, which occurs when the ownership by “non-look-through persons” (i.e., persons other than FODCs, REITs, RICs, etc.) has increased by more than 50 percentage points, in the aggregate, compared to their ownership as of April 25, 2024 (the “ownership requirement”).²⁷

If either the asset requirement or the ownership requirement is not met, the REIT at that time becomes subject to the look-through rule. Further, if applicable, the Final Regulations only apply prospectively and do not apply to any portion of the five-year look-back period when the transition rule applied to a REIT.²⁸

For example, VAREIT is a REIT formed on January 1, 2018. From the time of formation, 51 percent of VAREIT’s stock is held by X, a non-public U.S. corporation that is owned equally by FC2 and FC3 (i.e., non-U.S. corporations), which is treated as an FODC under the look-through rule. The remaining interests in VAREIT are held by FC1, i.e., a non-U.S. corporation, (25 percent) and nonresident alien individuals (24 percent). Accordingly, VAREIT would qualify as a DC REIT if solely considering direct owners, but fails to qualify as a DC REIT under the look-through rule of the Final Regulations.²⁹ The value of Asset 1 (held by VAREIT) is $100x. On January 1, 2026, VAREIT acquires Asset 2 (a USRPI) for $30x. VAREIT no longer meets the requirement for transitional relief, because the FMV of Asset 2 is 30 percent (i.e., more than 20 percent) of $100x, which is the FMV of VAREIT’s USRPI as of April 25, 2024. Therefore, the transition rule ceases to apply to VAREIT, and thus, the Final Regulations apply for purposes of determining whether VAREIT is domestically controlled with respect to transactions (e.g., sales by non-U.S. persons of their interests in VAREIT) occurring after January 1, 2026.³⁰

Alternatively, a change in VAREIT’s ownership can also cause VAREIT to fail to qualify under the transition rule. For example, if on January 1, 2025 FC3 sells its 50 percent stock interest in VAREIT to FC2, FC2’s ownership interest in VAREIT increases by 25.5 percentage points, from 25.5 percent (i.e., FC2’s 50 percent interest in X multiplied by X’s 51 percent interest in VAREIT) on April 25, 2024 to 51 percent (i.e., FC2’s 100 percent interest in X multiplied by X’s 51 percent interest in VAREIT) on January 1, 2025. Then, on January 1, 2026, FC1 sells its direct 25 percent interest in VAREIT to FC4. FC4’s stock interest in VAREIT increases by 25 percentage points, from zero percent on April 25, 2024 to 25 percent on January 1, 2026. Accordingly, as of January 1, 2026, non-look-through persons have increased their ownership in VAREIT by 50.5 percentage points (i.e., 25.5 percent and 25 percent for FC2 and FC4, respectively), and hence, the transition rule ceases to apply to VAREIT. As a result, the Final Regulations apply for purposes of determining whether VAREIT is domestically controlled with respect to transactions (e.g., sales by non-U.S. persons of their interests in VAREIT) occurring after January 1, 2026.³¹

Therefore, if a REIT’s status as a DC REIT is grandfathered under the transition rule, the REIT should closely monitor any asset acquisitions and any changes in its ownership to ensure that it meets the asset requirement and the ownership requirement throughout the ten-year transition period. 

Effective Date

Subject to the transition rule, the Final Regulations apply to transactions occurring on or after the date when the Final Regulations are published in the U.S. Federal Register (i.e., April 25, 2024).³²

Practical Application of Final Regulations

Look-Thorough Rule

Both sponsors and investors in real estate funds, private equity funds and other investment structures involving DC REITs should analyze the application of the narrower look-through rule of the Final Regulations to their funds or investment structures and any applicable covenants and/or representations relating to DC REIT status or withholding taxes in fund documents (including side letters). Based on our experience, sponsors and investors alike undertook a similar analysis after the Proposed Regulations were issued.

Further, the Final Regulations do not provide guidelines regarding procedures to determine if a U.S. corporation is an FODC, and a REIT must take appropriate measures to determine the identity of its direct and indirect shareholders in determining whether it qualifies as a DC REIT. As such, among other actions, sponsors of REITs may include questions and confirmations relating to potential investors’ direct and indirect shareholding in subscription documents to determine whether REITs in their fund structures qualify as DC REITs. 

In practice, some real estate funds may currently rely on the direct shareholding of their U.S. taxable investors (that are not FODCs) and U.S. tax-exempt investors for purposes of qualifying a REIT as a DC REIT and therefore may not be impacted by the Final Regulations. Particularly, U.S. taxable investors generally would choose to invest directly in a REIT, rather than through a U.S. corporation, to avoid the additional layer of tax introduced by investing in a REIT indirectly through a U.S. corporation. U.S. tax-exempt investors may also choose to invest directly in a REIT, as the REIT often shields such investors from incurring unrelated business taxable income (assuming that the U.S. tax-exempt investors’ interest in the REIT is not debt financed and that the pension-held REIT rules under Section 856(h)(3)(D) do not apply).

For example, 51 percent of the stock of a REIT (that expects to generate a substantial amount of REIT capital gain dividends) may be held by U.S. taxable investors and U.S. tax-exempt investors, and 49 percent of the stock may be held by a non-publicly-traded U.S. corporation that is held collectively by non-U.S. investors (please refer to structure below). Here, the look-through rule of the Final Regulations is not expected to impact the REIT’s qualification as a DC REIT because 51 percent of the REIT’s direct shareholders constitute U.S. taxable investors and U.S. tax-exempt investors (regardless of the non-U.S. investors’ indirect shareholding through the U.S. corporation), assuming that no transfers or redemptions cause the percentage of the REIT that is owned by U.S. investors to fall below the required threshold.³³

Treatment of QFPFs and QCEs

The treatment of QFPFs and QCEs as “foreign persons” for purposes of determining DC REIT status pursuant to the Final Regulations (consistent with the Proposed Regulations) is primarily expected to impact non-U.S. investors that do not qualify as QFPFs or QCEs (or that are not entitled to an exemption pursuant to Section 892), rather than QFPFs or QCEs particularly where an exit is planned to be structured as a sale of the REIT.³⁴

As such, a non-U.S. investor (who does not qualify as a QFPF or a QCE, and is not otherwise exempt from tax pursuant to Section 892) is expected to be subject to tax under FIRPTA on a sale or disposition of its interest in such REIT. However, a QFPF or a QCE generally continues to be exempt from tax under FIRPTA on a sale or disposition of its interest in such REIT, regardless of the REIT failing to qualify as a DC REIT.³⁵

Transition Rule

As noted above, a REIT that qualifies as a DC REIT but for the look-through rule of the Final Regulations is grandfathered under the transition rule until April 24, 2034 (or earlier if it fails to meet the asset requirement or ownership requirement or ceases to be domestically controlled more generally). If such “grandfathered” REIT foresees that it will fail to meet either the asset requirement or the ownership requirement, then non-U.S. investors in such REIT should consider selling or disposing of their stock in such REIT during the transition period (prior to such failure). For example, if a “grandfathered” REIT fails to meet either the asset requirement or the ownership requirement on January 1, 2026, it will be subject to the Final Regulations starting on such date. Therefore, if a non-U.S. investor in such REIT sells or disposes of its stock after January 1, 2026, the REIT will not be treated as a DC REIT, because it did not qualify as a DC REIT at all times during the five-year look-back period. However, if the non-U.S. investor sells or disposes of its stock in such REIT on or prior to January 1, 2026, the REIT generally should qualify as a DC REIT under the transition rule, and the non-U.S. investor (that does not qualify for a special exemption as a QFPF, a QCE or pursuant to Section 892) should generally be exempt from U.S. tax pursuant to FIRPTA. 

Conclusion

In sum, the Final Regulations primarily affect non-U.S. persons (that do not qualify for a special exemption as a QFPF, a QCE or pursuant to Section 892) that own stock in a REIT that would be a USRPI if the REIT does not qualify as a DC REIT on applying the look-through rule in the Final Regulations (and taking into account the transition rule). As a result, non-U.S. investors in such a REIT are generally expected to be subject to tax pursuant to FIRPTA upon a sale or disposition of their interest in the REIT (assuming that the non-U.S. investors do not qualify for a special exemption as a QFPF, a QCE or pursuant to Section 892).

Further, as compared to the Proposed Regulations, the Final Regulations generally (i) implement a narrower “look-through rule”, which treats an FODC as a flow-through entity for purposes of determining if a REIT owned in part by an FODC qualifies as a DC REIT, and (ii) apply only prospectively (subject to the transition rule for existing REITs that continue to meet the asset requirement and ownership requirement), unlike the Proposed Regulations which could have been applied retroactively.

Vasudha Anil Kumar is a Counsel in Linklaters LLP’s U.S. Tax Group and Max Levine is a Partner and the Head of Linklaters LLP’s U.S. Tax Group. The authors owe a debt of gratitude to their colleague, Gabriel Grossman, who provided comments to this article.

¹ T.D. 9992 published in the U.S. Federal Register on April 25, 2024.

² REG-100442-22 issued on December 29, 2022.

³ Section 897(a).

⁴ Section 897(c)(2).

⁵ Section 897(h)(2); Treas. Reg. Sec. 1.897-1(c)(2)(i).

⁶Section 897(h)(1). However, a special exemption may be available to “qualified foreign pension funds” and certain “qualified controlled entities”.

⁷ Section 897(h)(4).

⁸ Treas. Reg. Sec. 1.897-1(c)(2)(i).

⁹Treas. Reg. Sec. 1.857-8(b).

¹⁰ PLR 200923001 (June 5, 2009).

¹¹Prop. Reg. Sec. 1.897-1(c)(3)(iii)(B).

¹² Prop. Reg. Sec. 1.897-1(c)(3)(v)(B). The authors note that other areas of the Code, such as the pension-held REIT rules under Section 856(h)(3)(D), analyze the ownership of a single investor to determine if a similar 25 percent ownership threshold is met.

¹³ The Preamble also notes that Treas. Reg. Sec. 1.897-1(c)(2)(i) does not provide any guidance on the meaning of “held directly or indirectly by foreign persons”.

¹⁴ Prop. Treas. Reg. Secs. 1.897-1(c)(3)(iv)(A) and 1.897-1(c)(3)(vi)(A), Example 1(4).

¹⁵ See Section 897(l). Neither a QFPF nor a QCE is treated as a “foreign person” for U.S. withholding tax purposes with respect to FIRPTA, and both a QFPF and a QCE can provide a non-foreign affidavit to the relevant withholding agent to claim an exemption from FIRPTA (Section 1445(f)(3); Treas. Reg. Secs. 1.1445-2(b)(2)(i), 1.1445-5(b)(3)(ii)(A)).

¹⁶ See A. Velarde, “ABA Section of Taxation Meeting: IRS Weighing Relief From REIT Domestic Control Rules”, Tax Notes (May 8, 2023).

¹⁷ Treas. Reg. Sec. 1.897-1(c)(3)(v)(B). Although the Final Regulations replace the term “foreign-owned domestic corporation” with “foreign-controlled domestic corporation”, the authors have retained the defined term “FODC” for simplicity. Further, the authors note that the “more than 50 percent” threshold is similar to the threshold used for purposes of determining whether a non-U.S. corporation is a “controlled foreign corporation” under Section 957(a) and for purposes of determining whether a REIT is a “pension-held REIT” under Section 856(h)(3)(D).

¹⁸ For instance, a shareholder owning 50 percent or more in value of a corporation’s stock, directly or indirectly, is considered to constructively own the stock actually owned by such corporation, in proportion to the shareholder’s percentage stock ownership (Section 318(a)(2)(C)). 

¹⁹ See Sections 897(k), 897(c)(4), (5) and (6), which reference the constructive ownership rules under Section 318.

²⁰ See Section 897(h)(4)(B).

²¹ See STAFF OF THE JOINT COMM. ON TAX’N, General Explanation of Tax Legislation Enacted in 2015 (JCS-1-16) 279 (2016).

²²Treas. Reg. Sec. 1.897-1(c)(3)(iv).

²³ The Preamble also notes that Congress expressed an intent to provide a tax benefit specifically for QFPFs and QCEs by enacting Section 897(l), and not for other owners of a DC QIE that would benefit from the QFPF’s or QCE’s exemption from FIRPTA.

²⁴ Effectively, the Final Regulations introduce a ten-year transition rule, which is more generous than a five-year transition period that was proposed by at least one commentator, which is consistent with the five-year look-back period for testing a REIT’s status as a DC REIT (See “Firm Targets Look-Through Rule in Regs on Foreign Government”, Tax Notes (February 27, 2023)).

²⁵ Treas. Reg. Sec. 1.897-1(c)(3)(vi)(A)(2).

²⁶ USRPI does not include an interest held solely as a creditor, such as an interest in a mortgage loan (Treas. Reg. Sec. 1.897-1(c)(1)). However, an interest is not held “solely as a creditor” if it includes a right to share in the value appreciation of, or in the gross or net proceeds, or profits generated by the real property (Treas. Reg. Sec. 1.897-1(d)(2)).

²⁷ Treas. Reg. Sec. 1.897-1(c)(3)(vi)(A)(3). The authors note that the ownership requirement is somewhat analogous to the rules for determining whether an ownership change under Section 382 takes place, where an ownership change is generally defined as a greater than 50 percent change in the ownership of stock among certain 5 percent shareholders over a three-year testing period (See Section 382(g)).

²⁸ Treas. Reg. Sec. 1.897-1(c)(3)(vi)(C).

²⁹ Treas. Reg. Sec. 1.897-1(c)(3)(vii)(E), Example 5(1).

³⁰ Treas. Reg. Sec. 1.897-1(c)(3)(vii)(E), Example 5(2).

³¹ Treas. Reg. Sec. 1.897-1(c)(3)(vii)(E), Example 5(3).

³² Treas. Reg. Sec. 1.897-1(a)(2).

³³ See V. Anil Kumar and M. Levine, “Proposed Regulations on Domestically Controlled REITs Introduce Seismic Changes”, Practical Tax Strategies, pg. 7 (June 2023).

³⁴ Id. at pg. 8.

³⁵ QFPFs and QCEs are expected to be exempt from any gain on the sale or disposition of their interest in a REIT and on any capital gain dividends from a REIT, regardless of the REIT’s qualification as a DC REIT (Section 897(l)(1); Treas. Reg. Sec. 1.897(l)-1(b)(1)).