Final Regulations on Domestically Controlled REITs: Key Impacts and Transition Period

On April 24, 2024, the Treasury Department and the IRS released final regulations (T.D. 9992) related to domestically controlled REITs. These regulations may impact structures that real estate funds and REITs use to shield foreign investors from U.S. tax exposure.  

Although the final regulations implemented some taxpayer-friendly rules compared to the previously released proposed regulations on December 29, 2022, real estate fund sponsors need to stay vigilant to ensure current structures remain compliant during the “transition” period, and proper thought should be given to any new structures. Below is a summary of the background and the impact the final regulations may have on taxpayers.   

Background on IRC Sec. 897 and USRPIs 

IRC Sec. 897 notes that foreign investors must generally treat gains from the sale of a U.S. real property interest (USRPI), i.e., U.S. real property, as effectively connected with a U.S. trade or business.  

The definition of a USRPI also includes equity interests in a U.S. real property holding corporation (USRPHC), which is generally a corporation with more than 50% of its assets represented by USRPIs. Disposing of USRPIs typically triggers potential tax exposure for foreign investors and withholding requirements for the seller under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA).   

An important exception to the treatment of a disposition of an equity interest being subject to FIRPTA withholding is the sale of stock shares of a “domestically controlled” REIT (DCR).    

DCRs – Prior to Final Regulations 

A REIT is domestically controlled if less than 50% of its stock is directly or indirectly owned by foreign “persons” continuously during the five-year period ending on the day of sale or during which the REIT existed, if shorter. While the sale of REIT stock would seem to fall under IRC Sec. 897 -- thereby imposing a tax on foreign persons -- there is a key exception to this rule with the sale of stock shares of DCRs. A foreign person disposing of DCR shares generally would not be subject to U.S. tax.   

As previously stated, the definition of a DCR looks for “direct or indirect” foreign person ownership. Still, there has been ambiguity concerning when it is necessary to “look through” the direct owners to the ultimate indirect owners for purposes of this test.  

Due to the absence of clear guidance on this issue, many have relied upon Private Letter Ruling 200923001, which refers to Treas. Reg. 1.857-8, which states that the actual owner of the REIT is the person who is required to include in gross income the dividend received.  As such, a foreign-owned C corporation that includes a REIT’s dividend on its U.S. corporate tax return will count as a non-foreign person for purposes of DCR rules despite their indirect foreign ownership in the REIT. 

DCRs - Under the Final Regulations 

The final regulations apply a “look-through” approach in determining whether a REIT is a DCR until you reach a “non-look-through person.” Examples of non-look-through persons are:   

• Individuals 
• Domestic C corporations (other than foreign-owned domestic corporations) 
• Foreign corporations (including foreign governments) 
• Publicly traded REITs 

Additionally, under the proposed regulations, a publicly traded C corporation was treated as a U.S. person. However, the final regulations highlight that if a REIT has actual knowledge that the public C corporation is foreign-controlled, then for purposes of this test, the C corporation is not considered a U.S. person. 

The final regulations apply a “limited” look-through approach for foreign-owned C corporations. A foreign-owned domestic corporation is defined as a U.S. corporation that is (i) not publicly traded and (ii) whose stock is owned directly or indirectly 50% or more by foreign persons.  The 50% threshold reflects an increase from the 25% previously stated in the proposed regulations issued on December 29, 2022.  

Another item in the proposed regulations that raised some concern was the applicability of the proposed rules. A common concern raised by tax professionals and taxpayers was if approved, retroactively applying these rules would pose heavy compliance and cost burdens on existing structures. After reviewing many comments, the Treasury Department and the IRS introduced a 10-year transition period for existing structures. 

Transition Period 

Adopting the transition rule in the final regulations helped alleviate major compliance concerns. The transition period exempts existing structures (in existence on April 24, 2024) from the final domestic corporation look-through rules for ten years, provided they meet certain requirements.

For existing structures to be “protected” by the 10-year transition period, they must not acquire a significant amount of new USRPIs and/or undergo a significant change in ownership. If either of these two thresholds is exceeded, the REIT at that time becomes subject to the look-through rules under the final regulations.   

What is considered a significant amount of new USRPIs? 

A REIT is considered to have acquired a significant amount of new USRPIs if the total fair market value of the USRPIs it acquires, directly and indirectly, exceeds 20% of the fair market value of the USRPIs held directly and indirectly as of April 24, 2024. 

What is considered a significant change in ownership? 

The final regulations look to whether the direct or indirect ownership of the REIT by non-look-through persons (determined by applying the final domestic corporation look-through rule) has increased by more than 50% in the aggregate relative to the REIT stock owned by such non-look-through persons on April 24, 2024. Furthermore, to simplify the change of ownership rules for public REITs, the final regulations disregard transfers by any person that owns less than 5% interest in the REIT unless the REIT has actual knowledge of the person’s ownership. 

The ultimate goal is for all REITs to comply with the same rules, and the 10-year transition period is meant to give existing structures enough time to eventually comply with the final regulations.   

Key Takeaways 

While the threshold increase from 25% to 50% is beneficial, significant hurdles for foreign investors may still exist. A common technique to shield foreign investors from taxes imposed by IRC Sec. 897 was using a blocker corporation owned by foreign investors who typically hold more than a 50% stake in the corporation. Therefore, these changes could potentially impact many real estate funds and REITs that were utilizing such structures.  

Foreign investors and real estate fund sponsors should review their new structures to determine whether they satisfy the final regulation guidelines. For preexisting structures, be mindful of not triggering any significant ownership changes and/or significant purchases of USRPIs that would force the REIT to comply with the current final regulations.  

Speak with an EisnerAmper professional today to learn how to best navigate the complexities and obstacles associated with the final DCR regulations.