Its Crystal Tide Ever Flowing: The United States Revises its REIT Rules
to Encourage Capital Flows in the Real Property Sector
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Recently, I was fortunate to have been asked to attend a Lyceum Associates,
roundtable discussion on capital market opportunities for real estate investment
trusts (“REITs”). This roundtable featured several prominent international
property market experts, including Nick van Ommen and Fraser Hughes of the
European Public Realty Association (“EPRA”), Liz Peace of the British Property
Foundation (“BPF”), and Lachlan Gyde of the Asian Public Real Estate Association
(“APREA”). These experts, among others, have been lobbying for the creation
of REIT vehicles in Germany and the United Kingdom, as well as throughout
Europe and the Far East. Fraser and Liz, among others, have been lobbying
for the creation of REIT vehicles in Germany and the United Kingdom, as
well as throughout Europe. They each cited numerous statistics supporting
their position that these vehicles substantially increased local commercial
property values by allowing institutional investors (and others) to gain
readily-tradable real estate exposure through the capital markets.
|“These revisions are intended
to even further increase REIT flexibility and encourage non-United
States investors to invest in the U.S. real property sector…”
In light of the current efforts of EPRA and BPF, it is worthwhile to
examine recent United States revisions to its REIT laws (probably the most
advanced in the industrialized world). These revisions are intended to even
further increase REIT flexibility and encourage non-United States investors
to invest in the U.S. real property sector by lessening the instances in
which such persons will be subject U.S. taxes on their REIT investments.
These changes, long-sought by the real estate industry, were enacted as
part of the American Jobs Creation Act of 2004 (the “Jobs Act”),2
and are generally effective for tax years beginning after October 22, 2004.
The U.S. rules relating to REITs are extremely complex and will not be
covered in any depth in this article. In general, REITs are treated in the
same manner as regular corporations with one major exception. If stringent
requirements on shareholder diversification, asset composition, income source
and activities, as well as distributions, are met in a given year, the REIT
is entitled to claim a dividends-paid deduction.3
In general, since most REITs pay dividends equal to their REIT taxable income,
the dividend paid deduction has the effect of wiping out any income at the
REIT. Therefore, generally REITs will not be subject to U.S. federal income
tax. When a REIT can distribute pre-tax income without tax withholding to
a non-U.S. investor, the attractiveness of the REIT securities is greatly
Background On U.S. Rules Affecting Real Property Investments by Non-U.S.
There are two sets of tax rules affecting non-U.S. persons who invest
within the United States. The first set of rules affect foreign persons
who do not, directly or through a pass-through entity (such as a partnership),
engage in a trade or business within the United States.4
The second set of rules govern the taxation of foreign persons who have
income or loss from the conduct a trade or business within the United States.5
The U.S. tax rules affecting non-U.S. persons who invest (but do not
do business) within the United States begin with the so-called “source rules.”6
In general, non-U.S. persons who derive income from U.S. sources are subject
to a 30% (or less if reduced by an applicable income tax treaty) tax on
the gross amount of such income.7
These rules, however, do not impose a tax on gain from so-called capital
transactions (even if the capital transaction occurs in the U.S.). Capital
transactions generally include a sale or exchange of property. Thus, these
rules mostly capture U.S. tax on rent (including real property rents), dividends
(including REIT dividends), interest and royalties.8
The trade or business rules tax income, wherever earned, that is attributable
to a United States trade or business or, if an income tax treaty applies,
that is attributable to a permanent establishment located in the United
In practice, there is usually not much difference between the trade or business
and permanent establishment standards. It is at this point, however, where
our inquiry starts to get somewhat complicated. On one hand, the U.S. Tax
Code contains very liberal rules that allow non-U.S. persons to trade in
U.S. securities and commodities from within the United States without being
treated as engaged in the conduct of U.S. trade or business (or having a
permanent establishment if a tax treaty applies).10
This complete exemption was considered justified because of the importance
of attracting foreign funds to the United States capital markets. On the
other hand, gains from the disposition of real property located within the
United States are always treated as gains recognized in the conduct of a
U.S. trade or business, even if the activity simply consists of holding
undeveloped real estate.11
These latter rules are known as the FIRPTA rules, after the Congressional
Act (the Foreign Investor in Real Property Tax Act) that created them.
Publicly-traded REITs have aspects of both regimes – their stock looks
and feels like securities, but at the same time they are quasi pass-through
entities engaged in a trade or business that Congress has decided should
be subject to tax as such. Prior to the Jobs Act, in general, foreign holders
of U.S. REITs were taxed under the onerous rules that govern the taxation
of investments in U.S. real property and not under the beneficial rules
that govern the taxation of securities transactions, even if the REIT was
Specifically, the pre-2005 rules required that REITs withhold U.S. tax on
distributions of gain from the sale of real property held by the REIT. Gain
from the sale of stock in a REIT was likewise subject to withholding tax
(unless the REIT was controlled by U.S. persons) or the REIT stock was regularly
traded on an established securities market and the shareholder owned 5%
or less of such class of stock.13
Certain Rules for Publicly-Traded REITs are Conformed to the Stock and
Commodity Trading Rules
In general, there are three types of income or gains that can be realized
with respect to an investment in a REIT. First, there are ordinary income
distributions, which represent distributions of net rent or net interest
on property or mortgages held by the REIT. Second, there are capital gain
distributions which generally represent gains from the dispositions of real
property or mortgages held by a REIT. Last, there can be market gains earned
upon a disposition of stock in the REIT. This section discusses how these
potential sources of income from a REIT investment are tax following the
passage of the Jobs Act.
Gains from the Disposition of Real Property
Under the new rules, if a REIT makes a distribution of gain attributable
to a disposition of real property, such distribution will be treated as
an ordinary income distribution (see B below) if shares of the REIT are
“regularly traded on an established securities market located in the United
States” and the shareholder owned 5% or less of the class of the REIT’s
shares upon which the distribution is made at all times during the taxable
Neither the statute nor legislative history elaborate on either (i) the
established securities market standard or (ii) who should be treated as
the shareholder should be for this purpose. Analogous rules, however, provide
assistance in their interpretation.
The phrase “established securities market” is also used in the dividend
taxation rules as a condition for certain foreign equity securities to pay
For this latter purpose, an established securities market includes a “national
securities exchange that registered under section 6 of the Securities Exchange
Act of 1934 or on the Nasdaq Stock Market.16
The IRS has reserved on whether the OTC Bulletin Board and the electronic
pink sheets qualify as established securities markets.17
It is worth noting, however, that such reservation applies to stocks that
are required to be actively traded and the REIT rules do not require active
trading of the REIT shares. In addition, the U.S. tax straddle rule define
an “established financial market” to include national securities exchanges,
Securities Act sponsored inter-dealer quote systems, inter-bank markets
and inter-dealer markets.18
This standard, which seems fairly similar on its face to the “established
securities market” standard, leaves some room for private equity transactions
as it picks up some smaller markets.
In addition, if the “shareholder” is determined at the investor/partner
level of a tax-transparent investment fund, it might be possible for an
overseas hedge fund to own a substantial position in a REIT, provided that
the remaining stock is considered to be publicly-traded. Support for this
position is found in the withholding rules which, absent satisfaction with
a special procedure, treat the owners of a foreign partnership as the payees.19
For example, assume a European hedge fund has 20 equal partners, each with
a 5% capital and profits interest in the fund. Since the withholding tax
exemption applies if the “shareholder owns less than 5%, in theory, the
fund could acquire up to 99% of the REIT’s stock (99% ÷ 20 = 4.95%), provided
that the remaining 1% of the REIT’s stock was regularly traded in some NASDAQ
Regardless of how these two standards are ultimately determined, the
rules as written certainly offer opportunities for PIPES transactions. In
more complex situations, it might be possible to apply for an IRS private
Distributions of Operating Earnings
As noted above, the starting point for REIT taxation is the premise that
they are corporations. Accordingly, notwithstanding that a REIT effectively
passes through all of its operating income through the mechanism of the
dividends paid deduction, REIT distributions, other than capital gain dividends,21
do not retain the character of the income earned by the REIT. Accordingly,
such dividends are subject to the 30% withholding tax imposed on income
not earned in connection with the conduct of a trade or business (or such
lesser rate as may be imposed by treaty). Many income tax treaties to which
the United States is a party provide for a beneficial rate of rate on dividend
income although certain treaties contain more onerous rules for REIT dividends.22
The Jobs Act did not make any changes to these rules. It is important to
note that the REIT rules require a REIT to distribute at least 90% of its
operating income (although a REIT must distribute 100% of its REIT taxable
income to avoid corporate tax.23
Accordingly, earnings reinvestment is not an option to avoid this problem,
but there are planning techniques to ameliorate the impact of this burden.
|“…the U.S rules offer an important
model for the laws of other countries seeking to attract foreign
capital to their real estate markets.”
The rules relating to market gains have been expanded by the Jobs Act
(although the rule for REITs was not changed by the Jobs Act). Specifically,
after the Jobs Act revisions, the disposition of an interest in either a
REIT or a regulated investment company (a registered mutual fund) (a “RIC”)
will not be subject to the FIRPTA rules or any other U.S. taxes provided
that the REIT or RIC is “domestically controlled.” The domestically controlled
standard is met when less than 50% of the value of the company’s stock has
been owned, directly or indirectly, by foreign persons during the testing
The testing period is the 5-year period ending on the date of the distribution.25
The rules relating to RICs expire at the end of 2007.26
If a REIT cannot be structured to be publicly-traded, then the market-gain
rule will limit the amount of equity that non-U.S. investors can hold in
the REIT without being subject to U.S. tax. Using our foreign investment
fund example above, the maximum amount of REIT stock that could be held
by the foreign fund would be less than 50%, if the ultimate disposition
strategy was a disposition strategy was to sell the stock of the REIT rather
than having the REIT sell its holdings. If these limitations turn out to
be practical limitations, the REIT could consider raising preferred equity
capital, rather than indebtedness, from U.S. finance parties to increase
the value of the REIT held by U.S. persons.
Other Capital Market Provisions of the Jobs Act Affecting REITs
The Jobs Act adds a provision to the REIT rules specifying that hedge
gains will not be counted for purposes of satisfaction of the REIT income
tests if the hedge is incurred to reduce risk on indebtedness incurred to
acquire or hold real estate assets.27
This provision frees up a REIT to engage in the most advantageous hedging
strategies without worrying about whether such hedging would result in a
loss of REIT qualification. The new rule does, however, require that the
REIT clearly identify the hedging transaction as such when it is acquired.
The existing REIT rules impose rules relating to the composition of the
assets of the REIT. Under one such limitation (the “75% Asset Test”), at
least 75% of the REIT’s assets must be composed of real estate assets, cash
and Government securities.28
A sub-rule under the 75% Asset Test requires that the securities of any
single issuer do not have a value of more than 10% of the total securities
of any single issuer.29
The Jobs Act amended to the REIT rules to provide that partnership interests
are not treated as securities for this purpose and that the REIT is treated
as owning its proportionate share of any assets held by the partnership.30
Also, debt issued by a partnership will not be treated as a security to
the extent of the REIT’s interest in the partnership and, regardless of
the REIT’s interest in the partnership, debt issued by a partnership will
be excluded from the 10% concentration test if at least 75% of the partnership’s
gross income is REIT-qualified income.31
As the traditional capital markets and the real estate capital markets
continue their march towards convergence, Congress continues to amend the
U.S. REIT rules to facilitate opportunities for real estate investment and
financing transactions. Given the success that these vehicles have had in
the United States, it is reasonable to expect that other countries will
continue to mimic the U.S. rules for their own domestic markets. Accordingly,
the U.S rules offer an important model for the laws of other countries seeking
to attract foreign capital to their real estate markets.
1 An alternative to traditional Wall Street
research firms, Lyceum brings together institutional investors to debate
actionable ideas with leading economic thinkers and industry experts. It
executes this through small workshops and roundtables, and through its newsletter
Perspectives, which drives the content of the workshops, filters
debate into actionable ideas, and showcases commentary by fellow investors
and industry experts. Lyceum Associates, Inc. is a registered investment
adviser. For more information, contact Sydney Williams (email@example.com).
2 P.L. 108-357, 108th Cong., 2d Sess. (2004).
3 Code §§ 561, 856(b)(2)(B).
4 See Section 881(a) of the Internal
Revenue Code of 1986, as amended (the “Code”).
5 Code §§ 871(b), 882(a).
6 See Code §§ 861 through 864.
7 Code §§ 871(a), 881(a).
8 A nonresident alien or foreign corporation
may elect to treat rents as effectively connected to a U.S. trade or business
and thereby become subject to regular federal income tax on net rents. Code
§§ 871(d)(1), 882(d)(1). In addition, a non-U.S. person is not subject to
withholding on portfolio interest. Code §§ 871(h), 882(c).
9 Code §871(b), 882.
10 Code § 864(b)(2).
11 Code § 897(a).
12 See Section 897(h)(1) of the Internal Revenue
Code of 1986, as amended and in effect prior to the passage of the Jobs
Act (the “pre-2005 Code”).
13 Pre-2005 Code §§ 897(c)(3), (h)(2).
14 Code § 897(h)(1).
15 Code § 1(h)(11)(C)(ii).
16 Notice 2003-71, 2003-43, IRB 1; Notice 2003-79,
§3.03(a), 2003-50 IRB 1; Notice 2004-71, 2004-45, IRB 1.
17 Notice 2003-71, supra.
18 Treas. Reg. § 1.1092(d)-1(b).
19 Treas. Reg. § 1.1441-5(c)(1)(i).
20 In addition, the REIT would have to ensure
that it does not become closely held within the meaning of Code § 856(a)(6).
21 See Code § 857(b)(3)(C).
22 See, for example, art. 10(2) of
Convention between the Government of the United States of America and the
Government of the French Republic for the avoidance of double taxation and
the prevention of fiscal evasion with respect to taxes on income and capital
(1994) as amended by Protocol (2004); art. 10(3) of Convention between the
Government of the United States of America and the Government of the Kingdom
of Denmark for the avoidance of double taxation and the prevention of fiscal
evasion with respect to taxes on income (1999).
23 Code § 857(a)(1).
24 Code § 897(h)(2).
25 Code § 897(h)(4)(D). If the entity
has not been in existence for 5 years, such shorter period is used.
26 Code § 897(h)(4)(A)(i)(II).
27 Code § 856(c)(5)(G).
28 Code § 856(c)(4)(A).
29 Code § 856(c)(4)(B)(iii)(III). Treasury
Regulation § 1.856-3(g) provided a similar rule for other asset tests prior
to the passage of the Jobs Act.
30 Code § 856(m)(3)(A).
31 Code § 856(m)(3)(B).
This article will appear in 7 Derivatives 1 (January 2006). Copyright
2006 RIA. Reprinted with permission. All rights reserved.
This Alert was written
Mark Leeds in the New York
office. Please contact Mr. Leeds at 212.801.6947 or your Greenberg Traurig
liaison, if you have any questions regarding the subject matter of this
© 2005 Greenberg Traurig
For more information, please review our Tax Practice description, or
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