Final Regulations on Domestically Controlled REITs
The IRS has finalized rules for determining whether a real estate investment trust (REIT) and other qualified investment entities are considered domestically controlled.
These rules retain much of the original context from regulations first proposed in December 2022, and these changes will affect both current and prospective REIT ownership structures.
Understanding domestically controlled REITs and implications for foreign investors
Generally, a REIT is an entity treated as a corporation for federal income tax purposes, organized for investing in real estate and real estate related assets. An ownership interest in a domestically controlled REIT is not considered a U.S. real property interest, which means foreign investors may not be subject to certain federal tax withholding requirements.
Meeting the domestic control requirement, therefore, has important implications for a REIT in attracting foreign-sourced capital. Domestic control is met if foreign persons hold directly or indirectly less than 50% of the fair market value of the REIT’s outstanding stock.
The “look-through” approach and its impact on withholding taxes
These new rules implement a “look-through” approach for determining REIT stock indirectly held and modified the IRS’ treatment of foreign-owned domestic C corporations, sometimes referred to as “blocker entities.”
Under previous guidance, such blocker entities could be used to essentially convert ownership in a REIT from being considered held by a foreign investor into being held by a domestically regarded U.S. taxpaying entity. Under the new rules, non-public domestic C corporations owned greater than 50% by foreign persons no longer shield the foreign investors from being treated as direct owners of the REIT’s stock. As a result, the REIT may be required to withhold U.S. taxes on capital gain dividends or return of capital distributions paid to foreign investors.
In adding this new look-through approach, the IRS rejected several opposing comments to the proposed regulations, which asserted that Section 897 lacked direct reference to the constructive ownership rules in Section 318, and therefore the indirect ownership of domestic C corporations should not apply.
The IRS concluded applying the look-through rule to non-public domestic C corporations was necessary for carrying out the legislative intent of Section 897 in determining foreign ownership and the domestic control test for REITs and other qualified investment entities.
Similarly, the IRS rejected arguments that domestic C corporations were U.S. taxpaying entities and therefore should not alter the determination of the domestic control test.
Ultimately, the goal of these rules is to aid the IRS in identifying foreign investment in the U.S.
Evaluating your options
The final regulations contain a transition rule allowing certain REITs and qualified investment entities to disregard the new look-through approach to domestic C corporations for up to ten years if certain requirements are met (significant ownership changes or new real property purchases could cause an entity to lose this exemption before the 10-year window expires).
This presents a favorable opportunity for REITs to evaluate their ownership structures and implement any changes needed to meet the domestic control requirements under the new rules.
How we can help
Understanding new rules can be complex, and implementing new systems or processes can be similarly challenging. Contact us for assistance in reviewing your potential exposure to these new rules and how to manage them.
Brian is a Signing Director in CLA's Real Estate industry group and has more than 15 years of experience working with real estate operators, land developers, commercial real estate companies, private equity funds, and general contractors. Brian is also part of CLA's Opportunity Zone working group, and leads a team providing compliance, consulting, and advisory services to opportunity zone investors, qualified opportunity funds, and qualified opportunity zone businesses.
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