Proposed Regulations Contain Surprise on REIT Domestic Control

On December 29, 2022, the Treasury Department and the Internal Revenue Service (IRS) published proposed regulations (Proposed Regulations) under Section 897 of the Internal Revenue Code (Code) that, if finalized in their current form, would affect the determination of whether a REIT or RIC is domestically controlled for purposes of the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA). 

Under FIRPTA, foreign investors generally are subject to tax in the United States on dispositions of US real property interests.  One exception is the disposition of stock of a domestically controlled REIT.  Many foreign investors invest in US real property through domestically controlled REITs.

A REIT is domestically controlled if less than 50% of the value of the REIT’s stock is held “directly or indirectly” by foreign persons.  Many practitioners and real estate investors have interpreted this statutory provision to require looking through domestic entities that are not subject to tax in the United States, but not to require looking through domestic C corporations, which are themselves subject to tax in the United States.  This interpretation was adopted by the IRS in a private letter ruling in 2009. Private letter rulings may only be relied on by the taxpayer to which they are issued.

The Proposed Regulations take a different approach.  The Proposed Regulations contain a new concept of “look-through persons” and “non-look-through persons” for purposes of determining domestic control.  As one would expect, REITs, regulated investment companies (i.e., mutual funds), non-publicly traded partnerships, and S corporations are all look-through persons under the Proposed Regulations.  Contrary to the 2009 private letter ruling, the Proposed Regulations surprisingly also treat a “foreign-owned domestic corporation” as a “look-through person,” which means a REIT would be required to take into account the foreign or domestic status of the shareholders of a foreign-owned domestic corporation to determine whether the REIT is domestically controlled.  A “foreign-owned domestic corporation” is a non-publicly traded domestic C corporation if foreign persons hold directly or indirectly through look-through persons 25 percent or more of the fair market value of the corporation’s stock.  According to the IRS, the purpose of this provision is to “prevent the use of intermediary domestic C corporations by foreign investors to create domestically controlled [REITs].” 

The Proposed Regulations represent a departure from a common structuring approach used by many funds and other real estate investors.  To determine the potential impact of the Proposed Regulations, a REIT would need to determine whether any of its owners would be foreign-owned domestic corporations, which may require requesting additional information from investors.  These provisions could also impact side letters with fund investors, both in terms of covenants from investors and covenants to investors.

In addition to the provisions regarding foreign-owned domestic corporations described above, the Proposed Regulations also clarify that qualified foreign pension funds (QFPFs) are treated as foreign for purposes of determining whether a REIT is domestically controlled. 

The Proposed Regulations applicable to domestic control, if finalized, would apply to dispositions of REIT stock occurring on or after the date the final regulations are published in the Federal Register.  The notice indicates, however, that the IRS may challenge positions contrary to the Proposed Regulations before the issuance of final regulations. Comments with respect to the proposed regulations are due by February 27, 2023.

The Proposed Regulations also provide that, for purposes of Section 892 of the Code relating to foreign governments, a controlled commercial entity does not include a QFPF or a corporation that is a US real property holding corporation solely by reason of its non-controlling interests in other corporations.  Taxpayers may rely on the Proposed Regulations under Section 892 of the Code until final regulations are issued.

Please contact any of the attorneys on this alert for more information about the Proposed Regulations.