PATH Act Reforms REIT Rules
Berdon Tax Team
01.26.2016 | Client Alert
The December 18, 2015 enactment of the Protecting Americans from Tax Hikes Act of 2015 (PATH Act) featured significant changes to various real estate investment trust (REIT) rules. Here are some key provisions that relate to REITs.
Built-in Gains Tax: If a C corporation converts into a REIT or transfers assets to a REIT, the REIT is subject to a built-in gains tax upon the subsequent sale of the property received from the C corporation. There is an exemption from the tax if a REIT holds the property for a minimum period. For 2012 through 2014, the minimum holding period was five years.
If the PATH Act had not changed the law, the minimum holding period would have been ten years in 2015 and later taxable years. The PATH Act permanently reinstates the five-year holding period requirement to avoid the built-in gains tax.
REIT Spin-offs: In recent years, a common planning technique had been for companies to spin-off their real estate assets and have the spun-off company elect to be treated as a REIT. In many cases, the spun-off company would then lease the real estate back to the distributing company.
The PATH Act combats this perceived abuse by generally making REITs ineligible to participate in a tax-deferred spin-off – either as a distributing company or as the spun-off company. As a result, spin-offs involving REITs will generally be taxable transactions.
A tax deferred spin-off is still permitted if both entities participating in the spin-off are REITs. In addition, a REIT is permitted to spin-off its taxable REIT subsidiary (TRS) on a tax-deferred basis if certain requirements are met.
The PATH Act also prohibits companies that participate in a tax-deferred spin-off from making a REIT election during a ten-taxable year period following the spin-off (unless the company was a REIT at the time of the spin-off).
The spin-off provisions of the PATH Act generally apply to spin-offs that occur on or after December 7, 2015.
Taxable REIT Subsidiaries (TRS): Currently, no more than 25% of the assets of a REIT (by value) can consist of securities of one or more TRS. The PATH Act reduces the percentage limitation to 20%. This provision applies to 2018 and later taxable years.
A 100% excise tax is imposed on certain non-arm’s-length transactions between a REIT and a TRS. The PATH Act adds to the list of transactions that are subject to the excise tax, a category entitled “redetermined TRS service income.” This is defined as net income of a TRS attributable to services provided to or on behalf of a REIT to the extent the amount of net income is increased by the IRS to meet an arm’s length pricing standard. Net income from services rendered to a tenant of a REIT will not be considered redetermined TRS service income since such income is currently subject to the excise tax as “redetermined rent.” The changes to the TRS excise tax rules apply to 2016 and later taxable years.
Prohibited Transaction Safe Harbor: REITs are subject to a 100% tax on net income derived from prohibited transactions. A sale or other disposition of property is a prohibited transaction if the property is held by the REIT as inventory or held for sale to customers in the ordinary course of business.
Under a statutory safe harbor, REITs are permitted to make sales of real estate assets free of the prohibited transaction excise tax if:
- The property has been held for at least two years;
- The aggregate capitalized expenditures during the two-year period preceding the sale are 30% or less of the net selling price of the property;
- The property has been held for the production of rental income for at least two years unless the property was acquired through foreclosure or lease termination; and
- Substantially all of the marketing and developing expenditures were made through an independent contractor from whom the REIT does not derive any income unless there were seven or fewer sales during the taxable year.
If the safe harbor applies, REITs are permitted to make sales of 10% or less of their assets (by value or basis) in a taxable year. The PATH Act expands the amount of property that a REIT may sell within the safe harbor, in certain cases, from 10% to 20%. However, REITs can only qualify for the safe harbor at the 20% or less level in a taxable year if the three taxable year average sales are 10% or less.
Previously, to meet the safe harbor, substantially all of the marketing and development expenditures generally had to be made through an independent contractor. The PATH Act now permits REITs to take into account the marketing and development expenditures of a TRS in determining whether the “substantially all” test is met. A similar change is made with respect to marketing expenditures made by a TRS with respect to the safe harbor for timber property.
The above-described changes to the prohibited transaction safe harbor apply to 2016 and later taxable years.
In addition, the PATH Act clarifies that no inference is to be made as to whether the property is inventory or held for sale to customers by reason of failing to meet the safe harbor. This clarification generally applies retroactively to the original enactment of the safe harbors in 2008.
Preferential Dividend Rule: REITs are not permitted a deduction for dividends paid to shareholders if the dividend is a preferential dividend (i.e., a dividend that is not distributed pro rata among all of the shares). A dividend judged to be a preferential dividend can cause an issue with regard to REIT qualification since REITs are required to distribute 90% of their taxable income as a dividend.
The PATH Act repeals the preferential dividend rule for publicly-offered REITs (i.e., a REIT that files financial reports with the SEC). This provision is effective for distributions made in 2015 and later taxable years.
For privately-held REITs, the IRS now has the authority to provide an alternative remedy if it is determined that the preferential dividend problem was inadvertent or due to reasonable cause and not willful neglect. In such case, the IRS would provide the REIT with an appropriate remedy to cure the failure to comply with the preferential dividend requirement instead of not treating the distribution as a dividend. This provision is effective for distributions made in 2016 and later taxable years.
Designation of Dividends by REITs: A REIT may designate that a certain amount of dividends paid consist of net capital gains or qualified dividend income – both taxed to individual shareholders at preferential rates. Under current law, there is some uncertainty as to whether the amount designated can exceed the total of the dividends paid by the REIT. The PATH Act limits the amount that can be designated by a REIT to the total dividends paid during the taxable year. The Treasury Department and the IRS were given the authority to issue regulations or other guidance that will require the designations be pro rata among shares of REIT equity. This provision is effective for distributions made in 2016 and later taxable years.
Asset and Income Testing: At least 75% of a REIT’s assets (by value) must consist of real estate assets, cash and cash items, and government securities. In addition, at least 75% of a REIT’s gross income must be from real estate related items and at least 95% of a REIT’s gross income must be from 75% qualifying items, plus interest, dividends, and gains from the sale or disposition of securities.
Under current law, debt instruments issued by publicly-offered REITs are not considered qualifying income or assets for purposes of either the 75% asset or income tests, but the income does qualify for the 95% income test. Under the PATH Act, debt instruments issued by publicly-offered REITs will be qualifying assets for purposes of the 75% asset test. However, the amount of such debt instruments held by a REIT will be limited to 25% or less of the REIT’s assets (by value). The income from debt instruments of publicly offered REITs will qualify for the 95% income test but will generally not qualify for the 75% income test (as under current law).
Currently, mortgages on interests in real property (e.g., a mortgage on a lease) are not considered qualifying assets for purposes of the 75% asset test. However, the income from such a mortgage qualifies for both the 75% and 95% income tests. Under the PATH Act, mortgages on interests in real property will be qualifying assets for purposes of the 75% asset test.
Under current law, rents attributable to ancillary personal property (i.e., leased with real property such as carpets) are considered qualifying income for purposes of both the 75% and 95% income tests. Such personal property did not qualify for the 75% asset test. Under the PATH Act, ancillary personal property that is leased with real property will qualify for the 75% asset test.
The PATH Act also makes changes to the asset and income tests with regard to property that is secured by a mortgage. For purposes of the 75% income test, the interest income from a mortgage must be apportioned between the real property and any personal property if the amount of the loan exceeds the value of the real property. Currently, there is uncertainty as to whether a similar allocation is required for purposes of the 75% asset test. Under the PATH Act, the entire amount of a mortgage will qualify under both the 75% asset and income tests if the personal property does not exceed 15% of the property mortgaged (by value).
Income from clearly identified hedging transactions with respect to indebtedness and foreign currency is not included in gross income for purposes of either the 75% or 95% income tests. The PATH Act expands the current exception for hedging income to cover subsequent hedging transactions after the transaction is extinguished or disposed of. The PATH Act also clarifies the method in which a hedging transaction is identified.
Income and gain derived from foreclosure property qualifies for both the 75% and 95% income tests. Property ceases to be foreclosure property if it used in a trade or business conducted by the REIT after the 90th day following the acquisition of the property. However, foreclosure property retains its status if the trade or business is conducted through an independent contractor for whom the REIT does not derive or receive any income. The PATH Act allows a TRS to operate foreclosure property without affecting the status.
All of the changes to the asset and income testing rules are effective for 2016 and later taxable years.
Earnings and Profits (E&P): The current E&P rules for REITs can result in disparity between the REIT’s taxable income and its E&P with respect to certain deductible items and gain reported under the installment method. The PATH Act ends this disparity and a variety of traps for the unwary.
- Assume that a REIT had operating profits of $100 in each of five taxable years. In Year One, the REIT takes an energy-efficient commercial building deduction of $10. This reduces the taxable income to $90. For E&P purposes, the deduction is taken over five taxable years. So in Year One, the current E&P is $98. Due to a quirk in the existing rules, the current E&P in Years Two through Five would be $100. Under the PATH Act, the E&P in all five years would be $98.
The E&P provisions of the PATH Act are effective for 2016 and later years.
Foreign Investment in Real Property Tax Act (FIRPTA)
Special FIRPTA rules apply to foreign investment through a REIT.
Domestically-controlled REITs are not considered to be US real property interests (USRPI). As a result, gain from the sale of such REIT stock is not subject to FIRPTA. A REIT is considered to be domestically-controlled if foreign persons own less than 50% of the stock of the REIT (by value). Under the PATH Act, publicly-traded REITs will generally be permitted to presume that holders of less than 5% of a class of stock are US persons. The PATH Act also provides new rules for determining the foreign or domestic status of shareholders that are REITs or regulated investment companies (RIC) (i.e., mutual funds).
If a REIT is a US real property holding company (USRPHC) and is not domestically-controlled, foreign shareholders are generally subject to FIRPTA on gain and distributions with respect to the stock. There is an exception to this rule for publicly-traded REITs for shareholders that own 5% or less of a class of stock. The PATH Act changes the percentage ownership threshold with respect to publicly-traded REITs from 5% to 10%.
The PATH Act provides for a new exemption from FIRPTA for stock of a REIT which is held directly (or indirectly through one or more partnerships) by a qualified shareholder. In such case, FIRPTA will not apply to gains and distributions. A qualified shareholder is generally (i) a publicly-traded foreign person that is eligible for treaty benefits under an income tax treaty that provides for an exchange of information program, or (ii) a foreign limited partnership that is traded on the NYSE or NASDAQ and meets other requirements. The exemption for qualified shareholders does not apply to the extent that an investor in the qualified shareholder owns, indirectly by attribution, more than 10% of a class of stock of the REIT.
Under the so-called “cleansing rule,” a US corporation is not considered to be a USRPI if all of the USRPIs held in the prior five years were disposed of in fully-taxable transactions. Under the PATH Act, the cleaning rule will generally not apply if the corporation has been a REIT at any time in the prior five years before the disposition of stock.
The FIRPTA provisions of the PATH Act are effective for transactions on or after the date of enactment (December 18, 2015).
Dividends-Received Deduction: A US corporation that owns at least 10% of the stock (by vote and value) of a foreign corporation is entitled to a deduction for certain dividends received from the foreign corporation of 70% to 100%, depending upon the level of stock ownership, to the extent that the dividend is attributable to specified types of income. One of the types of income that supports a dividends-received deduction is a dividend received from a US corporation for which the foreign corporation owns at least 80% of the stock (by vote and value). Currently, there is uncertainty as to whether a dividend from an 80%-owned REIT can be eligible for a dividends-received deduction.
The PATH Act clarifies that dividends from a REIT do not qualify for the dividends-received deduction. The dividend-received deduction provisions of the PATH Act are effective for dividends received from a REIT on or after the date of enactment (December 18, 2015). The PATH Act provides that no inference is intended as to proper treatment for earlier periods.
If you have questions about these or other provisions, contact your Berdon advisor. Berdon LLP New York Accountants