The Protecting Americans from Tax Hikes (PATH) Act made substantial changes to certain areas of the Real Estate Investment Trust (REIT) rules. Many of the provisions provide REITs with additional flexibility regarding the nature of their assets and income, which make REITs an appealing investment vehicle for foreign taxpayers (see Sidebar).
Prohibited Transaction Safe Harbors
Generally, REITs must pay a 100% tax on net income from prohibited transactions, including a sale of property held as inventory or primarily for sale to customers in the ordinary course of business. An exception may apply when the tax basis or fair market value (FMV) of the property sold after a year does not exceed 10% of the aggregate tax basis or aggregate FMV of the REIT’s assets at the start of the year.
The PATH Act expands this safe harbor. Now, REITs can sell property with an aggregate tax basis or FMV up to 20% of its aggregate tax basis or aggregate FMV in one year, as long as the REIT does not sell property with a tax basis or FMV exceeding 10% of its aggregate tax basis or aggregate FMV over a three-year period. The safe harbor test can also be retroactively applied to inventory property.
The PATH Act also expands the definition of prohibited transactions. The list of prohibited transactions now includes certain services provided by a taxable REIT subsidiary (TRS) when the amounts charged do not equal arm’s length consideration.
Preferential dividends generally are not deductible, which results in double taxation for REITs (both the REIT and its investors pay taxes). Moreover, preferential dividends do not count toward the 90% distribution requirement. While the rules on preferential dividends were repealed for publicly-offered regulated investment companies in 2010, the PATH Act repeals it for publicly-offered REITs starting in 2015.
The PATH Act also authorizes the IRS to provide an alternative remedy that will not jeopardize REIT status when a REIT pays a preferential dividend. The agency may do so if the payment was inadvertent or due to reasonable cause.
Beyond prohibited transactions and preferential dividends, the PATH Act also made changes to:
- Asset and Income Tests
REITs must satisfy an asset test and two income tests. Under the PATH Act, debt instruments issued by publicly-traded REITs and interests in mortgages on real property now count as real estate assets for purposes of meeting the 75% asset test each quarter, as long as their value does not exceed 25% of the value of a REIT’s total assets. Income from such debt instruments is now generally treated as income for purposes of the 95% income test, but not the 75% income test.
- Tax-Free Spinoffs
The PATH Act generally prohibits tax-free spinoffs if only one of the resulting entities will be a REIT. In addition, no party to a tax-free spinoff can elect REIT status until ten years after the spinoff. A spinoff will be treated as tax-free only if:
- Immediately after the distribution, both the distributing and the controlled corporations are REITs; or
- A REIT distributes to its shareholders the stock of a TRS that was at least 80% REIT-owned for three years before the distribution.
- Taxable REIT Subsidiaries
For tax years beginning on or after December 31, 2017, the PATH Act reduces the limit on the value of TRS from 25% to 20% of the value of a REIT’s assets. These can provide marketing, development and management services to their parent REITs without subjecting the REIT to the prohibited transaction tax or causing the loss of foreclosure property status.
These are only some of the PATH Act provisions affecting REITs. Others address the designation of dividends, ancillary personal property and hedging. If you have REIT investments, review how the changes apply to your portfolio to ensure that you are getting the most out of the new provisions.
Sidebar: What About Foreign Investments?
The Foreign Investment in Real Property Tax Act (FIRPTA) imposes U.S. income tax on non-U.S. taxpayers that earn income on the disposition of U.S. real property interests. The tax applies to sales and corporate distributions and the distributing corporation must withhold the tax. The PATH Act made several changes to FIRPTA that could make REITs more appealing to foreign investors.
For example, foreign pensions, retirement plans and certain publicly-traded entities are now exempt from FIRPTA. In addition, the de minimis percentage rose from 5% to 10%. The percentage applies to publicly-traded REITs, which are generally excluded from FIRPTA, except for taxpayers that own more than a de minimis interest. These changes mean that more foreign investors will be exempt from FIRPTA.
The PATH Act also made it easier for publicly-traded REITs to take advantage of the FIRPTA exception for dispositions of stock in domestically-controlled REITs. It created a presumption that all shareholders with less than 5% of a REIT are U.S. persons, unless the REIT has actual knowledge to the contrary.