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Client Alert

May 2, 2024

Treasury Issues Final Regulations Addressing “Domestically Controlled” REIT Status

On April 25, 2024, the IRS and Treasury issued final regulations (the “Final Regulations”) addressing whether a real estate investment trust (a “REIT”) or a regulated investment company (a “RIC”) will constitute a “domestically controlled qualified investment entity” under the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”). 1Guidance on the Definition of Domestically Controlled Qualified Investment Entities, 89 Fed. Reg. 31618 (Apr. 25, 2024). The Final Regulations also address certain issues involving qualified foreign pension funds (“QFPFs”) and entities they control. The Final Regulations’ QFPF provisions are beyond the scope of this Alert. These regulations finalize  proposed regulations issued on December 29, 2022, (the “Proposed Regulations”) addressing (1) whether a REIT or a RIC will constitute a “domestically controlled qualified investment entity” under FIRPTA2Prop. Treas. Reg. §§ 1.897-1, 1.897-9T, 87 Fed. Reg. 80097, 80105–08 (Dec. 29, 2022). and (2) the definition of a “controlled commercial entity” for purposes of the exemption for sovereign wealth fund investors under Internal Revenue Code (the “Code”) section 892.3Prop. Treas. Reg. §§ 1.892-5, 1.892-5T, 87 Fed. Reg. 80097, 80104–05 (Dec. 29, 2022). Regulations finalizing the portions of the Proposed Regulations addressing Code section 892 will be issued in a separate rulemaking. The Final Regulations will have a significant impact on the structures used by non-U.S. investors in U.S. real estate, although transition rules included in the Final Regulations will generally mitigate the immediate impact of the new rules on existing structures.


a. FIRPTA Generally

By enacting FIRPTA, as embodied in Code section 897, Congress established an important exception to the rule that non-U.S. investors are not subject to U.S. federal income tax on their capital gains.  Specifically, a non-U.S. investor who disposes of a “United States real property interest” (“USRPI”) is subject to tax on any gain with respect to that disposition at regular U.S. tax rates as if the gain were effectively connected to a United States trade or business.  A USRPI includes a direct interest in U.S. real property as well as equity interests in “U.S. real property holding corporations” (“USRPHCs”).  Generally, a corporation will constitute a USRPHC if more than 50 percent of its aggregate real estate assets and other trade or business assets consist of USRPIs.

b. Domestically Controlled REITs

Although equity interests in USRPHCs generally are considered to be USRPIs, there is an important exception to this rule for interests in “domestically controlled qualified investment entities.”  Specifically, an interest in a domestically controlled qualified investment entity is not a USRPI.  A qualified investment entity (“QIE”) is a REIT or a RIC that is a USRPHC.4Although the rules relating to domestically controlled qualified investment entities discussed herein, including specifically the Final-Through Rule (defined below), apply to both REITs and RICs, the focus of this discussion is on domestically controlled REITs.  Non-U.S. investors more commonly invest in U.S. real estate through REITs, rather than RICs. Nonetheless, the implications of the Final Look-Through Rule also are relevant to RICs.

A QIE is considered to be domestically controlled under Code section 897, if less than 50 percent of its stock (by value) is held “directly or indirectly” by “foreign persons” at all times during the shorter of (1) the 5-year period ending on the relevant determination date or (2) the period during which the QIE was in existence .  Accordingly, a non-U.S. investor that owns an interest in a domestically controlled REIT (“DCREIT”) can dispose of that interest without incurring any U.S. federal income or withholding tax under FIRPTA with respect to gain on that disposition, despite the fact that the DCREIT otherwise constitutes a USRPHC. By contrast, a non-U.S. investor who disposes of an interest in a REIT that is not considered domestically controlled would generally be subject to U.S. federal income taxation with respect to any gain on that disposition.

Due to the beneficial tax treatment provided to holders of DCREITs, non-U.S. investors (in particular, those that are not eligible for the Code section 892 exemption and that are not “qualified foreign pension funds” under Code section 897(l)) commonly structure investments in U.S. real estate through DCREITs.  This structure permits those non-U.S. investors holding direct interests in the REITs (or indirect interests held through pass-through entities) to exit their investment via sales of stock in the DCREITs tax-free.  Moreover, subject to the application of Section 897(h) of the Code regarding certain REIT distributions, the non-U.S. investors are not required to file any U.S. federal income tax returns in connection with the investment or upon exiting the investment.

c. Look-Through

The term “directly or indirectly,” which is the lynchpin of the DCREIT test, has never been defined in this context under the Code or the Treasury regulations.  In particular, the FIRPTA rules do not clearly specify whether one must look through a domestic C corporation5The term “C corporation” is meant to refer to corporations taxed under Subchapter C of the Code that are taxable as separate entities.  This is in contrast to “S corporations” taxed under Subchapter S of the Code that are generally taxed as pass-through entities. to the C corporation’s shareholders.

Nonetheless, as discussed in our prior client alert on the Proposed Regulations, there is some authority supporting the position that one should not look through a domestic C corporation for this purpose.   As a result, many taxpayers had taken the position that they are not required to look through to the shareholders of a domestic C corporation.  That is, if a domestic C corporation owns stock in a REIT, the REIT, in determining whether it is a DCREIT, should not be required to look through to the corporation’s shareholders to treat them as indirectly owning stock in the REIT for that purpose, regardless of the extent of the C corporation’s non-U.S. ownership.

Final DC REIT Rules

a. Final Look-Through Rules

Under the Final Regulations, REIT stock owned by a non-public domestic C corporation will be treated as owned by the corporation’s shareholders for purposes of determining DCREIT status if more than 50 percent (by value) of the C corporation’s stock is owned by foreign persons (the “Final Look-Through Rule”). The Final Look-Through Rule retains the look-through approach contained in the Proposed Regulations, but increases the threshold from 25 percent or more to 50 percent or more. 6The IRS explains in the preamble to the Final Regulations that increasing the foreign ownership threshold for look-through of domestic C corporations to more than 50 percent (from more than 25 percent in the Proposed Regulations) was appropriate because it is consistent with the statutory requirement that stock of a DCREIT be at least 50 percent held by non-foreign persons, and the 50 percent threshold appropriately narrows look-through requirement for domestic non-public C corporations to circumstances where such corporations are controlled by foreign persons. The IRS also rejected commenters’ arguments that applying a look-through rule to domestic C corporations was inappropriate because domestic C corporations are subject to U.S. federal income tax, explaining that the relevant statutory test is on control of a QIE, rather than tax status of the QIE’s owners.Any required attribution is pro rata based on the proportionate ownership of the applicable REIT shareholder. Publicly traded domestic C corporations are not looked through when determining a REIT’s DCREIT status, unless the applicable REIT has actual knowledge that such public domestic C corporation is foreign controlled (i.e., more than 50 percent (by value) owned by foreign persons), in which case the Final Look-Through Rule applies to such corporation.

The Final Regulations mandate a look-through for partnerships, other than publicly traded partnerships, as well as other pass-through entities, such as S corporations, private REITs, private RICs, and trusts. A publicly traded partnership is looked through in the same manner as a foreign-controlled domestic C corporations if the REIT has actual knowledge that such publicly traded partnership is foreign controlled. These rules are consistent with those contained in the Proposed Regulations.

b. Transition Rule

The Final Regulations contain a transition rule for applying the new rules to existing structures. The new rules generally will not apply to REITs in existence on April 24, 2024, until April 25, 2034. However, if a REIT in existence on April 24, 2024, either (i) directly or indirectly acquires U.S. real property interests having an aggregate fair market value greater than 20 percent of the aggregate fair market value of the U.S. real property interests directly or indirectly held on April 24, 2024, or (ii) the percentage of the REIT’s stock held by non-look-through persons (e.g., individuals, domestically-controlled domestic C corporations, certain tax-exempt and governmental entities, public REITs and RICs) increases by more than 50 percentage points in the aggregate over the percentage of the REIT’s stock owned by non-look-through persons on April 24, 2024 (the events in the foregoing clauses (i) and (ii) each a “Triggering Event”), then the new rules will apply to the REIT on the day immediately following the day of the Triggering Event. For purposes of determining the fair market value of U.S. real property interests under the transition rule, existing REITs may use the fair market values for such properties used in the REIT’s most recent quarterly asset testing.

c. Implications

Although the Final Regulations are narrower in scope than the Proposed Regulations, they will nevertheless be consequential.  Many real estate fund structures utilize domestic corporate blocker entities that are mostly or entirely foreign-owned.  Thus, increasing the threshold from 25 percent to 50 percent in the Final Regulations will not be helpful for those structures.  The transition rules described above will prevent immediate application of the Final Look-Through Rule to existing REITs, providing time to evaluate and structure future investments. Nonetheless, existing REITs must closely monitor their existing direct and indirect ownership and their asset composition to prevent application of the new rules before expiration of the transition period.  Existing REITs may inadvertently subject themselves to the new rules as a result of direct or indirect transfers of REIT shares or acquisitions of new assets.  Please contact us if you would like to discuss the structuring implications of these regulations.