The REIT PATH Forward – Mostly a Smooth Ride but Watch …

August 2016

The REIT PATH Forward ? Mostly a Smooth Ride but Watch Out for the Potholes

Overview

The Protecting Americans from Tax Hikes Act of 20151 (the "PATH Act"), signed by President Obama on December 18, 2015, does more than merely extend various expired tax provisions as most other "tax extender" laws have done in the past.2 In addition to the substantial modifications that apply to individual and small business taxpayers, the PATH Act introduces significant changes to provisions of the Internal Revenue Code of 1986, as amended (the "Code"),3 with respect to real estate investment trusts (REITs) and the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA).4

"If you want to succeed you should strike out on new paths, rather than travel the worn paths of accepted success." John D. Rockefeller

A REIT is a corporate investment vehicle for real estate that is comparable to a mutual fund. It allows both small and large investors to acquire ownership in commercial and residential real estate interests such as apartment complexes, hospitals, office buildings, timberland, warehouses, hotels and shopping malls. REITs have existed for more than 50 years5 in the US and are taxed in a manner that typically results in REITs offering higher dividend yields than regular corporations. Further, the same tax considerations that attract investors to public REITs likewise position private REITs as the

1 Protecting Americans from Tax Hikes Act of 2015 enacted as a small part ("Division Q") of the "Consolidated Appropriations Act, 2016," Pub. L. No. 114-113, the omnibus bill that allowed Congress to end its 2015 session. The primary legislative history for the PATH Act is the Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the Protecting Americans from Tax Hikes Act of 2015, House Amendment #2 to the Senate Amendment to H.R. 2029 (Rules Committee Print 114-40), (JCX-144-15), December 17, 2015 (hereinafter, "JCT Technical Explanation"). 2 The Working Families Tax Relief Act of 2004, signed into law October 4, 2004, retroactively extended through 2005 most expired business tax provisions. The Tax Relief and Health Care Act of 2006, signed into law December 20, 2006, extended through 2007 provisions that expired the previous year and some that were scheduled to expire that year and created some new temporary tax measures. The Emergency Economic Stabilization Act of 2008, Energy Improvement and Extension Act of 2008, and Tax Extenders and Alternative Minimum Tax Relief Act of 2008, signed into law October 3, 2008, renewed and created extenders. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, signed into law December 17, 2010, renewed extenders through the end of 2011, providing for a retroactive extension for provisions that expired at the end of 2009. The American Taxpayer Relief Act of 2012, signed into law January 2, 2013, renewed extenders through the end of 2013, providing for a retroactive extension for provisions that expired at the end of 2011. 3 Unless otherwise indicated, all "section" and "?" references are to the Internal Revenue Code of 1986, as amended, and all "Reg. ?" references are to regulations issued thereunder. 4 The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), enacted as Subtitle C of Title XI of the Omnibus Reconciliation Act of 1980, Pub. L. No. 96-499, 94 Stat. 2599, 2682 (Dec. 5, 1980). 5 Congress granted legal authority to form REITs in 1960 as an amendment to the Cigar Excise Tax Extension of 1960, enacted to amend ? 5701 of the Internal Revenue Code of 1954 with respect to the excise tax on cigars, and for other purposes, See Pub. L. No. 86-779, ? 10(a), 74 Stat. 998, 1004.

01

vehicle of choice for US real estate investments of global private equity firms and non-US financial investors.

FIRPTA was enacted by Congress as a means to tax the gains on foreign investors' income from the sale of US real property.6 The new law was also applied to investments in US companies whose predominate assets are real estate assets whether as investments or as part of business operations.7 As a result, it may arguably create disincentives to foreign investment in not only US real estate but in US infrastructure and other real estate intensive industries.8 The Obama administration, which actively supported FIRPTA reform, offered that "foreign investors including large foreign pension funds regularly cite FIRPTA as an impediment to their investment in US infrastructure and real estate assets."9

Provisions included in the PATH Act generally are favorable toward REITs and the taxation of foreign investors in US REITs, thereby somewhat modifying such tax disincentives of investing in the US real estate market. Such provisions benefit both existing and newly created REITs by reducing the incidence of FIRPTA on investments through this vehicle. These changes in law are expected to lead to increased foreign capital investment in US commercial real estate. According to Kenneth Rosen, chairman of the Fisher Center for Real Estate and Urban Economics at University of California, Berkeley, it has been estimated that as much as $20 billion to $30 billion10 of new capital will be invested in the US commercial real estate markets in the wake of the PATH Act's relaxation of FIRPTA.

This article provides a high-level overview of certain of the provisions in the PATH Act that impact REITs, including the revisions to the FIRPTA rules. A discussion of issues that have been identified requiring further legislative and regulatory guidance follows. The authors also offer their views on certain areas requiring caution in moving forward with the new rules absent further guidance.

Changes to Certain REIT Provisions

In general, a REIT is an entity that otherwise would be taxed as a US corporation but elects to be taxed under a special regime that permits it to get a deduction for dividends paid. To qualify as a REIT, the entity must satisfy several tests, including:

a) 75% and 95% of its gross income must be derived from real estate and passive-type sources, respectively;11 and

6 See H.R. Rep. No. 96-1167, 96th Cong. 2nd Sess. H.R. 7765 (1980). 7 See ? 897(c)(1)(A)(ii). 8 Evan J. Cohen, An Analysis of the 1984 Withholding Requirements Under the Foreign Investment in Real Property Tax Act: Are New Methods of Handling U.S. Real Estate Transactions on the Horizon, 8 J. Int'l L. 319; available at: . 9 The White House Proposal, The "Rebuild America Partnership": The President's Plan to Encourage Private Investment in America's Infrastructure. Released on March 29, 2013; available at . See also, Jeffrey D. DeBoer, Unlocking Foreign Investment to Fix U.S. Infrastructure: A Bridge to Bipartisanship | Commentary. Posted on Jun 12, 2014; available at: 10 Liz Moyer and Michael J. de la Merced, House Approves Bill to End Tax-Free Real Estate Spinoffs, The New York Times, Dec. 18, 2015, at B5. 11 ? 856(c)(3) and ? 856(c)(2).

02 The REIT PATH Forward

b) 75% of the value of its assets must consist of cash and cash items, real estate assets, and Government securities.12

A REIT is allowed a deduction for dividends paid, as defined in ? 561, in computing its taxable income for the year, preserving "a single layer" of taxation.13 A REIT must distribute at least 90% of its "real estate investment trust taxable income" for a taxable year, determined without regard to the deduction for dividends paid, to its shareholders in order to qualify as a REIT for such year.14 Any amounts not distributed to its shareholders is taxable at the REIT level. Additionally, certain distributions by REITs can be designated as capital gain distributions or qualified dividend income, which may be subject to special capital gain tax rates for individual shareholders and US withholding tax under the FIRPTA provisions for foreign shareholders, as discussed below. A REIT is not required to distribute its capital gain income.15 If it chooses to retain its capital gains, a REIT may pay tax on the retained capital gains and still maintain its REIT status.

The PATH Act makes substantial changes to certain areas of the REIT rules as described below. Most of the provisions make it easier for REITs to operate their businesses, provide REITs with more flexibility regarding the nature of their assets and/or income, and make REITs more attractive as investment vehicles for non-US taxpayers; however, a few provisions are more restrictive. These more restrictive provisions limit the ability of a corporation in certain situations to avail itself of the REIT regime and reduce the ability of REITs to engage in non-REIT activities. In addition, other provisions of the PATH Act tighten up some areas of the REIT tax law to provide more equitable results to shareholders and impose additional controls on the REIT's operations.

1.

Smooth Pavement ? Generally Favorable Changes to the Law

Changes to the Prohibited Transaction Safe Harbors

REITs are subject to tax of 100% of the net income derived from prohibited transactions.16 A prohibited transaction is a sale of property held as inventory or primarily for sale to customers in the ordinary course of a REIT's business.17 A sale will not be considered a prohibited transaction, however, if it meets certain safe harbor requirements.18 One of those requirements is that (i) the aggregate adjusted bases of property sold during the taxable year does not exceed 10% of the aggregate bases of all the assets of the REIT as of the beginning of the taxable year, or (ii) the aggregate fair market value of property sold during the taxable year does not exceed 10% of the fair market value of all of the assets of the REIT as of the beginning of the taxable year.19

The PATH Act helps REITs meet the safe harbor requirements by providing alternate safe harbor tests for the amount of certain assets that can be sold in a given year. The alternate safe harbor provides that a REIT may sell up to 20% of the aggregate adjusted bases or fair market value of its assets in a single year provided that its 3-year average adjusted bases or fair market value of assets

12 ? 856(c)(4)(A). 13 ? 857(b)(2)(B). 14 ? 857(a)(1). 15 ? 857(a)(1)(A)(i). 16 ? 857(b)(6)(A). 17 ? 857(b)(6)(B)(iii) and ? 1221(a)(1). 18 The safe harbor requirements are set forth in ? 857(b)(6)(C) and ? 857(b)(6)(D). 19 ? 857(b)(6)(C)(iii)( II), ? 857(b)(6)(C)(iii)( III), ? 857(b)(6)(D)(iv)(II), and ?

857(b)(6)(D)(iv)(III).

03 The REIT PATH Forward

sold does not exceed 10% on a lookback basis.20 This provision generally applies to taxable years beginning after December 18, 2015.21

Guidance needed: While the expansion of the 10% limitation on sales for the prohibited transaction safe harbor to allow a 3-year average of 10% and up to 20% of a REIT's portfolio to be sold in any one year is more favorable, a REIT's ability to rely on the new rule still remains unclear in some situations. In order for this safe harbor to apply, not only must these thresholds for percentage of the REIT portfolio sold be satisfied, but substantially all of the marketing and development expenditures with respect to the properties must be performed, now by a taxable REIT subsidiary (TRS)22, or an independent contractor from whom the REIT derives no income.23 There is currently no guidance on what "substantially all" means in this context. Until this prong of the prohibited transaction safe harbor is clarified, there may be risk associated with a REIT's reliance on the new safe harbor provisions.

In addition, even if all of the REIT's marketing and development expenditures are incurred by a TRS or independent contractor, there may still be uncertainty in computing the annual and 3-year average percentages of the portfolio sold. For example, do you look through partnerships? How is a sale of a partnership interest treated? And what happens if the entity has not been around for 3 taxable years? More guidance on these types of details would help REITs use the safe harbor more effectively.

Caution: The PATH Act provides favorable new rules in the safe harbor provisions for REIT prohibited transactions. These provisions, however, only address certain of the requirements needed in order to satisfy the safe harbor. A REIT seeking to rely on the safe harbors still needs to satisfy the other requirements as set forth in ? 856(b)(6)(C) or ? 856(b)(6)(D). If all safe harbor prongs cannot be satisfied, the REIT must satisfy a "facts and circumstances" analysis of whether its sales constitute dealer sales that will be subject to a 100% tax. Most REITs, therefore, are likely to still find themselves in a situation where they will need to rely on the specific facts and circumstances of each sale. The haven of the safe harbors, although now to some degree more attainable, may still not be completely achievable in many cases.

Repeal of the Preferential Dividend Rule for Publicly Offered REITs

As previously mentioned, a REIT is required to distribute 90% of its REIT taxable income on an annual basis.24 Generally a REIT is allowed a deduction for dividends paid if the distribution is (i) pro rata, (ii) with no preference to any share of stock as compared with other shares of the same class, and (iii) no preference to one class of stock as compared with another class except to the extent that the former is entitled to such preference.25 Distributions violating these requirements, regardless of whether the violation is inadvertent or de minimis, are considered "preferential dividends," and the dividends paid

20 ? 857(b)(6)(C)(iii)( II), ? 857(b)(6)(C)(iii)( III), ? 857(b)(6)(D)(iv)(II), and ? 857(b)(6)(D)(iv)(III). 21 PATH Act, ? 313(c). 22 See discussion under "Expansion of Ability to Use a TRS" below. 23 ? 857(b)(6)(C)(v). 24 ? 857(a)(1). 25 ? 857(b)(2)(B), ? 561(b), and ? 562(c)(1).

04 The REIT PATH Forward

deduction for such dividends is generally not allowed to REITs. The disallowance extends to the distribution in its entirety, subjecting a REIT to potential corporate income tax, payment of deficiency dividends or even loss of REIT status.

The PATH Act repeals the preferential dividend rule for publicly offered REITs effective for distributions made in tax years after December 31, 2014.26 A publicly offered REIT is a REIT that is required to file annual and periodic reports with the Securities and Exchange Commission.27 Prior to the PATH Act, a number of private letter rulings had been issued that ruled that a discount on a REIT's dividend reinvestment plan ("DRIP") would not be considered preferential if the discount did not exceed 5%.28 For publicly offered REITs, presumably this limitation for DRIP discounts is no longer applicable.

Privately held REITs are still subject to the preferential dividend rule. Congress recognized, however, that denial of the deduction for dividends paid was overly harsh in the case of small foot faults or comparable mistakes in the payment of dividends. The PATH Act grants the IRS authority to provide an appropriate remedy for violations of the preferential dividend rule by REITs that are not publicly offered that were inadvertent or resulting from reasonable cause.29

Guidance needed: As stated in the new statute, guidance may be forthcoming for inadvertent preferential dividends paid by non-publicly offered REITs.30 The REIT industry is keenly interested in such guidance as the lack of a de minimis threshold has caused much angst. It has not been unusual for REIT transactions to be delayed or restructured as a result of due diligence in which immaterial, yet near fatal, foot faults have been discovered. The National Association of Real Estate Investment Trusts has submitted suggestions for such guidance in hopes that the guidance will be coming soon.31

Application of Curative Provisions for Hedge Identifications

Although the REIT income tests are based on gross income as determined under ? 61, there are a number of items that may be disregarded for purposes of the REIT income tests even though they are includible in taxable income of the REIT.32 Income from transactions entered into to hedge risk of (1) interest rate changes with respect to a borrowing made or to be made to acquire or carry real estate assets or (2) currency fluctuations with respect to an item of income or gain that qualifies for the 75% or 95% gross income test may be excluded in calculating both the 75% and 95% income tests, if such hedging transactions are properly identified as tax hedges under the rules of ? 1221(a)(7).33 Among other requirements, the identification rules provide that a hedging transaction must be

26 ? 562(c)(1). 27 ? 562(c)(2). 28 PLR 9837008, PLR 9731007. 29 ? 562(e)(2). 30 ? 562(c)(1). 31 National Association of Real Estate Investment Trusts, Re: Notice 2016-26: Request for Comments Regarding Recommendations for Items that Should be Included on the 2016-2017 Priority Guidance Plan, May 16, 2016. 32 E.g., passive foreign exchange gain and real estate foreign exchange gain as provided in ? 856(n), discharge of indebtedness as provided in ? 108(e)(9), and items designated as such under the authority of ? 856(c)(5)(J)(i). 33 ? 856(c)(5)(G).

05 The REIT PATH Forward

clearly identified as such before the close of the day on which it is acquired, originated, or entered into, and identification must be unambiguous.34

Prior to the PATH Act, if a REIT inadvertently failed to properly identify a hedge, it was unclear whether, for purposes of the REIT income tests, the REIT could rely on the remedies for inadvertent identification failures set forth in the regulations under ? 1221. The PATH Act clarified that, for tax years beginning after December 31, 2015, a REIT may take into account the curative provisions provided in the regulations for purposes of determining the REIT income test treatment of hedge income.35

Expansion of Ability to Use a TRS

Subject to certain limitations, a REIT is able to own up to 100% of the stock of a corporate entity through which it may conduct activities that may be nonqualifying for REIT purposes. A REIT must jointly elect for such a corporation to be treated as a TRS of the REIT.36 When the TRS provisions were enacted,37 a TRS was permitted to perform many services for a REIT that previously were required to be performed by an independent contractor. Certain provisions of the Code requiring the use of independent contractors were, however, not modified.

The PATH Act modifies two such provisions to allow a TRS to provide certain services for the REIT effective for taxable years beginning after December 31, 2015. These provisions are as follows:

(i) A REIT was permitted to rely on one of the prohibited transaction safe harbors only if substantially all of the marketing and development expenditures with respect to the property were made through an independent contractor. The PATH Act expanded this requirement to allow a TRS to also provide such services.38

(ii) When a REIT acquires property through foreclosure, it may make an election to treat, for a limited time, the property as "foreclosure property."39 Income and gain from foreclosure property is qualifying income for the REIT income tests.40 This election would terminate, however, if after 90 days following the date the property was acquired by the REIT, the property were used in a trade or business that was not conducted by the REIT, other than through an independent contractor. The Path Act expanded this requirement to allow such trade or business to be conducted through a TRS.41

Debt Instruments of Publicly Offered REITs

As mentioned above, a REIT must meet certain asset and income tests. Under pre-PATH Act law, unsecured debt instruments of publicly offered REITs and interests in mortgages on interests in real property were not qualifying assets

34 Reg. ? 1.1221-2(f)(1), (4)(ii). 35 ? 856(c)(5)(G)(iv). 36 ? 856(l). 37 Real Estate Investment Trust Modernization Act, Part II, Subpart A of Public Law 106-170. 38 ? 857(b)(6)(C)(v). 39 ? 856(e)(5). 40 ? 856(c)(2)(F) and ? 856(c)(3)(F). 41 ? 856(e)(4)(C).

06 The REIT PATH Forward

under the 75% asset test and income from such assets was not qualifying income under the 75% income test.

Effective for tax years beginning after December 31, 2015, debt instruments issued by publicly offered REITs and interests in mortgages on interests in real property are qualifying assets for purposes of the 75% asset test.42 Income from debt instruments of publicly offered REITs, including gain from the sale of such instruments, does not qualify for the 75% income test, however, unless the income qualified for the 75% income test under pre-PATH Act law.43

Caution: The addition of unsecured publicly offered debt instruments to the definition of "real estate assets" for purposes of the REIT 75% asset test carries with it some cautions. These instruments now carry an unusual characteristic of being an instrument that qualifies as real estate for purposes of the REIT asset test, but unlike mortgages, REIT stock, and other qualifying real estate assets, the income generated by debt instruments of publicly offered REITs does not automatically qualify under the 75% income test. This disconnect lends itself to the potential for misclassification of the income by the unwary. To further add to the potential for misclassification, this exception only applies to debt instruments of publicly offered REITs. A perhaps more common investment by a REIT is an investment in debt instruments of REITs that are not publicly offered, e.g., a subsidiary REIT, since it is typical to partially fund subsidiary REITs with downstream loans. Such instruments continue not to qualify for the REIT 75% asset test.

Ancillary Personal Property

Under the general rule, rent received from a lease of personal property in connection with the lease of real property is treated as qualifying rental income if the amount of the rent attributable to personal property does not exceed 15% of the total rent received under the lease.44 Prior to the PATH Act, however, such ancillary personal property was not considered real estate for any other REIT purpose.

For tax years beginning after December 31, 2015, the PATH Act conforms the asset test to the income test for certain ancillary personal property that is leased with real property. Such personal property is treated as qualifying real estate for the 75% asset test if the rent attributable to that personal property is treated as rent from real property for the 75% income test.45 Furthermore, the PATH Act provides that an obligation secured by a mortgage on both real and personal property is treated as producing qualifying income for both of the income tests and as a qualifying real estate asset for the 75% asset test if the fair market value of the personal property is not more than 15% of the total fair market value of the personal property and real property combined.46

Caution: Although the change to the ancillary personal property rules to conform the asset test treatment to the income test treatment is generally a welcomed and logical change, it should be noted that no corollary was added to the statute

42 ? 856(c)(5)(B). 43 ? 856(c)(3)(H). 44 ? 856(d)(1)(C). 45 ? 856(c)(9)(A). 46 ? 856(c)(9)(B).

07 The REIT PATH Forward

to cause the gain from the sale of such personal property to be qualifying income for purposes of the REIT income tests. Therefore, the gain from sales of personal property, no matter how small in relation to the property as a whole, continues to be nonqualifying income for purposes of both the REIT 95% and 75% income tests. It should also be noted that the 15% threshold is a cliff. Thus once the value of the personal property exceeds 15%, the entire value of the personal property is treated as nonqualifying for the 75% asset test, not just the incremental percentage in excess of 15%.

Counteracting Hedges

As stated above, income from transactions entered into to hedge risk of (1) interest rate changes with respect to a borrowing made or to be made to acquire or carry real estate assets or (2) currency fluctuations with respect to an item of income or gain that qualifies for the 75% or 95% gross income tests may be excluded in calculating both the 75% and 95% income tests, if such hedging transactions are properly identified as tax hedges under the rules of ? 1221(a)(7).47

The PATH Act expands the scope of the exclusion to include income from positions that manage risk of a prior hedge in connection with the extinguishment or disposal, in whole or part, of the liability or asset associated with such prior hedge, if the new position qualifies as a hedging transaction under ? 1221(b)(2)(A) or would qualify if the hedged position were ordinary property.48 Such counteracting hedges have been the subject of private letter rulings.49 With the new statute, a request for a private ruling on such transactions is no longer necessary.

2.

Potholes ? Not-So-Favorable Changes to the Law

Restrictions on Tax-Free Spinoffs involving REITs

In order to qualify for tax-free treatment under the Code, a spinoff must meet certain requirements, including the requirement that the distributed corporation be engaged in the active conduct of a trade or business. In 2001, the IRS ruled that a REIT could satisfy the active trade or business requirement solely by virtue of functions engaged in with respect to its rental activity.50 More recently, the IRS issued a private letter ruling indicating that a REIT with a TRS could satisfy the active trade or business requirement by virtue of the active business of its TRS.51 Subsequently, an increasing number of operating companies attempted to structure tax-free REIT spinoffs in which a business conducted by a TRS was used to satisfy the active trade or business requirement. Section 355, related to tax free spinoffs, can generally be used to separate business activities into multiple entities, subject to certain requirements. Among other requirements, there must be a valid business purpose for the spinoff, both the distributing corporation and distributed corporation (referred to as the "controlled corporation") must be actively engaged in the conduct of a trade or business

47 ? 856(c)(5)(G) 48 ? 856(c)(5)(G)(iii). 49 See e.g., PLR 201406009, PLR 201527013. 50 Rev. Rul. 2001-29, 2001-1 C.B. 1348. 51PLR 201337007.

08 The REIT PATH Forward

 ................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download