United States: New Legislation Affects The Taxation Of Foreign Investments In U.S. Real Estate

The Protecting Americans from Tax Hikes Act of 2015 (the "Act") became law on Dec. 18, 2015. The Act retroactively extended, either permanently or temporarily, various tax provisions that Congress had periodically been extending on a temporary basis. In addition, the Act made important changes affecting the taxation of investments, including several changes specifically affecting real estate investment trusts ("REITs") and foreign investments in U.S. real estate. Summarized below are certain provisions of the Act affecting foreign investments in U.S. real estate. Our previous issue addressed changes affecting REITs.

Foreign investments in U.S. Real Estate

The Act made significant changes to the taxation of U.S. real estate investments by foreign investors. Under the Foreign Investment in Real Property Tax Act of 1980, known as "FIRPTA," a foreign person's gain from the disposition of a U.S. real property interest (a "USRPI") is generally treated as income that is effectively connected with the conduct of a U.S. trade or business, which is taxable at the income tax rates applicable to U.S. persons.

Increase in FIRPTA Withholding Rate from 10% to 15%

The purchaser of a USRPI is generally required to withhold tax from the gross proceeds paid to a foreign person. Certain distributions to a foreign shareholder by a corporation that is (or was) a U.S. real property holding corporation (a "USRPHC") are also subject to withholding. A USRPHC is a U.S. corporation the majority of whose real property and business assets are represented by USRPIs. The Act generally increased the rate of withholding under FIRPTA from 10% to 15%, effective for dispositions and distributions after Feb. 16, 2016.

Increase in Minority Ownership Exception from FIRPTA for Certain REIT Stock

The disposition of stock of a USRPHC (or the receipt of a distribution from a REIT attributable to gain from a USRPI) can give rise to tax and withholding under FIRPTA, unless the stock is of a class that is regularly traded on an established securities market and the shareholder holds no more than 5% of that class of stock during the five years preceding the sale. The Act increased that threshold in the case of a REIT — but not a regulated investment company ("RIC") or other entity — from 5% to 10%, effective Dec. 18, 2015.

Exemption from FIRPTA for REIT Stock Held by "Qualified Shareholders"

Under the Act, "qualified shareholders" can own and dispose of any amount of stock of a REIT without triggering FIRPTA withholding. A qualified shareholder is, in general, a foreign publicly traded entity that is eligible for the benefits of a comprehensive income tax treaty with the U.S., is a "qualified collective investment vehicle" and maintains records with respect to its 5% owners. A qualified collective investment vehicle is a foreign entity that either would be eligible for a reduced rate of withholding under a comprehensive income tax treaty even if it holds more than 10% of the stock of the REIT; is a publicly traded partnership, treated as a partnership, that is a withholding foreign partnership and would be a USRPHC if it were a U.S. corporation; or is designated as a qualified collective investment vehicle by the Secretary of the Treasury and is either fiscally transparent or is required to include dividends in its gross income but is entitled to a deduction for distributions to its investors. However, withholding will still apply to the extent an investor in such entity holds, directly or indirectly, more than 10% of the REIT stock. This exception became effective Dec. 18, 2015.

Exemption from FIRPTA for Qualified Foreign Pension Funds

The Act exempts from FIRPTA tax any USRPI held by, and any distribution received from a REIT by, a qualified foreign pension fund (directly or indirectly through one or more partnerships) or a foreign entity wholly owned by a qualified foreign pension fund. To be qualified, the pension fund must, among other requirements, have no single participant or beneficiary with a right to more than 5% of its assets or income. This change generally applies to dispositions and distributions after Dec. 18, 2015, and should facilitate U.S. real estate-related investments by both private and governmental foreign pension plans.

Extension of RIC Qualified investment Entity Treatment Under FIRPTA

Interests in "qualified investment entities" are subject to special rules under FIRPTA. Except for shareholders who own no more than 5% of a class of stock that is regularly traded on an established market in the U.S., foreign shareholders are generally subject to tax under FIRPTA on distributions from a qualified investment entity to the extent they are paid out of gain derived by the entity from sales of interests in U.S. real property. Gain realized by a foreign shareholder on the disposition of an interest in a qualified investment entity that is "domestically controlled" is not subject to FIRPTA tax. Qualified investment entities include REITs and, until Dec. 31, 2014, included RICs. The Act retroactively and permanently includes RICs as qualified investment entities.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.