As many of you already know, Section 897 of the Internal Revenue Code imposes taxation on the disposition of U.S. real property interests held by foreign individuals or foreign corporations by treating those persons as engaged in a trade or business within the U.S. and the gain from the disposition as effectively connected with a U.S. trade or business. This is known as the FIRPTA tax since Section 897 was added to the IRC by the Foreign Investment in Real Property Tax Act of 1980. U.S. real property interests also include interests in domestic entities such as REITs. The tax is collected by withholding by the transferee of the interest of 10 percent of the amount realized by the transferor.
Last month both the U.S. House of Representatives and the Senate passed legislation which would help encourage more foreign investment in U.S. real estate. H.R. 2989, the Real Estate Jobs and Investment Act of 2011 was passed by the House of Representatives on September 21, 2011 and referred to the Ways and Means Committee. This bill is similar to H.R. 5901, which was passed by the House in 2010. S. 1616, also entitled the Real Estate Jobs and Investment Act of 2011 and similar in content to H.R. 2989, was passed by the Senate on September 22, 2011 and referred to the Committee on Finance.
The changes to Section 897 proposed by these two bills represent the most significant changes to FIRPTA since its enactment over 30 years ago. These two bills increase the amount of stock that a foreign investor can hold without triggering the FIRPTA tax. Presently, a foreign investor owning 5 percent or less of a publicly traded U.S. real property company, including a REIT, is exempt from the FIRPTA tax on the sale of that stock. A foreign investor owning 5 percent or less of a publicly traded REIT is also exempt from the FIRPTA tax on the receipt of a capital gain distribution attributable to the sale or exchange of a U.S. real property interest. This threshold is increased from 5 percent to 10 percent and is also applied to investors in certain widely held “qualified collective investment vehicles.”
Where the two bills differ is how they approach the issue of determining the qualification of the collective investment vehicle. The House bill uses the approach taken in existing tax treaties of looking through the investment vehicle to the individual investors. The Senate bill looks to whether the “qualified collective investment vehicle” is eligible for benefits under a comprehensive income tax treaty with the U.S. and can comply with certain reporting requirements with respect to its large owners.
For publicly traded REITs, this change will allow foreign investors to increase their investment in publicly traded REITs dramatically without subjecting themselves to FIRPTA.
There is also good news in the bills for private REITs and other private funds seeking to invest in U.S. real estate. The bills reverse IRS Notice 2007-55. Prior to the issuance of this notice, liquidating distributions from a REIT or redemptions of REIT stock generally were considered a sale of REIT stock and to a foreign investor, not subject to US tax. Notice 2007-55 concluded that, solely for foreign shareholders, these transactions should be treated as capital gain distributions subject to FIRPTA and possibly the branch profits tax. Prior to the issuance of the notice, there appeared to be no reason for foreign investors to believe that these transactions should be treated as anything other than sales of stock. Consequently, this change in IRS position severely constrained foreign investment in U.S. real estate.
The bills clarify that liquidating distributions or redemptions by REITs are treated as sales of stock. This simple change should unleash foreign investment that was constrained by the uncertainty created by Notice 2007-55.
Given the historical importance of foreign investment to the US economy, these bills are welcome news in these challenging times. If enacted, the bills are likely to generate sizeable new investments in U.S. REITs.
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