Checkpoint Special Study: REIT reforms in the “Protecting Americans from Tax Hikes” Act
Checkpoint Special Study: REIT reforms in the “Protecting Americans from Tax Hikes” Act
December 18, 2015
On December 17, the House passed a bipartisan, bicameral agreement on tax extenders—i.e., the 50 or so temporary tax provisions that are routinely extended by Congress on a one- or two-year basis—and numerous other tax provisions in the “Protecting Americans from Tax Hikes (PATH) Act of 2015” (the Act). The agreement, which makes permanent many of the individual and business extenders and contains provisions on Real Estate Investment Trusts (REITs), IRS administration, the Tax Court, and miscellaneous other rules, is expected to be quickly passed by the Senate and signed into law by the President. This Special Study explains the REIT provisions in the Act.
For a Special Study on the individual provisions in the Act, see ¶ 50.
For a Special Study on the key business tax breaks in the Act, see ¶ 52.
For a Special Study on the depreciation and expensing provisions in the Act, see ¶ 53.
For a Special Study on the energy tax provisions in the Act, see ¶ 55.
For a Special Study on miscellaneous non-extender provisions in the Act, see ¶ 48.
For a Special Study on IRS administration and Tax Court provisions in the Act, see ¶ 28.
Background on REITs. A REIT is a tax-preferred entity that provides several important advantages to investors. A REIT is taxed as a conduit and generally isn’t subject to tax on income that it distributes to shareholders. This advantage allows small investors to pool funds so they can diversify, participate in large projects, and get expert investment counsel. A REIT is analogous to a regulated investment company (RIC; i.e., mutual fund) but is designed for holding real estate.
The legislative history underlying REITs indicates Congress’s intent to provide REITs with “substantially the same tax treatment… as present law provides for regulated investment companies.” The policy underlying the REIT income tests is to ensure that the REIT’s income is passive-type income and not income from the active conduct of a trade or business.
Corporations, trusts, and associations that meet certain requirements can elect to be treated as REITs. Once made, the election is valid until terminated or revoked.
To qualify as a REIT, an entity must satisfy a 2-part income test. An entity must derive at least 95% of its gross income from sources listed in Code Sec. 856(c)(2), and at least 75% must be from sources listed in Code Sec. 856(c)(3) (generally, certain real estate sources). Both of those provisions include as an eligible source “rents from real property.” Included in the term “rents from real property” is “rents from interests in real property” (i.e., the gross amount received for the use or right to use real property). (Code Sec. 856(d))
There is also an “assets test” for REIT qualification under which at least 75% of the value of the REIT’s total assets must be represented by real estate assets, government securities, and cash and cash items (including receivables). (Code Sec. 856(c)(4)(A)) The assets test also provides that a REIT may not hold securities of any one issuer reflecting more than 10%, by vote or value, of the outstanding securities (except for a taxable REIT subsidiary; see below). (Code Sec. 856(c)(4)(B)(iii))
A REIT is generally required to distribute at least 90% of its taxable income each year (excluding net capital gain) to maintain its status as a REIT (the distribution requirement), and it is entitled to a deduction for dividends paid. (Code Sec. 857(b)(2)(B)) REIT shareholders are taxed on their distributions similar to other corporate distributions, except that REIT dividends aren’t subject to the reduced rate on qualified dividend income, and corporate shareholders don’t qualify for the dividends received deduction.
A qualified REIT subsidiary (QRS) isn’t treated as a corporation separate from its parent REIT. Rather, all assets, liabilities, and items of income, deduction, and credit of the QRS are treated as belonging to the parent. (Code Sec. 856(i)(1)) A QRS must be 100% owned by a REIT.
On the other hand, a taxable REIT subsidiary (TRS) of a REIT is defined as a corporation that is not a REIT (a) in which the REIT directly or indirectly owns stock, and (b) that the REIT and the corporation jointly elect to treat as a TRS. (Code Sec. 856L) In general, a TRS can be used by a REIT to avoid receiving disqualifying income.
Restriction on tax-free spin-offs involving REITs
Under pre-Act law, a corporation is permitted to distribute (or spin off) to shareholders the stock of a controlled corporation on a tax-free basis if the transaction satisfies certain requirements. (Code Sec. 355) One such requirement is that both the distributing corporation and the controlled corporation must be engaged immediately after the distribution in the active conduct of a trade or business that has been conducted for at least five years. (Code Sec. 355(b))
In 2001, IRS, obsoleting a prior ruling, held that a REIT could satisfy the active trade or business requirement for tax-free spin-off transactions, even though gain on the sale of property that is stock in trade of a REIT, or property that is includible in inventory of a REIT, does not satisfy the REIT income tests. (Rev Rul 2001-29, 2001-26 IRB 1348)
In recent years, REIT spin-offs have become increasingly popular. In a typical transaction, a company spins off real estate and other qualifying assets to an existing or newly formed REIT (sometimes involving a simultaneous REIT election) then lease the properties back. These transactions provide several tax advantages including transfer of the income associated with these assets to a REIT (which has no entity-level income tax) and avoidance of capital gains tax that the company would incur if the assets were sold instead of spun off on a tax-free basis. In addition to the tax benefits described above, paying rent to an affiliated REIT potentially provides further tax advantages in that rent deductions may well exceed depreciation that the company was previously claiming on the spun-off assets.
New law. Generally effective for distributions on or after Dec. 7, 2015, the Act generally provides that a spin-off involving a REIT will qualify as tax-free only if, immediately after the distribution, both the distributing and controlled corporation are REITs. In other words, capital gains tax on any appreciation in the property cannot be avoided. In addition, neither a distributing nor a controlled corporation can elect to be treated as a REIT for ten years following a tax-free spin-off transaction. (Act Sec. 311)
Reduction in percentage limitation on assets of REIT which may be taxable REIT subsidiaries
As noted above, under the assets test, a REIT generally may not own more than 10% of the vote or value of a single entity. However, there is an exception for ownership of TRSs that are taxed as corporations, provided the securities of one or more TRSs do not represent more than 25% of the value of the REIT’s assets.
New law. The Act modifies the rules with respect to a REIT’s ownership of a TRS taxed as a corporation, effective for tax years beginning after Dec. 31, 2017, by providing that the securities of one or more TRSs held by a REIT may not represent more than 20% of the value of the REIT’s assets. (Act Sec. 312)
Prohibited transaction safe harbors
A REIT is subject to a 100% prohibited transactions tax (PTT) on the net income from certain prohibited transactions. The sale or other disposition of property (other than foreclosure property) held by a REIT primarily for sale to customers in the ordinary course of its trade or business is generally a “prohibited transaction” subject to the PTT. (Code Sec. 857(b)(6)(B)(iii))
However, under pre-Act law, “prohibited transactions” don’t include sales of property which are real estate assets and are property held primarily for sale to customers in the ordinary course of a trade or business if the following four requirements are met:
- 1. The property has been held for two or more years.
- 2. Total expenditures made by the REIT during the 2-year period preceding the date of sale which are includible in the property’s basis do not exceed 30% of the property’s net selling price.
- 3. Either (i) the REIT doesn’t make more than seven sales of property (other than foreclosure property or property that was involuntarily converted in a transaction to which Code Sec. 1033 applies) during the tax year (the 7-sale rule), or (ii) the aggregate adjusted basis, as determined for purposes of computing earnings and profit, of property (other than foreclosure property or property that was involuntarily converted in a transaction to which Code Sec. 1033 applies) sold during the year doesn’t exceed 10% of the aggregate bases (as so determined) of all the REIT’s assets as of the beginning of the tax year, or (iii) the fair market value of property (other than sales of foreclosure property or Code Sec. 1033 involuntary conversions) sold during the tax year does not exceed 10% of the fair market value of all of the assets of the REIT as of the beginning of the tax year.
- 4. If the property is land or improvements not acquired through foreclosure or lease termination, the REIT has held the property for at least two years for production of rental income. (Code Sec. 857(b)(6)(C))
New law. The Act adds an alternative condition that could be satisfied in (3), above. Effective for tax years beginning after the date of enactment, the new provision establishes an alternative 3-year averaging safe harbor for determining the percentage of assets that a REIT may sell annually. In addition, the provision clarifies that the safe harbor is applied independent of whether the real estate asset is inventory property. The clarification of the safe harbor takes effect as if included in the Housing Assistance Tax Act of 2008. (Act Sec. 313)
Repeal of preferential dividend rule for publicly offered REITs
As described above, a REIT is subject to an annual distribution requirement and is entitled to a deduction for dividends paid. A preferential dividend, however, does not qualify for a deduction (Code Sec. 562(c)) and does not count toward satisfying the 90% distribution requirement. A dividend is generally “preferential” unless it is distributed pro rata to all shareholders.
New law. The Act repeals the preferential dividend rule for publicly offered REITs, effective for distributions in tax years beginning after Dec. 31, 2014. (Act Sec. 314)
Authority for alternative remedies to address inadvertent, etc. REIT distribution failures
Reg. § 1.562-2(a) provides that where a preference exists (see above), the disallowance of the dividends paid deduction extends to the entire amount of the distribution and not merely to that part of the distribution as to which there is a preference. Put otherwise, current law doesn’t provide for a less harsh remedy when the preference was inadvertent or de minimis.
New law. The Act provides IRS with authority to provide an “appropriate” remedy for a preferential dividend distribution by non-publicly offered REITs in lieu of the existing remedy—i.e., treating the entire dividend as not qualifying for the REIT dividend deduction and not counting toward satisfying the 90% distribution requirement. Such authority applies if the preferential distribution is inadvertent or due to reasonable cause and not due to willful neglect. The provision applies to distributions in tax years beginning after Dec. 31, 2015. (Act Sec. 315)
Limitations on designation of dividends by REITs
Under pre-Act law, in addition to being allowed to deduct the dividends they actually pay (i.e., avoiding an entity-level tax), REITs could also pass through the character of capital gains and qualified dividend income that is taxed at capital gains rates to their shareholders.
New law. Effective for distributions in tax years beginning after Dec. 31, 2014, the Act limits the aggregate amount of dividends that can be designated by a REIT as qualified dividends or capital gain dividends to the dividends actually paid by the REIT. (Act Sec. 316)
Debt instruments of publicly offered REITs and mortgages treated as real estate assets
Under pre-Act law, for purposes of meeting the 75% income test, gross income from certain real estate sources includes rents from real property, interest on obligations secured by mortgages on real property or on interests in real property, and gain from the sale or other dispositions of real property (including interests in real property and interests in mortgages on real property) unless the gain is from property held primarily for sale to customers in the ordinary course of a trade or business.
New law. Effective for tax years beginning after Dec. 31, 2015, the Act amends the definition of “real estate assets” to include debt instruments issued by publicly offered REITs, as well as interests in mortgages on interests in real property, for purposes of the 75% asset test. Income from debt instruments issued by publicly offered REITs would be treated as qualified income for purposes of the 95% income test, but not the 75% income test (unless they already are treated as qualified income under current law). However, not more than 25% of the value of a REIT’s assets would be permitted to consist of such debt instruments. (Act Sec. 317)
Asset and income test clarification regarding ancillary personal property
Under pre-Act law, for purposes of meeting the asset test, 75% of the value of the REIT’s assets had to be real estate assets (such as real property, including interests in real property and mortgages on real property, and shares of other REITs), government securities, and cash. No more than 25% of the REIT assets may be securities other than such assets that qualify under the 75% asset test. And, under the 75% income test, 75% of its gross income had to be from certain real estate sources, including rents from real property and gain from the sale or other dispositions of real property. For this purpose, rents from interests in real property included rents from interests in real property, amounts received for services customarily furnished in connection with the rental of real property, whether or not separate charges are made for those services, and rents attributable to personal property which is leased in connection with a lease of real property provided the rent allocable to personal property doesn’t exceed 15% of the total rent.
New law. Effective for tax years beginning after Dec. 31, 2015, the Act treats certain ancillary personal property that is leased with real property as real property for purposes of the 75% asset test. In addition, an obligation secured by a mortgage on such property is treated as real property for purposes of the 75% income and asset tests, provided the fair market value (FMV) of the personal property does not exceed 15% of the total FMV of the combined real and personal property. (Act Sec. 318)
Under pre-Act law, income from certain REIT hedging transactions (i.e., to (i) hedge any indebtedness incurred or to be incurred to acquire or carry real estate assets, or (ii) manage risk of currency fluctuations relating to any item that qualifies under the 95% and 75% income tests) that is clearly identified as such generally is not included as gross income under either the 95% or 75% income tests. (Code Sec. 856(c)(5)(G)))
New law. Effective for tax years beginning after Dec. 31, 2015, the Act expands the treatment of REIT hedges to include a third category of excluded hedging income—i.e., income from hedges of previously acquired hedges that a REIT entered to manage risk associated with liabilities or property that have been extinguished or disposed. (Act Sec. 319)
Modification of REIT earnings and profits calculation to avoid duplicate taxation
Under pre-Act law, REIT shareholders who receive distributions are treated as having received a dividend to the extent of the REIT’s current and accumulated earnings and profits (E&P), with distributions in excess of E&P treated as a return of shareholders’ capital (reducing the shareholders’ basis on their REIT stock) and as capital gain to the extent they exceed stock basis. A REIT may deduct a distribution to shareholders from its taxable income and satisfy the 90% distribution requirement only to the extent of distributions that are made out of E&P. However, current E&P of a REIT are not reduced by any amount that does not reduce REIT taxable income. (Code Sec. 857(d)(1))
New law. Effective for tax years beginning after Dec. 31, 2015, the Act provides that current (but not accumulated) REIT E&P for any tax year are not reduced by any amount that is not allowable in computing taxable income for the tax year and was not allowable in computing its taxable income for any prior tax year (e.g., certain amounts resulting from differences in the applicable depreciation rules). The provision applies only for purposes of determining whether REIT shareholders are taxed as receiving a REIT dividend or as receiving a return of capital (or capital gain if a distribution exceeds a shareholder’s stock basis). (Act Sec. 320)
Treatment of certain services provided by TRSs & 100% excise tax on redetermined TRS service income
Under current law, certain income from foreclosed real property satisfies the 95% and 75% REIT income tests. (Code Sec. 856(e)) In addition, REITs are subject to a 100% PTT (see above) that prohibits REITs from being dealers in real property and limits the number of real property sales that a REIT may conduct.
A TRS generally may engage in any kind of business activity, except that it is not permitted to operate either a lodging or health care facility, although a TRS is permitted to rent certain lodging or health care facilities from its parent REIT and is permitted to hire an independent contractor to operate such facilities. A 100% excise tax applies to certain non-arm’s length transactions between a TRS and its parent REIT. (Code Sec. 857(b))
New law. Effective for tax years beginning after Dec. 31, 2015, the Act allows a TRS to provide certain services to the REIT, such as marketing, that typically are done by a third party. In addition, a TRS is permitted to develop and market REIT real property without subjecting the REIT to the 100% prohibited transactions tax (PTT). (Code Sec. 856(e)(4)(C)) The provision also expands the 100% excise tax on non-arm’s length transactions to include services provided by the TRS to its parent REIT. (Act Sec. 321(a))
Also effective for tax years beginning after Dec. 31, 2015, the Act expands the 100% excise tax on non-arm’s length transactions to apply to redetermined TRS services income, as defined in new Code Sec. 857(b)(7)(E). (Act Sec. 321(b))
Background on FIRPTA
Foreign investors are generally not subject to U.S. tax on U.S. source capital gain unless it is effectively connected with a U.S. trade or business or it is realized by an individual who meets certain presence requirements. Gain from the disposition of a U.S. real property interest (USRPI), however, is treated as income effectively connected with a U.S. trade or business under the Foreign Investment in Real Property Tax Act (FIRPTA) and is subject to tax and withholding under Code Sec. 897 and Code Sec. 1445. In recent years, FIRPTA has often been criticized as deterring foreign investment in U.S. real estate.
Stock or a beneficial interest (other than solely as a creditor) in a U.S. real property holding corporation (USRPHC) is a USRPI. The determination of whether a domestic corporation is a USRPHC is based on the percentage of USRPIs held by such corporation. A USRPHC is any domestic corporation if the FMV of its USRPIs equals or exceeds 50% of the FMV of the sum of its (i) USRPIs, (ii) interests in real property located outside of the U.S., and (iii) any other of its assets which are used or held for use in a trade or business. (Code Sec. 897(c)(2))
By the nature of its assets, a REIT would generally constitute a USRPHC unless it is “domestically controlled” within the meaning of Code Sec. 897(h)(2). As such, the sale or other disposition of the REIT shares could be subject to FIRPTA.
A number of exceptions to FIRPTA apply, as explained below.
Exception from FIRPTA for certain stock of REITs
Under pre-Act law, there was an exemption from FIRPTA for certain foreign shareholders of certain publicly-traded corporations who, during the applicable testing period, did not actually or constructively own more than 5% of that class of stock. (Code Sec. 897(c)(3) and Reg. § 1.897-1(c)(2)(iii) ) Furthermore, Code Sec. 897(h)(1) exempts from FIRPTA certain distributions that are made by a U.S. publicly-traded REIT to foreign taxpayers owning a 5% or less interest (the “small portfolio investor” exemption).
New law. Effective for dispositions and distributions on or after the date of enactment, the Act doubles, from 5% to 10%, the maximum stock ownership a shareholder may hold in a publicly traded corporation to avoid having that stock treated as USRPI on disposition. In addition, the Act allows certain publicly traded entities to own and dispose of any amount of stock in a REIT without the REIT stock being treated as a USRPI except to the extent an investor in the shareholder holds more than 10% of that class of REIT stock. (Act Sec. 322)
Exception for interests held by foreign retirement or pension funds
U.S. pension funds are generally exempt from U.S. tax. However, under pre-Act law, foreign pension funds were subject to FIRPTA.
New law. Effective for dispositions and distributions after the enactment date, the Act excludes from FIRPTA any USPRI held by a qualified foreign pension fund, or any entity, all of the interests of which are held by a qualified foreign pension fund. (Act Sec. 323)
Increase in rate of withholding of tax on dispositions of USRPIs
Under pre-Act law, U.S. tax must generally be withheld by at the rate of 10% on the amount realized when a foreign person disposes of a USRPI. (Code Sec. 1445(a)) However, withholding doesn’t apply in certain situations, including if the USRPI is acquired by the transferee as his residence, and the amount realized doesn’t exceed $300,000. (Code Sec. 1445(b)(5))
New law. Effective for dispositions occurring 60 days after the date of enactment, the Act provides that the rate of withholding on dispositions of USRPIs is increased from 10% to 15%. (Act Sec. 324(a)) The increased rate of withholding, however, does not apply to the sale of a personal residence where the amount realized is $1 million or less. In this situation, where Code Sec. 1445(b)(5) (above) does not apply, then a 10% rate of withholding applies. (Act Sec. 324(b))
Interests in RICs and REITs not excluded from definition of USRPIs
Under pre-Act law, the “cleansing rule” provided that an interest in a corporation is not a USRPI if, as of the date of disposition of such interest, such corporation did not hold any USRPIs and all of the USRPIs held by such corporation during the shorter of (i) the period of time after June 18, ’80, during which the taxpayer held such interest, or (ii) the 5-year period ending on the date of disposition of such interest, were either disposed of in transactions in which the full amount of the gain (if any) was recognized, or ceased to be USRPIs by reason of the application of this rule to one or more other corporations. (Code Sec. 897(c)(1)(B))
According to legislative history, the purpose of the cleansing rule was to “cleanse” the USRPHC treatment of stock of a domestic corporation if that corporation has recognized all the gain inherent in its USRPIs, and paid U.S. corporate tax on that gain.
New law. The Act provides, for dispositions on or after the date of enactment, that the cleansing rule applies only to interests in a corporation that is not a qualified investment entity. In addition, the Act provides that the cleansing rule applies to stock of a corporation only if neither the corporation nor any predecessor of such corporation was a regulated investment company (RIC) or REIT at any time during the shorter of (a) the period after June 18, ’80 during which the taxpayer held such stock, or (b) the 5-year period ending on the date of the disposition of the stock. (Act Sec. 325)
Dividends derived from RICs and REITs ineligible for deduction for U.S. source portion of dividends from certain foreign corporations
Under pre-Act law, a deduction is allowed for dividends received by a U.S. corporation from certain foreign corporations. (Code Sec. 245(a)) In general, the dividends-received deduction (DRD) is intended to provide relief to a corporation that receives dividends from another corporation whose income was subject to U.S. tax.
However, unlike other corporations, RICs and REITs deduct income that is distributed to shareholders without paying an entity-level tax on such distributed income. IRS has concluded in a CCA that dividends attributable to interest income of an 80% owned RIC are not entitled to be counted in determining the DRD under Code Sec. 245, and regs further state that REIT dividends are not eligible for Code Sec. 245.
New law. The Act provides, for dividends received from RICs and REITs on or after the enactment date, that for purposes of determining whether dividends from a foreign corporation (attributable to dividends from an 80% owned domestic corporation) are eligible for a DRD, dividends from RICs and REITs are not treated as dividends from domestic corporations, even if the RIC or REIT owns shares in a foreign corporation. (Act Sec. 326)