A bill introduced late last month in the United States House of Representatives (H.R. 2870) by Congressmen Kevin Brady, a Republican from Texas, and Joseph Crowley, a Democrat from New York, sets forth several proposed amendments to the Foreign Investment in Real Property Act (FIRPTA), aimed at easing the burden on foreign investors in United States real property and spurring overseas investment in U.S. real estate. A companion measure (S. 1181) was introduced in the Senate in June. A copy of the House bill can be found here.
A Brief FIRPTA Background
FIRPTA was enacted in 1980 amid fear of increasing foreign control over U.S. real estate. Among its key provisions, FIRPTA requires non-U.S. residents to recognize U.S. source income on the gain realized from the disposition of “United States Real Property Interests” (USRPI), defined to include fee ownership, leaseholds, interests in natural resources, and other real property interests located within the United States or the U.S. Virgin Islands. Absent this provision, disposition by non-US residents of USRPI would be sourced as a capital gain to the taxpayer’s country of residence under I.R.C. §§ 871 and 882, thereby escaping U.S. taxation.
Entity Interests Can Constitute USRPI
Interests in entities that own U.S. real estate, such as partnerships, are also considered USRPI and thus sales of those interests give rise to U.S. source income to the non-U.S. resident seller. Similarly, sales by a foreign partnership of USRPI will be attributed directly to the entity owners, rather than the entity itself, and thus non-resident entity owners must realize U.S. source income upon entity-level disposition of USRPI.
Conversely, consistent with the Internal Revenue Code’s treatment of corporations as distinct entities, income from sales by a foreign corporation of USRPI will be attributed to the corporation itself instead of the shareholder. However, stock in a United States corporation deemed to be a United States Real Property Holding Corporation (USRPHC) is considered a USRPI and therefore sale of such stock by a non-U.S. resident will trigger U.S. source income like any other sale of U.S. real property. This rule prevents circumvention of FIRPTA’s requirements through the ownership of U.S. real property in a corporation. Without the rule, a foreign owner of stock of a foreign corporation that owned USRPI could cause the corporation to sell the USRPI and then extract the cash from the stock either through a distribution or sale of the stock. In the process, the shareholder would avoid any FIRPTA gain because all such gain would be foreign source capital gain recognized only by the corporation.
How Does a Corporation Become a USRPHC?
Whether a U.S. corporation constitutes a USRPHC is determined by comparing the value of the corporation’s USRPI with the value of its worldwide real estate holdings and business assets. If the ratio is 50 % or greater in favor of USRPI, then the corporation is a USRPHC and its stock is considered a USRPI.
An Exception to USRPHC Stock’s Status as USRPI
Generally, an exception to the USRPHC rules exempts from FIRPTA treatment sales of USRPHC stock traded on an established securities market. However, this exception currently does not apply to any shareholder that holds more than 5 % of the stock of the subject corporation. Thus, even if the stock is publicly traded on an established securities market, if the seller of the stock was a greater than 5 % holder prior to the sale, the sale will be treated as a sale of a USRPI.
How H.R. 2870 Proposes to Change FIRPTA
Under the proposed amendments to FIRPTA in H.R. 2870, the above-referenced 5 % threshold will be raised to 10 % in the case of shares held in a publicly traded Real Estate Investment Trust (REIT). The proposed change encourages additional investment of foreign capital in U.S. real estate by permitting an additional 5 % of ownership of a publicly traded REIT without incurring FIRPTA gain upon disposition of the stock. FIRPTA can also dissuade investment in U.S. real estate due to the fact that FIRPTA gain is U.S. source income requiring the recipient to file a U.S. tax return and bear the administrative burden associated with doing so. Under the proposed amendment, investors holding 10 % or less of the stock of a publicly traded REITs will not recognize U.S. source income and thus will avoid onerous U.S. filing requirements.
Another important change to FIRPTA proposed in H.R. 2870 concerns distributions made by REITs. Under current law, distributions made by U.S. REITs to non-resident individuals, foreign corporations, or other REITs are treated as gains on the sale or exchange of a USRPI (and thus subject to FIRPTA) to the extent the distribution is attributable to a gain by the distributing REIT on the sale or exchange of a USRPI. In essence, under FIRPTA, distributions to non-US recipients are “looked through” to the underlying source of the property constituting the distribution. If the distribution is attributable to gain on the sale of exchange of USRPI, it will be FIRPTA gain to the recipient.
An exception to this look through rule applies to any distribution made with respect to REIT stock traded on an established securities market within the United States, unless the recipient of the distribution owns more than 5 % of such stock. The proposed bill will raise that threshold from 5 % to 10 %. Further, H.R. 2870 removes from the scope of the look through rule REIT distributions that are treated as a sale of stock under §§ 301(c)(3), 302 (relating to redemptions of stock), and 331 (relating to distributions in complete liquidation of a corporation). This revision would override I.R.S. Notice 2007-55, which treated REIT redemptions and liquidating distributions as sales or exchanges of USRPI, thus giving rise to US source gain under FIRPTA.
Finally, H.R. 2870 clarifies the definition of a “domestically controlled REIT.” Classification of a REIT as domestically controlled is important because stock of a domestically controlled REIT is not considered USRPI and thus its disposition does not give rise to FIRPTA gain. A REIT is domestically controlled if less than 50 percent of its stock is held by non-U.S. persons. Under H.R. 2870, any shareholder owning less than 5 % of the REIT stock that is traded on an established U.S. securities market can be presumed to be a U.S. person unless the REIT has actual knowledge to the contrary. Conversely, any stock in the REIT held by another REIT is presumed to be held by a foreign person, unless the parent REIT is actually domestically controlled. Both of these proposed amendments provide a degree certainty for REIT administrators struggling to determine the identity and classification of their shareholders.
Overall, the proposed amendments to FIRPTA contained in H.R. 2870 would go a long way toward easing the burden on foreign investment in U.S. real estate by exempting dispositional and distribution income arising from REIT shares and by clarifying and providing certainty for those investors seeking to take advantage of the Code’s favorable treatment of domestically controlled REITs.