IRS proposes changes to U.S. real estate tax rules

The United States Internal Revenue Service released proposed regulations that, when effective, will make it easier for certain foreign government entities, such as pension funds, that invest in U.S. real estate to maintain their ability to rely on the exemption provided by U.S. Code Section 892. The proposed regulations will, however, make it more difficult for U.S. REITs to qualify as “domestically controlled” for purposes of the FIRPTA rules under Section 897 of the Code.

In general, the regulations are not effective until final versions are published, but taxpayers are permitted to rely on them in the interim.

What you need to know

The proposed regulations make it easier for Section 892 controlled entities to avoid being treated as engaged in “commercial activities” by curtailing the impact of a noted trap for the unwary.

• Relaxed USRPHC Deeming Rule
  • The regulations lessen the impact of the so-called Deeming Rule of current temporary Regulation Section 1.897-5T(b)(1) by providing that a controlled entity that would be a United States real property holding corporation (a USRPHC) solely by reason of owning minority interests in USRPHCs shall not be subject to the Deeming Rule and shall therefore not be “deemed” to be engaged in commercial activities. In other words, if a controlled entity only owns minority interests in USRPHCs and other blocked investments, including interests in non-domestically controlled REITs, it will not be subject to the Deeming Rule even if most of its value comes from investments in USRPHCs, and will therefore still be eligible to claim the benefits of Section 892 with respect to these minority investments.
  • For Section 892 controlled entities that are also Qualified Foreign Pension Funds (QFPFs) for purposes of Code Section 897(l), the proposed regulations further provide that the Deeming Rule will not apply at all. As a result, controlled entities that are QFPFs will no longer need to track what percentage of their assets are U.S. real property interests.

The proposed regulations make it more difficult for U.S. REITs to qualify as domestically controlled pursuant to Section 897(h) of the Code, which provides that interests in “domestically controlled” REITs are generally not treated as United States real property interests.

• QFPFs not “domestic” for purposes of determining Domestically Controlled REIT Status
  • The proposed rules provide that Qualified Foreign Pension Funds will be considered “foreign persons” for purposes of determining whether a REIT is domestically controlled. Thus, a REIT majority owned by QFPFs and/or other foreign investors will not be considered a domestically controlled REIT. Although this rule does not apply until the regulations are finalized, the preamble to the regulations indicates that the U.S. Internal Revenue Service “may challenge” taxpayers that take a contrary position under current law.
• Look-through of Foreign-Owned U.S. Corporations for purposes of determining Domestically Controlled REIT Status
  • The proposed regulations would look through a “foreign-owned” U.S. domestic corporation for purposes of determining whether a REIT is domestically controlled. A “foreign-owned” domestic corporation is defined for this purpose as any non-publicly traded U.S. corporation where 25 percent or more of the value is owned by non-U.S. investors. Thus, if a foreign investor or group of foreign investors form a taxable U.S. corporate blocker and that blocker invests in a REIT, the blocker will be treated as foreign to the extent of its foreign ownership to determine whether the REIT is domestically controlled, notwithstanding the blocker’s general status as a taxable U.S. corporation.

A separate set of regulations was also issued finalizing the rules regarding the definition of a QFPF and related issues. Those rules largely follow the proposed rules previously issued in 2019.