Significant Tax Changes for REITs under Protecting Americans from Tax Hikes Act of 2015 (the “PATH Act”)
On December 18, 2015, President Obama signed into law the Protecting Americans from Tax Hikes Act of 2015 (the “PATH Act” or the “Act”) as a part of the budget bill. In general, the PATH Act extends or makes permanent a number of temporary tax provisions that had expired or were set to expire. Several provisions are specific to real estate investment trusts ("REITs"), including the following:
- The Act significantly restricts the ability of companies that are not already REITs to spin off REIT subsidiaries on a tax-free basis,
- The Act expands the opportunities for certain foreign investors to invest in U.S. real estate without paying FIRPTA (Foreign Investors in Real Property Tax Act) taxes, and
- The Act modifies a number of the REIT and FIRPTA rules.
The following discussion describes the new REIT spinoff provisions, expanded opportunities for foreigners to invest in U.S. real estate without incurring FIRPTA tax, and certain other REIT and FIRPTA provisions under the Act.
Restriction on Tax-Free Spinoffs Involving REITs
- Under prior law, corporations were able to spin off REITs or corporations that elect REIT status after a spinoff. This was a popular strategy for separating an operating company’s real estate assets into a REIT that would lease the assets back to the operating company, or otherwise held qualifying REIT assets.
- The Act 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 addition, neither a distributing nor a controlled corporation would be permitted to elect to be treated as a REIT for ten years following a tax-free spin-off transaction.
- The provision applies to distributions on or after December 7, 2015, but shall not apply to any distribution pursuant to a transaction described in a ruling request initially submitted to the IRS on or before such date, which request has not been withdrawn and with respect to which a ruling has not been issued or denied in its entirety as of such date.
Reduction in Percentage Limitation on Assets of REIT Consisting of Taxable REIT Subsidiaries (“TRSs”)
- The provision modifies the rules with respect to a REIT’s ownership of a taxable REIT subsidiary (“TRS”), which is taxed as a corporation.
- Under the Act, the securities of one or more TRSs held by a REIT may not represent more than 20 percent (rather than 25 percent under current law) of the value of the REIT’s assets.
- The provision is effective for tax years beginning after December 31, 2017.
Prohibited Transaction Safe Harbors to Avoid Dealer Status
- A REIT is subject to a prohibited transaction tax of 100% on the net income derived from prohibited transactions. A prohibited transaction includes a sale or other disposition of property by a REIT that is stock in trade, would b e included in inventory, or is property held for sale to customers in the ordinary course of a trade or business. Safe harbors under current law require an asset holding period of at least two years and certain other requirements and permit a REIT to avoid the 100% prohibited transaction tax so long as during the taxable year, the REIT (i) made no more than seven sales (other than sales of foreclosure property or involuntary conversions) or (ii) sold no more than 10% of its assets at the beginning of the taxable year, computed based on either their aggregate basis or aggregate fair market value, and without regard to sales of foreclosure property or involuntary conversions
- The Act provides for an alternative three-year averaging safe harbor whereby the REIT may sell up to 20% of its assets rather than 10% during a taxable year, but only if the aggregate property sales (other than sales of foreclosure property or involuntary conversions) sold in the three taxable year period does not exceed 10% of the aggregate assets of the REIT as of the beginning of the same thee taxable years that are part of the same period (computed based on either their aggregate bases or their aggregate fair market values).
- In addition, the provision clarifies that the safe harbor is applied independent of whether the real estate asset is inventory property.
- The provision generally is effective for tax years beginning after the date of enactment. However, the clarification of the safe harbor takes effect as if included in the Housing Assistance Tax Act of 2008.
Repeal of Preferential Dividend Rule for Publicly Offered REITs
- Under prior law, if a REIT paid a non-pro rata dividend to shareholders of a particular class, the dividend was treated as a preferential dividend and the REIT was not entitled to a dividends paid deduction (which could require the REIT to pay corporate tax, possibly excise taxes with respect to the dividend, and possibly threaten the REIT’s status as a REIT).
- The Act repeals the preferential dividend rule for distributions by publicly offered REITs in taxable years beginning after December 31, 2015, and authorizes the IRS to grant an appropriate remedy to cure a preferential dividend distribution in taxable years beginning after December 31, 2015, discussed further below.
Authority for Alternative Remedies to Address Certain REIT Distribution Failures
- The Act provides the IRS with authority to provide an appropriate remedy for a preferential dividend distribution by non-publicly offered REITs in lieu of treating the dividend as not qualifying for the REIT dividend deduction and not counting toward satisfying the requirement that REITs distribute 90 percent of their income every year. 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 December 31, 2015.
Limitations on Designation of Dividends by REITs
- REITs may designate certain dividends that they pay as “capital gains dividends” that are treated as long-term capital gain, or as “qualified dividend income” that is subject to reduced rates in the hands of non-corporate shareholders. In certain circumstances, RICs may designate dividends as capital gains dividends or qualified dividend income even if those amounts exceed the total amount of the RIC’s dividend distributions, and under prior law it was unclear whether REITs were entitled to do the same.
- The Act provides that, in contrast to RICs, the aggregate amount of dividends that may be designated by a REIT as “capital gains dividends” or “qualified dividends income” may not exceed the dividends actually paid by the REIT.
- The provision is effective for distributions in tax years beginning after December 31, 2014.
Debt Instruments of Publicly Offered REITs and Mortgages Treated as Real Estate Assets
- At least 75% of the value of a REIT’s assets must be real estate assets, cash and cash items, and government securities (the “75% asset test”). At least 75% of a REIT’s gross income must be from rents from real property plus certain other items (the “75% income test”). At least 95% of a REIT’s gross income generally must be from income that qualifies under the 75% income test, plus interest, dividends, and gain from the sale or other disposition of securities (the “95% income test”).
- Under the Act, all debt instruments issued by publicly offered REITs, and mortgages on interests in real property, are treated in whole as good “real estate assets” for purposes of the 75% asset test. However, income from publicly offered REIT debt instruments that would not qualify as real estate assets but for the new provision (“nonqualified publicly-offered REIT debt instruments”) is not qualified income under the 75% income test. In addition, not more than 25% of the value of a REIT’s assets is permitted to consist of these nonqualified publicly-offered REIT debt instruments.
- The provision is effective for tax years beginning after December 31, 2015.
Asset and Income Test Clarification Regarding Ancillary Personal Property
- The Act treats certain ancillary personal property that is leased with real property as real property for purposes of the 75% asset test, provided the rent attributable to the personal property for a taxable year does not exceed 15% of the total rent attributable to both real and personal property under the lease.
- In addition, an obligation secured by a mortgage on both real property and personal property is treated in its entirety as real property for purposes of the 75% income and asset tests so long as the fair market value of the personal property secured by the mortgage does not exceed 15% of the total fair market value of the combined real and personal property.
- This provision applies for tax years beginning after December 31, 2015.
REIT Hedging Provisions
- Under the Act, income from certain REIT hedging transactions that are clearly identified is not included as gross income under either the 95% income test or the 75% income test.
- Hedges of previously acquired hedges that (i) qualify under the hedging exceptions from prior law and that (ii) a REIT entered to manage risk associated with liabilities or property underlying the previously acquired hedges and that have been extinguished or disposed of are treated as good REIT hedges.
- This provision applies for tax years beginning after December 31, 2015.
Modification of REIT Earnings and Profits Calculation to Avoid Duplicate Taxation
- The Act provides that current (but not accumulated) REIT earnings and profits 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).
- The provision is effective for tax years beginning after 2015.
Treatment of Certain Services Provided by Taxable REIT Subsidiaries
- The Act provides that a taxable REIT subsidiary (TRS) is permitted 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 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.
- The provision is effective for tax years beginning after December 31, 2015.
Exception from FIRPTA for Certain Stock of REITs
- The Act increases from 5 percent to 10 percent the maximum stock ownership a shareholder may have held in a publicly traded corporation to avoid having that stock treated as a U.S. real property interest on disposition.
- In addition, the provision allows certain publicly traded entities to own and dispose of any amount of stock treated as a U.S. real property interest, including stock in a REIT, without triggering FIRPTA withholding. However, an investor in such an entity that holds more than 10 percent of such stock is still subject to withholding.
- The provision applies to dispositions and distributions on or after the date of enactment.
Exception for Interests Held by Foreign Retirement or Pension Funds
- The Act exempts any U.S. real property interest held by a foreign pension fund (“qualified foreign pension fund”) from FIRPTA withholding.
- The exemption is available for any trust, corporation, organization or other arrangement if: It is organized under the laws of a foreign country; It is established to provide retirement or pension benefits to participants or beneficiaries that are current or former employees of one or more employers; No single participant or beneficiary has a right to more than 5% of its assets or income; It is subject to government regulation and provides annual information reporting about beneficiaries to the tax authorities in the foreign country in which it is established or operates; and under the laws of the country in which it is established or operated, either: contributions to it that otherwise would be subject to tax under local law are “deductible or excluded from the gross income of such entity or taxed at a reduced rate,” or taxation of its investment income is deferred or taxed at a reduced rate.
- The provision applies to dispositions and distributions after the date of enactment (December 18, 2015).
Increase In FIRPTA Withholding Tax Rate From 10% to 15%
- The withholding tax rate on proceeds paid from the disposition of a U.S. real property interest and certain related distributions to a non-U.S. person has increased from 10% to 15% (other than for sales of personal residences for $1 million or less).
- Personal residences selling for $300,000 or less remain exempt from withholding, and those selling for more than $300,000 and not more than $1 million remain subject to withholding at the 10% rate.
- This provision is effective for dispositions after February 16, 2016 (i.e., 60 days after the date of enactment, December 18, 2015).
Dividends Derived From RICs and REITs Ineligible for Deduction for United States Source Portion of Dividends From Certain Foreign Corporations
- The provision provides that for purposes of determining whether dividends from a foreign corporation (attributable to dividends from an 80-percent owned domestic corporation) are eligible for a dividend received deduction, 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.
- The provision applies to dividends received from RIC and REITs on or after the date of enactment (December 18, 2015).
Repeal of the FIRPTA “Cleansing Rule” For RICs and REITs
- Under the “cleansing rule” of section 897(c)(1)(B) of the Code, a U.S. real property interest does not include an interest in a corporation if, on the date of the disposition of the interest, the corporation did not hold any United States real property interests, and the corporation was subject to tax on the disposition of any United States real property interests it held (or the United States real property interests ceased to be treated as such by reason of section 897(c)(1)(B)). Under current law, the cleansing rule permitted REITs and RICs to sell all of their real property and liquidate without subjecting their foreign shareholders to FIRPTA tax, even though the sale and liquidation did not give rise to a corporate-level tax or dividend withholding tax.
- Under the Act, the cleansing rule will apply to stock of a corporation (so that it is not treated as a U.S. real property interest subject to FIRPTA tax) only if neither the corporation nor any predecessor was a RIC or a REIT at any time during the shorter of (a) the period after June 18, 1980 (the date of enactment of FIRPTA) during which the taxpayer held the stock, or (b) the 5-year period ending on the date of the disposition of the stock.
- The provision applies to dispositions on or after December 18, 2015.
Clarification of the Definition of “Domestically Controlled REIT”
- Generally, if less than 50% of the value of a RIC or a REIT that is, or in certain cases would be, a U.S. real property holding company (collectively, “qualified investment entities” or QIEs) is directly or indirectly owned by foreign persons (i.e., the QIE is “domestically controlled’) during the shortest of (i) the period beginning after June 18, 1980 (the enactment of FIRPTA) and ending on the date of a disposition or distribution, (ii) the 5-year period ending on the date of the disposition or of the distribution, or (iii) the period during which the QIE was in existence, then the QIE stock is not treated as a United States real property interest and is not subject to FIRPTA tax. There had been significant uncertainty as to when a QIE was treated as “indirectly owned” by a foreign person for purposes of this rule.
- The Act provides that a publicly traded QIE can presume that a holder of less than 5% of a class of its stock regularly traded on an established securities market in the United States is a U.S. person unless the QIE has actual knowledge that the holder is not a U.S. person.
- The Act also provides that any stock in a QIE that is held by a domestically controlled QIE that (i) has issued a class of stock that is regularly traded on an established stock exchange, or (ii) is a RIC that issues redeemable securities is treated as held by a U.S. person. However, if the shareholder QIE is not domestically controlled, then the stock in the lower-tier QIE is treated as held by a foreign person.
- Finally, if stock in a lower-tier QIE is held by another QIE whose stock is not regularly traded on an established stock exchange and which is not a RIC that issues redeemable securities, then the shares held by the shareholder QIE are treated as held by a U.S. person only to the extent that the shareholder QIE’s stock is (or is treated as) held by a U.S. person.
- These provisions are effective as of December 18, 2015.
Built-In Gain Recognition Period Reduced To 5 Years
- The period during which a REIT that acquired an asset from a C corporation in a carryover basis transaction could be subject to a corporate tax upon a sale of the asset has been permanently reduced to 5 years.
- This provision tracks the change in the built-in gain recognition period for S corporations under the Act.
- The provision is effective for tax years beginning after 2014.
Further questions regarding the REIT tax changes under the PATH Act should be directed to Wells Hall of the Charlotte office or Mike Rafter of the Atlanta office of Nelson Mullins Riley & Scarborough.
The articles published in this newsletter are intended only to provide general information on the subjects covered. The contents should not be construed as legal advice or a legal opinion. Readers should consult with legal counsel to obtain specific legal advice based on particular situations.