The real estate investment trust (REIT) reform enacted as part of December’s sweeping $680 billion tax deal offers new investment and tax opportunities to REITs but also tightens many REIT rules.
The REIT legislation represents significant reform and includes most of the major revenue-raising and tax-cut provisions that Congress proposed for REITs over the past several years. Lawmakers sought to curb recent expansions in the use of preferential REIT treatment with provisions that end tax-free REIT spinoffs into or from non-REIT entities and reduce the amount of non-REIT assets allowed in a taxable REIT subsidiary (TRS). But the bill also makes many favorable changes, particularly expanded opportunities for foreign investments. On balance, the 16 provisions are estimated to cut taxes by $1 billion.
REITs need to not only understand how to comply with the rules, but also consider how the changes affect investment decisions and expand potential sources of capital. The Protecting Americans from Tax Hikes Act of 2015 (PATH Act) was signed into law on Dec. 18, and the individual provisions take effect on varying dates.
The legislation bars a C corporation from spinning off a REIT tax-free under Section 355 unless the distributing corporation is also a REIT. Neither a distributing nor a controlled corporation is permitted to elect treatment as a REIT for 10 years following a tax-free spinoff transaction. A REIT can still spin off a TRS tax-free under the legislation if the spinoff meets certain requirements. The new rules are effective for any transaction on or after Dec. 7, 2015, unless the transaction is pursuant to a private letter ruling requested before this date and the request hasn’t been withdrawn, issued or denied in its entirety as of such date.
The legislation makes a significant change to reduce the amount of non-REIT activity a REIT can conduct through a TRS. Like the provision limiting tax-free spinoffs involving non-REIT companies, this provision appears aimed at protecting the historical intent of REIT provisions by limiting the increasing use of TRS entities to perform activities that the REIT itself isn’t allowed to perform. The bill lowers the value of gross assets a REIT can own in securities of one or more TRS entities from 25% of all assets to 20% for tax years beginning after 2017.
The legislation makes several new exceptions to the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA). FIRPTA generally provides that gain from selling U.S. real property interest is subject to 10% withholding.
The bill makes the following beneficial changes:
Allows foreign shareholders to hold up to 10% of a publicly traded REIT (up from 5%) before triggering FIRPTA withholding on the sale of the REIT stock or upon the receipt of capital gain dividends
Relaxes the rules for determining when a REIT is domestically controlled and stock sales are exempt from FIRPTA by creating a presumption that anyone who holds less than 5% of the stock is a U.S. person unless the taxpayer has actual knowledge regarding the stock ownership
Exempts REIT stock held by a qualifying foreign pension fund for FIRPTA
All three changes are effective on the date of enactment, but the benefits come with a price. The bill increases the general withholding rate from 10% to 15% effective for disposition 60 days after the date of enactment.
Taxpayers should also note that prior law subjected foreign pension funds to U.S. federal income tax on the disposition of U.S. real property interest under FIRPTA while U.S. pension funds were generally exempt. The PATH Act exempts qualified foreign pension funds from the FIRPTA withholding tax on sales of U.S. real property interests held directly or indirectly, including capital gain distributions of a REIT. This change is effective for dispositions and distributions after the enactment date.
Dealer sale safe harbors
The legislation has expanded the safe harbor for prohibited transactions, or “dealer sales.” A prohibited transaction tax is imposed on REITs upon the sale of what the IRS could deem “dealer property.” For tax years beginning after July 30, 2008, a REIT must meet one of the three alternative safe harbor limitations on sales of property (other than foreclosure property or involuntarily converted property) to avoid the prohibited transaction tax.
The PATH Act amends the second and third alternatives to increase the allowable aggregate tax basis of property sold not to exceed 20%, up from 10%, of the aggregate bases of all the REIT’s properties as of the beginning of the year. Under the new provisions, a REIT must ensure the aggregate sales do not exceed 10% of the REIT’s aggregate tax basis or aggregate fair market value over a three-year period. REITs can still substitute aggregate fair market value for tax basis when performing the test. The change applies to tax years beginning after the date of enactment.
The PATH Act also makes several other modifications to the prohibited transactions tax. It clarifies a TRS’ ability to provide development and marketing expenditures similar to those of an independent contractor. It also reinforces the importance of the arm’s-length standard by making certain non-arm’s-length service income between a TRS and a REIT subject to the prohibited transaction tax. Finally, it modifies the rules on foreclosure property.
Publicly traded REIT dividends
The legislation makes the following two important changes to dividend rules for publicly traded REITs.
Income and asset tests
It repeals the rule denying a deduction for preferential dividends for tax years beginning in 2015 or later. The act provides alternative remedies to a REIT that pays preferential dividends. The remedy will be available to a REIT if the IRS determines that the failure is inadvertent or due to reasonable cause and not due to willful neglect. This will allow REITs to correct inadvertent preferential dividends without affecting their REIT status.
It limits the aggregate amount of dividends that a REIT can designate as qualified dividends or capital gains dividends to the amount of dividends actually paid out by the REIT. This provision is effective for distributions in tax years beginning after 2014.
REITs implicitly accept strict limitations on their activities and composition for their special consideration under the tax code. But the real estate industry has obtained technical changes providing more leeway under the income tests, which require 95% of income to come from sources like rents, dividends and interest, and 75% to come from real estate-related sources. REITs have also gained more flexibility under the quarterly asset test, which requires at least 75% of total assets to be represented by real estate assets, cash, cash items (including receivables) and government securities.
Significant new changes effective for tax years beginning in 2016 or later include the following:
Modification of REIT earnings and profits rules
Expanding the 75% asset test to include debt instruments of publicly trade REITs, as well as interests in mortgages on real property, though the instrument cannot represent more than 25% of the REIT’s total assets. Income from debt instruments issued by publicly offered REITs is treated as qualified income for purposes of the 95% test, but not the 75% test (unless they are already treated as qualified income under current law).
Allowing certain ancillary personal property leased with real estate to be treated as real estate for the 75% asset test to the extent that rents that can be attributed to such personal property is included as qualifying income under the 75% income test.
Expanding the exception of hedging income from the 95% and 75% income tests.
Current law states that current (but not accumulated) REIT earnings and profits (E&P) for any tax year are reduced only by amounts that are allowable in computing taxable income for the current tax year. The PATH Act changes this rule to provide that current REIT E&P can be reduced only by amounts allowable in computing taxable income during the current year and prior years. This provision applies solely for determination of the tax treatment of a REIT distribution to its shareholders (i.e., whether such distribution is taxed as a dividend, return of capital or capital gain if a distribution exceeds a shareholder’s stock basis).
Effectively, this rule causes E&P to be calculated similarly to REIT taxable income and, as a result, attempts to prevent mismatches between the two that can result in a number of adverse tax consequences for REITs and their shareholders. Accordingly, the modifications included in the law provide long-awaited consistency to REIT E&P calculations.
The PATH Act also makes a conforming change to a similar rule that increases a REIT’s E&P solely for purposes of the dividends paid deduction by the total amount of gain recognized on the sale of property.
RIC and REIT international rules
The PATH Act includes several changes that apply to both REITs and regulated investment companies (RICs). These will generally make certain RIC and REIT dividends ineligible for the dividends-received deduction and make certain RIC and REIT interests ineligible for the so-called FIRPTA “cleansing rule” under Section 897(c)(1)(B).
Many of the changes are already effective for the 2016 tax year, and REITs must ensure they comply with these rules immediately. REITs have until 2018 to make sure that TRS assets no longer represent more than 20% of all assets, but REITs should begin immediately considering how the potential for more foreign capital and new flexibility in other areas can help rebalance activities and investments.
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