Final Treasury Regulations on the Definition of Domestically Controlled REITs

On April 23, 2024, the U.S. Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) published final regulations (Final Regulations) relating to the determination of whether a real estate investment trust (REIT) is “domestically controlled” under Section 897(h)(4)(B) of the Internal Revenue Code of 1986, as amended (Code).¹

These Final Regulations finalize the proposed Treasury regulations, published on December 29, 2022 (Proposed Regulations), except that the Final Regulations do not finalize the Proposed Regulations relating to the exemption from taxation afforded to foreign governments under Section 892, which will be addressed in a separate rulemaking. The Final Regulations are effective as of April 25, 2024.

The Final Regulations also apply to a regulated investment company (RIC) that is (or would be, absent certain exceptions) a United States real property holding corporation (USRPHC). This overview of the Final Regulations, however, focuses on REITs because REITs are more likely than RICs to be USRPHCs that could benefit from the “domestically controlled” exception and nonresident alien individuals, and foreign corporations are more likely to invest in REITs than in RICs.

Background

Section 897, commonly referred to as the Foreign Investment in Real Property Act (FIRPTA), subjects a nonresident alien individual or foreign corporation to U.S. federal income tax at graduated rates, in a similar manner as a U.S. person on any gain realized from the disposition of a United States real property interest (USRPI).² A USRPI generally includes an interest in real property located in the United States or the Virgin Islands and any interest (other than solely as a creditor) in a USRPHC, which generally is a domestic corporation, including a REIT, if at least 50% of its assets by value are USRPIs at any time during the applicable testing period.³

Section 897(h)(2) provides an important exception that an interest in a “domestically controlled” REIT is not a USRPI. As a result, a nonresident alien individual or a foreign corporation can sell its equity interest in a domestically controlled REIT without being subject to U.S. federal income tax under FIRPTA. A REIT is “domestically controlled” only if less than 50% of the value of its stock is held “directly or indirectly” by foreign persons at all times during the applicable testing period (generally, the five-year period ending on the date of the disposition of the stock of the REIT).⁴

Prior to the Proposed Regulations, neither the Code nor the Treasury regulations provided guidance on what it means for stock of a REIT to be “indirectly” held by foreign persons under the domestically controlled exception. However, in a widely relied-on and widely discussed private letter ruling (PLR) from 2009, the IRS concluded that a domestic C-corporation would not be looked through for purposes of determining whether a REIT is domestically controlled.⁵ Thus, under that PLR, because it was irrelevant who owned that domestic corporation, it could be owned 100% by foreign persons.

Summary of Final Regulations

Limited Look-Through Rule

The Final Regulations, rejecting almost all comments by taxpayers, change the law by adopting a limited look-through rule in respect of domestic C corporations and certain other owners of stock of a REIT solely for purposes of determining whether the REIT is domestically controlled. The Final Regulations are similar to the Proposed Regulations with certain modifications, the majority of which are described below. Under the limited look-through approach, a REIT must look through each “look-through person” and determine whether it is domestically controlled based on direct and indirect beneficial ownership by “non-look-through persons.” Key aspects of the new limited look-through rule are described below.

• REIT stock owned by non-public domestic C corporation — The Final Regulations have the effect of looking through a nonpublic domestic C corporation if one or more foreign persons hold directly or indirectly more than 50% (up from “25%  or more” in the Proposed Regulations) of the fair market value of the nonpublic domestic C corporation’s outstanding stock (i.e., the nonpublic domestic C corporation is “foreign controlled”). For these purposes, a domestic C corporation does not include a RIC or a REIT.
• REIT stock owned by public domestic C corporation or publicly traded partnership — A public domestic C corporation or publicly traded partnership (domestic or foreign) is treated as a non-look-through person.  However, the Final Regulations include an exception that was not in the Proposed Regulations, which provides that a public domestic C corporation or domestic publicly traded partnership is treated as a look-through person if the REIT whose status as domestically controlled is being determined has actual knowledge that the public domestic C corporation or domestic publicly traded partnership is foreign controlled (treating the entity as a non-public domestic C corporation for this purpose).
• REIT stock owned by non-publicly traded partnership — A non-publicly traded partnership, whether domestic or foreign, is treated as a look-through person. This rule removes any uncertainty regarding whether a foreign non-publicly traded partnership counts as a foreign person for purposes of determining whether the REIT is domestically controlled.
• REIT stock owned by publicly traded partnership — A publicly traded partnership, whether domestic or foreign, is treated as a non-look-through person. However, the Final Regulations include an exception that was not in the Proposed Regulations, which provides that a domestic publicly traded partnership is treated as a look-through person if the REIT whose status as domestically controlled is being determined has actual knowledge that the domestic publicly traded partnership is foreign controlled (treating the entity as a nonpublic domestic C corporation for this purpose).
• REIT stock owned by other REITs — Special rules apply when the stock of a REIT is owned by a REIT. These rules are consistent with the statutory rules.  
• REIT stock owned by RICs — Special rules also apply when REIT stock is owned by a RIC. These rules are particularly relevant, given that RICs are large investors in REITs. These rules turn on whether the RIC is a “qualified investment entity” (QIE) (i.e., a RIC that is also a USRPHC).⁶
  • RIC is a QIE:
    • First, if the RIC is (i) a QIE and (ii) either (A) one or more classes of stock of the RIC is regularly traded on an established securities market or (B) the RIC generally issues redeemable securities within the meaning of the Investment Company Act of 1940, the stock is treated as held by a foreign person or a U.S. person based on whether the RIC is itself domestically controlled. This rule is consistent with Section 897(h)(4)(E)(ii).
    • Second, if the RIC is a QIE but does not satisfy either subclause (A) or (B) of clause (ii) of the prior paragraph (i.e., a private RIC), the RIC is treated as a look-through person. This rule is consistent with Section 897(h)(4)(E)(iii).
  • RIC is not a QIE:
    • Third, if the RIC is (i) not a QIE and (ii) either (A) one or more classes of stock of the RIC is regularly traded on an established securities market or (B) the common stock of the RIC is continuously offered pursuant to a public offering within the meaning of Securities Act of 1933 and is held by or for no fewer than 500 persons, the RIC is treated as a non-look-through person. However, the RIC is treated as a look-through person if the REIT whose status as domestically controlled is being determined has actual knowledge that the RIC is foreign controlled (treating the entity as a nonpublic domestic C corporation for this purpose).
    • Fourth, if the RIC is not a QIE and does not satisfy either of subclause (A) or (B) of clause (ii) of the prior paragraph (i.e., a private RIC), the RIC is treated as a look-through person.

The Final Regulations also provide that for purposes of determining whether a REIT is domestically controlled, a qualified foreign pension fund (or any part thereof) or a qualified controlled entity, each of which is exempt from FIRPTA, is nonetheless counted as a foreign person for purposes of determining “domestically controlled” REIT status.

Identification and Certification Under Limited Look-Through Rule

The Final Regulations do not provide procedures for a REIT to identify its non-look-through person owners for purposes of determining whether it is domestically controlled. The Final Regulations also do not provide guidance regarding how a domestic C corporation can certify to a REIT that it is not foreign controlled (and therefore is not a look-through person). The preamble provides, however, that a REIT must take “appropriate measures” to determine the identity of its direct and indirect shareholders in determining whether it is domestically controlled.

Effective Date and Transition Rule

The Final Regulations, effective April 25, 2024, adopt a new transition rule that was not in the Proposed Regulations. The transition rule exempts REITs that were in existence on April 24, 2024, from the limited look-through rule for domestic C corporations for a 10-year period but only if the REIT satisfies all of the following three requirements at all times on and after April 24, 2024:

• The REIT is domestically controlled (determined without regard to the limited look-through rule for a nonpublic domestic C corporation).
• The aggregate fair market value of any USRPIs acquired by the REIT after April 24, 2024, is no more than 20% of the aggregate fair market value of the USRPIs held by the REIT as of April 24, 2024. For this purpose, the REIT can use the values it uses for its regular asset tests.
• The percentage of the stock of the REIT held directly or indirectly by one or more non-look-through persons (determined based on fair market value and generally based on the limited look-through rules described above) does not increase by more than 50% in the aggregate over the percentage of stock of the REIT owned directly or indirectly by such non-look-through persons on April 24, 2024. For these purposes, (i) if the REIT is regularly traded on an established securities market, all stock owned by persons holding less than 5% of that stock is treated as owned by a single non-look-through person, except to the extent the REIT has actual knowledge regarding the ownership by any person, (ii) in an F reorganization, the transferor corporation and the resulting corporation are treated as the same corporation, and (iii) any binding commitment to acquire stock by written agreement (subject to customary conditions) is treated as having been acquired on April 24, 2024.

The transition rule will cease to apply, and the limited look-through rule for nonpublic domestic C corporations and certain other owners of stock of a REIT will apply, for purposes of determining whether a REIT is domestically controlled on the earlier of (i) April 24, 2034, and (ii) the day immediately following the day in which the REIT fails to satisfy any of the three requirements. As a result of the second requirement, REITs in fund structures that are designed to continue to make new investments (e.g., evergreen funds or funds that are still in the investment period) are not expected to be able to use the transition rule for the full 10 years.

¹ All “Section” references herein are to the Code.
²Section 897(a)(1).
³Section 897(c)(1)(A) (defining USRPI), Section 897(c)(1)(A)(ii) (testing period).
⁴Section 897(h)(4)(B) (defining domestically controlled), Section (h)(4)(D) (testing period).
⁵ PLR 200923001 (June 5, 2009). While only the taxpayer to whom the PLR was issued can rely on the PLR, the PLR was understood by other taxpayers to be indicative of the IRS’ position.
⁶Section 897(h)(4)(A). A RIC also is a QIE if it would be a USRPHC if the exceptions in Sections 897(c)(3) and 897(h)(2) did not apply to interests in any REIT or RIC.