Real Estate Investment and Jobs Act of 2015: The Arrival of FIRPTA Reform
By the WeiserMazars Tax Practice Board
A foreign person that is neither engaged in the conduct of a United States trade or business nor considered a U.S. resident based on the substantial presence test is typically not subject to U.S. tax on capital gains from U.S. sources. However, the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) generally treats a foreign person’s gain or loss from the disposition of a U.S. real property interest as income effectively connected to a U.S. trade or business. Consequently, the gain or loss is subject to taxation in the U.S. at applicable income tax rates. Such treatment is inconsistent with most other U.S. investments by foreign persons.
The recently introduced Real Estate Investment and Jobs Act of 2015 (H.R. 2128), and its companion bill S.915, mark an important development in the bipartisan effort to reform the FIRPTA rules. The bipartisan proponents of the two bills contend that expanding the exemptions to FIRPTA and clarifying the application of certain FIRPTA provisions that apply to REITs and their shareholders will lead to increased foreign investment in U.S. real estate.
H.R. 2128 exempts “qualified foreign pension funds” and entities wholly owned by such funds from FIRPTA taxation, thus equalizing the tax treatment of domestic and foreign pension funds on the disposition of U.S. real property interests. To be “qualified,” a foreign pension fund generally must (i) be subject to government regulation and certain reporting requirements in its jurisdiction, (ii) not have any beneficiary owning a greater than 5 percent interest, and (iii) offer certain tax benefits with respect to either contributions or investment income in its jurisdiction.
With respect to stock exchange-listed U.S. REITs, H.R. 2128 seeks to expand the FIRPTA exemption available to small foreign “portfolio investors.” Under the current law, foreign investors owning 5% or less of a publicly traded REIT are not subject to FIRPTA taxation upon a sale of the REIT’s stock or upon the receipt of a capital gain dividend from the REIT. If enacted, the bill would increase this ownership threshold exception to 10%, bringing the FIRPTA regime in alignment with the definition of a portfolio investor utilized in most U.S. tax treaties.
The bill would also clarify the determination of the “domestically controlled” exception to REIT taxation. Under current law, gain resulting from the sale or disposition of stock of a domestically controlled REIT (one with at least 50% percent of the stock held by U.S. persons) is not subject to FIRPTA taxation. However, in many cases publicly traded REITs have been unable to take advantage of this exception due to a lack of information required to determine the domestic or foreign status of their “small” shareholders. The bill provides that stock exchange-listed U.S. REITs may consider all shareholders owning less than 5% of the stock as U.S persons unless the REIT has actual knowledge to the contrary. In addition, stock in a REIT held by an upper-tier entity that is either a publicly traded REIT or a regulated investment company (RIC) will be treated as held by a foreign person unless the upper-tier REIT or RIC itself is domestically controlled. These proposed reforms will provide certainty to both foreign investors and the IRS as to the domestic status of an investment in U.S. REITs and clarification for the administration of U.S. tax law.
In its current state, FIRPTA taxation generates a significant deterrent to foreign investment in U.S. real estate which unintentionally drives potential foreign real estate investment to other U.S. industries or to real estate opportunities abroad. These FIRPTA reforms also represent a substantive, bipartisan effort to attract significant foreign investment capital into U.S. REITs. Such capital will enable REITs to pay off outstanding loans, increase investment in building and infrastructure, and purchase other assets.