Overview
Introduction
The Protecting Americans from Tax Hikes Act of 2015, signed into law on December 18, in addition to making substantial changes to numerous expiring tax provisions, contains 16 provisions relating to tax rules for real estate investment trusts (REITs). According to estimates from the Joint Committee on Taxation (JCT), the package of REIT provisions will cost approximately $1 billion over the next 10 years.
The law largely retains the text of the REIT provisions in the December 8 bill (H.R. 34), with some changes. With respect to the REIT spinoff provisions, the law clarifies that the amendments do not apply to any distribution pursuant to a transaction described in a ruling request initially submitted to the IRS on or before December 7, 2015, if the request has not been withdrawn and if a ruling has not been issued or denied in its entirety as of such date. Additionally, three revenue raisers (sections 324 through 326) were added to the law. Two of the provisions relate to US real property interests (USRPIs). The first provision increases the rate of withholding of tax on dispositions of USRPIs from 10% to 15%, while the second provision states that the so-called “cleansing rule” does not apply to the stock of a corporation if the corporation or any predecessor of the corporation was a regulated investment company (RIC) or REIT at any time during the shorter of (a) the period after June 18, 1980 during which the taxpayer held such stock, or (b) the five-year period ending on the date of the disposition of the stock. The other provision states that for purposes of determining whether dividends from a foreign corporation are eligible for a dividends received deduction, dividends from RICs and REITs are not treated as dividends from domestic corporations. Although not included in H.R. 34, these provisions were included in the Senate’s version of the Real Estate Investment and Jobs Act of 2015 (S. 915), and two of them were included in former Chairman Camp’s Tax Reform Act of 2014.
The law also removed a provision in H.R. 34 which provided that rents from real property and interest do not include amounts that are based on a fixed percentage of receipts or sales, to the extent that such amounts are received or accrued from a single tenant that is a C corporation and the amounts received or accrued from such tenant constitute more than 25% of the total amount received or accrued by the REIT, based on a fixed percentage of receipts or sales.
The law makes numerous other changes to the tax treatment of REITs, and includes provisions that reduce the percentage of REIT assets that may be invested in taxable REIT subsidiaries (TRSs), repeal the preferential dividend rule for publicly offered REITs, treat debt instruments of publicly offered REITs as real estate assets, treat certain personal property that is ancillary to real property as real property for purposes of the asset test, and modify the calculation of REIT earnings and profits to avoid duplicate taxation. Many of these provisions appeared in former Chairman Camp’s Tax Reform Act of 2014.
The core of the package of REIT provisions is the trade-off of new restrictions on REIT spinoffs for loosening of the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) rules. The biggest revenue raiser in the law is the restriction on tax-free spinoffs involving REITs, which is estimated to generate $1.9 billion in revenue over the next 10 years. Meanwhile, the provisions resulting in the largest increased expenditures are the new exceptions from FIRPTA for certain REIT stock and for interests held by foreign retirement and pension funds, which together will cost approximately $4.2 billion over the next 10 years. Aaron Nocjar, a partner in Steptoe’s Washington office, commented, “The REIT rules and the FIRPTA rules have always been at odds with each other. The REIT rules generally were enacted to expand investment in US real estate assets. The FIRPTA rules then were enacted to restrict foreign investment in US real estate, in part as a protectionist reaction to the fear that US real estate (e.g., large swaths of farmland in states that had influential members of Congress) would become primarily foreign-owned over time. The FIRPTA-related amendments in sections 322 and 323 of the Act begin to chip away at such protectionist policy.”
The following is a more detailed analysis of each REIT provision in the law.
Section 311 - Restriction on Tax-Free Spinoffs Involving REITs
This provision bans the type of spinoff transaction recently completed by companies such as Darden Restaurants Inc. and Windstream Holdings Inc. The IRS recently provided in Rev. Proc. 2015-43 that it would ordinarily not rule on any issue regarding whether such transactions qualified for tax-free treatment under section 355 of the Code, and indicated that such transactions were under study in Notice 2015-59.
Specifically, this provision makes section 355 inapplicable to any distribution if either the distributing corporation or controlled corporation is a REIT. Exceptions exist for spinoffs of a REIT by another REIT and for spinoffs of certain TRSs if (1) the distributing corporation has been a REIT at all times during the three-year period ending on the date of the distribution; (2) the controlled corporation has been a TRS of the REIT at all times during such period; and (3) the REIT has had control (as defined in section 368(c) of the Code) of the TRS at all times during such period. The law clarifies that section 368(c) is applied by taking into account stock owned directly or indirectly, including through one or more corporations or partnerships, by the distributing corporation, and that control of a partnership means ownership of 80% of the profits interests and 80% of the capital interests. The law also adds language indicating that a controlled corporation will be treated as meeting the requirements of (2) and (3) if the stock of such corporation was distributed by a TRS in a transaction to which section 355 applies and the assets of such corporation consist solely of the stock or assets held by one or more TRSs of the distributing corporation meeting the requirements of (2) and (3).
Lisa Zarlenga, a partner in Steptoe’s Washington office, commented: “This provision will change the scope of the IRS and Treasury’s study in Notice 2015-59, but REIT spinoffs likely won’t be completely off the table. Because a REIT may still spin off of another REIT or a TRS under the new law, the small active trade or business concern described in the Notice is still relevant.”
Additionally, the law states that if a corporation is a distributing corporation or controlled corporation with respect to any distribution to which section 355 applies, the law generally provides that such corporation is ineligible to make a REIT election for any taxable year beginning before the end of the 10-year period beginning on the date of such distribution. Under Treas. Reg. § 1.337(d)-7(a), section 1374 of the Code applies to the conversion of a C corporation to a REIT (and to the transfer of property owned by a C corporation to a REIT). Section 1374 imposes tax on the net built-in gain of the property if the REIT disposes of the property in a taxable transaction within a “recognition period.” Section 127 of the law changes the recognition period from 10 years to five years. Consequently, even though the amendments permit a corporation to make a REIT election 10 years following a distribution to which section 355 applies, such corporation must wait an additional five years before it can dispose of property without incurring tax on the built-in gain.
These amendments apply to distributions made on or after December 7, 2015. The law adds a statement indicating that the amendments do not apply to any distribution pursuant to a transaction described in a ruling request initially submitted to the IRS on or before December 7, 2015, if the request has not been withdrawn and if a ruling has not been issued or denied in its entirety as of such date. This grandfather rule will allow the planned Caesars Entertainment Operating Co. reorganization and Hilton Worldwide Holdings Inc. spinoff to go forward.
Based on estimates from the JCT, the added restrictions on tax-free spinoffs involving REITs will generate $1.9 billion in revenue over the next 10 years. This is over $2 billion less than $4.3 billion the REIT spinoff provisions in H.R. 34 were estimated to generate, with the difference resulting from the added transitional rule and other changes described above. The restrictions in the law do not go as far as those in former Chairman Camp’s Tax Reform Act of 2014, which would have disallowed all REIT spinoffs, including spinoffs of a REIT by another REIT, and would have generated approximately $5.9 billion in revenue over 10 years.
Section 312 - Reduction in Percentage Limitation on Assets of REIT That May be Taxable REIT Subsidiaries
This provision amends section 856(c)(4)(B)(ii) of the Code, modifying the rules related to a REIT’s ownership of a TRS such that at the close of each quarter of the taxable year, not more than 20% (rather than 25% under current law) of the value of the REIT’s total assets may be represented by securities of one or more TRSs. These amendments are effective for taxable years beginning after December 31, 2017 and will generate $167 million over the next 10 years according to the JCT’s estimates. This provision is unchanged from H.R. 34.
Section 313 - Prohibited Transaction Safe Harbors
This provision amends section 856(b)(6) of the Code to provide an alternative safe harbor for determining the percentage of real estate assets that a REIT may sell annually without being subject to the prohibited transactions tax. Under the new safe harbor, a prohibited transaction will not include sales of real estate assets (other than sales of foreclosure property or sales to which section 1033 applies) if (1) the aggregate adjusted basis for the year does not exceed 20%, and the three-year average adjusted bases percentage for the taxable year does not exceed 10%; or (2) the fair market value for the year does not exceed 20%, and the three-year average fair market value does not exceed 10%. These additional safe harbors apply to taxable years beginning after December 7, 2015.
The provision also clarifies that the safe harbor is applied independent of whether the real estate asset is inventory property. This clarification takes effect as if included in the Housing Assistance Tax Act of 2008, but shall not apply to any sale of property to which section 857(b)(6)(G) of the Code applies.
The JCT’s estimates indicate that these amendments will generate $7 million of revenue over the next 10 years. This provision is unchanged from H.R. 34.
Section 314 - Repeal of Preferential Dividend Rule for Publicly Offered REITs
Under section 562(c) of the Code, a REIT is allowed a deduction for dividends paid to shareholders, unless the dividend is a “preferential dividend.” A dividend is “preferential” unless it is distributed pro rata to shareholders, with no preference to any share of stock compared with other shares of the same class, and with no preference to one class as compared with another, except to the extent the class is entitled to a preference. This provision repeals the preferential dividend rule for publicly offered REITs by amending section 562(c). A REIT is publicly offered if it is required to file annual and periodic reports with the Securities and Exchange Commission under the Securities Exchange Act of 1934. The provision, which would have a negligible revenue effect according to the JCT’s estimates, applies to distributions in taxable years beginning after December 31, 2014. It is unchanged from H.R. 34.
Section 315 - Authority for Alternative Remedies to Address Certain REIT Distribution Failures
This provision amends section 562(e) of the Code to provide that in the case of a failure of a distribution by a REIT to qualify for a deduction under section 562(c) of the Code, the IRS may provide an appropriate remedy to cure such failure in lieu of not considering the distribution to be a dividend for purposes of computing the dividends paid deduction, as long as the IRS determines that such failure is inadvertent or due to reasonable cause and not due to willful neglect.
These amendments, which are unchanged from H.R. 34, apply to distributions in taxable years beginning after December 31, 2015. According to the JCT’s estimates, this provision will cost approximately $4 million over a 10-year period.
Section 316 - Limitations on Designation of Dividends by REITs
This provision amends section 857 by adding a limitation that prevents the aggregate amount of dividends designated by a REIT as qualified dividends or capital gain dividends with respect to any taxable year from exceeding the dividends paid by the REIT with respect to such year. Capital gain dividends are treated by shareholders as gain from the sale or exchange of a capital asset held more than one year, while qualified dividends are taxed to individuals at the same tax rate as net capital gain. The IRS may prescribe regulations or other guidance requiring the proportionality of the designation of particular types of dividends among shares or beneficial interests of a REIT.
These amendments, which are unchanged from H.R. 34, apply to distributions in taxable years beginning after December 31, 2015. According to the JCT’s estimates, this provision will generate revenues of approximately $4 million over a 10-year period.
Section 317 - Debt Instruments of Publicly Offered REITs and Mortgages Treated as Real Estate Assets
Under section 856(c)(4)(A) of the Code, at least 75% of the value of a REIT’s assets must be real estate assets, cash and cash items (including receivables), and government securities (the “75% asset test”). This provision amends section 856(c)(5) of the Code by adding debt instruments issued by publicly offered REITs and interests in mortgages on interests in real property to the definition of real estate assets. The amendments apply to taxable years beginning after December 31, 2015 and will cost approximately $7 million, according to the JCT’s estimates. The provision is unchanged from H.R. 34.
Section 318 - Asset and Income Test Clarification Regarding Ancillary Personal Property
Under section 856(c)(3), at least 75% of the gross income of a REIT in each taxable year must consist of real estate-related income, including (i) rents from real property; (ii) gain from the sale or disposition of real property (including interests in real property) that is not stock in trade of the taxpayer, inventory, or other property held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business; (iii) interest on mortgages secured by real property or interests in real property; and (iv) certain foreclosure property (the “75% income test”).
This provision amends section 856(c) of the Code to allow certain ancillary personal property to be treated as a real estate asset to the extent that rents attributable to such personal property are treated as rents from real property under section 856(d)(1)(C) of the Code for purposes of the 75% income test. Additionally, the provision adds language stating that in the case of an obligation secured by a mortgage on both real property and personal property, if the fair market value of such personal property does not exceed 15% of the total fair market value of all such property, such obligation is treated as a real estate asset for purposes of the 75% asset test, and interest on the obligation is treated as income for purposes of the 75% income test.
These amendments, which are unchanged from H.R. 34, apply to taxable years beginning after December 31, 2015. According to the JCT’s estimates, the amendments will cost approximately $8 million over the next 10 years.
Section 319 - Hedging Provisions
In addition to the 75% income test, section 856(c)(2) of the Code requires that at least 95% of a REIT’s gross income must be from specified sources that include the 75% items, as well as interest, dividends, and gain from the sale or other disposition of securities (whether or not real estate related) (the “95% income test”). This provision amends section 856(c)(5)(G) of the Code to exclude income from certain hedges from gross income for purposes of the 95% or 75% income test.
Under the amendments, if:
- A REIT enters into one or more positions described in section 856(c)(5)(G)(i) with respect to indebtedness described therein or one or more positions described in section 856(c)(5)(G)(ii) with respect to property that generates income or gain described in section 856(c)(2) or (3);
- Any portion of such indebtedness is extinguished or any portion of such property is disposed of; and
- In connection with such extinguishment or disposition, such REIT enters into one or more transactions which would be hedging transactions described in section 1221(b)(2)(A)(ii) or (iii) with respect to any position described herein if such position were ordinary property;
then any income of such REIT from any position referred to in (1) and any income from any transaction referred to in (3) (including gain from the termination of any such position or transaction) shall not constitute gross income for purposes of the 95% or 75% income tests, to the extent that such transaction hedges such position.
These amendments are intended to extend the current hedging exception to positions that manage risk related to a prior hedge when the REIT extinguishes or disposes of the liability related to the prior hedge, to the extent the new position qualifies as a section 1221 hedge or would so qualify if the position were ordinary property.
This provision also clarifies that the income from the hedges described above and in section 856(c)(5)(G)(i)-(ii) shall not be excluded from gross income for purposes of the income tests unless the transactions satisfy the identification requirement described in section 1221(a)(7) of the Code.
These amendments apply to taxable years beginning after December 31, 2015, and will cost approximately $2 million over the next 10 years according to the JCT’s estimates. The provision is unchanged from H.R. 34.
Section 320 - Modification of REIT Earnings and Profits Calculation to Avoid Duplicate Taxation
This provision makes technical modifications to section 857(d) of the Code to state that current earnings and profits of a REIT shall not be reduced by any amount which (1) is not allowable in computing its taxable income for such taxable year (as is the case under current law), and (2) was not allowable in computing its taxable income for any prior taxable year (which is a change from current law). However, if an amount is allowed as a REIT taxable income deduction in year one and subsequent years, the amount can be deducted in calculating current earnings and profits, which will reduce the extent to which a shareholder's distribution will constitute a dividend. The disparate earnings and profits treatment addressed by this provision is generally related to accelerated or bonus depreciation, where the deductions for earnings and profits purposes are different than the amount allowed for taxable income purposes.
In addition, the provision amends section 562(e)(1) of the Code, providing that current earnings and profits of a REIT shall be increased by the amount of gain (if any) on the sale or exchange of real property, which is taken into account in determining the taxable income of such REIT for the taxable year (and not otherwise taken into account in determining such earnings and profits). Together, section 857(d) and section 562(e)(1) are meant to provide that a REIT has sufficient earnings and profits to support the REIT’s required dividend distributions without duplicating the earnings and profits taxed as a dividend to shareholders.
These amendments, which are unchanged from H.R. 34, apply to taxable years beginning after December 31, 2015, and will cost approximately $4 million over the next 10 years according to the estimates from the JCT.
Section 321- Treatment of Certain Services Provided by Taxable REIT Subsidiaries
This provision modifies the language of sections 857(b)(6)(C) and 857(b)(6)(D) of the Code to allow a TRS to make marketing expenditures (and development expenditures in the case of section 857(b)(6)(C)) with respect to real estate assets without causing the sale of such property to be subject to the prohibited transactions tax under section 857(b)(6)(A) of the Code. In addition, the provision amends section 856(e)(4)(C) of the Code to allow a TRS to operate foreclosure property without causing loss of foreclosure property status, which will result in income derived from such property to be excluded from the 95% and 75% income tests.
Finally, the provision expands the 100% excise tax on non-arm’s length transactions under section 857(A) to redetermined TRS income, which is defined as gross income of a TRS of a REIT attributable to services provided to, or on behalf of, the REIT (less deductions properly allocable thereto) to the extent the amount of such income (less deductions) is increased on distribution, apportionment, or allocation under section 482. The definition does not include gross income attributable to services furnished or rendered to a tenant of the REIT (or to deductions properly allocable thereto).
These amendments, which contain a minor modification to the provision in H.R. 34, apply to taxable years beginning after December 31, 2015 and increases expenditures by approximately $65 million over the next 10 years according to the JCT’s estimates.
Section 322 – Exception From FIRPTA for Certain Stock of REITs
Under section 897(a), which was added by FIRPTA, a foreign person’s gain or loss from the disposition of a USRPI is generally treated as income that is effectively connected with the conduct of a US trade or business, and thus taxable at the income tax rates applicable to US persons, including the rates for net capital gain.
Section 322 of the Act significantly relaxes the FIRPTA rules that apply to foreign investments in US REITs. Specifically, it increases from 5% to 10% the ownership threshold for the FIRPTA exemption that applies to gains from the sale of regularly traded REIT shares or certain distributions by a REIT.
This provision also provides a complete exemption from FIRPTA for sales by, or distributions to, a qualified shareholder of a REIT (i.e., certain foreign REITs or pass-through entities) to the extent that the qualified shareholder did not have greater than 10% shareholders or partners. The new exemption substantially ameliorates the effects of Notice 2007-55 for qualified shareholders. These shareholders are defined as foreign persons that:
- Either are eligible for the benefits of an income tax treaty, which includes an exchange of information program and whose principal class of interests is listed and regularly traded on one or more recognized stock exchanges, or is a foreign partnership that is created and organized under foreign law as a limited partnership in a jurisdiction that has an agreement for the exchange of information with respect to taxes with the United States and has a class of limited partnership units representing greater than 50% of the value of all the partnership units that is traded regularly on the NYSE or NASDAQ markets;
- Are qualified collective investment vehicles; and
- Maintain records on the identity of each person who, at any time during the foreign person’s taxable year, is the direct owner of five percent or more of the class of interests or units described in (1) above.
In Notice 2007-55, the IRS concluded that liquidating distributions by a REIT to foreign shareholders should be treated, to the extent attributable to gain with respect to US real property, as capital gain distributions subject to FIRPTA. The notice was criticized for constraining continued foreign investment in US real estate, and for creating a distinction in tax treatment between US shareholders and foreign shareholders in economically similar situations, for REIT liquidating distributions to US shareholders would be treated as sales of stock (which, if held by a foreign person, would have exempted the gain from such stock sales from FIRPTA). The changes described above limit the impact of Notice 2007-55 to foreign shareholders that are not qualified shareholders.
The provision also indicates that in the case of an applicable investor who is a nonresident alien individual or a foreign corporation and is a partner in a qualified shareholder partnership, if such partner’s proportionate share of USRPI gain for the taxable year exceeds the partner’s distributive share of such gain for the taxable year, then the partner’s distributive share of non-USRPI or gain is recharacterized as USRPI gain for the taxable year in the amount of the excess. Nocjar said, “This rule adds an additional limit (beyond, for example, the substantiality rules under section 704(b)) on attempts to specially allocate USRPI or gain away from significant foreign partners in exchange for non-USRPI or gain.”
Finally, the provision amends section 897(h)(4) of the Code to modify the definition of a “domestically controlled qualified investment entity,” clarifying when such entity is domestically controlled. The sale of an interest in such an entity is not considered a USRPI. A qualified investment entity is generally any RIC which is a US real property holding corporation and any REIT.
The amendments relating to the definition of a “domestically controlled qualified investment entity” took effect on December 7, 2015. The other amendments in the provision took effect on December 7, 2015 and apply to any disposition on and after such date, and any distribution by a REIT on or after such date that is treated as a deduction for a taxable year of the REIT ending after December 7, 2015. According to the JCT’s estimates, these amendments will cost approximately $2.3 billion over the next 10 years.
Section 323 - Exception for Interests Held by Foreign Retirement or Pension Funds
This provision amends section 897 of the Code and adds a version of the administration's proposal to exempt from FIRPTA gain of a qualified foreign pension fund or a foreign entity wholly-owned by a qualified foreign pension fund from the sale of an interest in US real property. It modifies the provision in H.R. 34 by clarifying that such interests may be held directly by the qualified foreign pension fund (or its wholly-owned foreign subsidiary), or indirectly through one or more partnerships. The IRS may prescribe regulations as necessary to carry out the new rules.
In addition, the provision amends section 1445(f)(3) of the Code to eliminate withholding on sales of USRPIs by qualified foreign pension funds and their wholly-owned foreign subsidiaries.
These amendments apply to dispositions and distributions after December 7, 2015, and will cost approximately $2 billion over the next 10 years according to the JCT’s estimates.
Section 324 - Increase in Rate of Withholding of Tax on Dispositions of United States Real Property Interests
This provision increases the rate of withholding of tax on dispositions of USRPIs from 10% to 15% by amending section 1445 of the Code. However, the increased rate does not apply to the sale of a personal residence where the amount realized is $1 million or less; such sale will be subject to the 10% rate. The provision applies to dispositions made at least 60 days after December 7, 2015, and will generate revenues of approximately $209 million over the next 10 years according to the JCT’s estimates.
Although this provision was not included in H.R. 34, it was included in S. 915.
Section 325 - Interests in RICs and REITs Not Excluded From Definition of United States Real Property Interests
Under section 897(c)(1)(B), an interest in a corporation is not a USRPI if (1) as of the date of the disposition of the interest, such corporation did not hold any USRPIs, and (2) all of the USRPIs held by such corporation during the shorter of (i) the period of time after June 18, 1980, during which the taxpayer held such interest, or (ii) the five-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 US real properties interests by application of this rule to one or more other corporations (the “cleansing rule”).
This provision amends the Code to state that the so-called cleansing rule does not apply to the stock of a corporation if the corporation or any predecessor of the corporation was a RIC or REIT at any time during the shorter of the two periods described in (i) and (ii) above. The provision applies to dispositions on or after December 7, 2015, and will generate revenues of approximately $256 million over the next 10 years according to the JCT’s estimates.
Although this provision was not included in H.R. 34, it was included in S. 915, and also appeared in former Chairman Camp’s Tax Reform Act of 2014.
Section 326 - Dividends Derived From RICs and REITs Ineligible for Deduction for United States Source Portion of Dividends From Certain Foreign Corporations
This provision amends section 245(a) of the Code by adding language indicating that for purposes of determining whether dividends from a foreign corporation (attributable to dividends from an 80% owned domestic corporation) are eligible for a dividends received deduction, dividends from RICs and REITs are not treated as dividends from domestic corporations. The provision applies to dividends received from RICs and REITs on or after December 7, 2015, and will generate revenues of approximately $762 million over the next 10 years according to the JCT’s estimates.
Although this provision was not included in H.R. 34, it was included in S. 915, and also appeared in former Chairman Camp’s Tax Reform Act of 2014.
