Obama Budget Calls for Corporate Tax Reform and Includes Several Provisions Relevant to REITs
On April 10, the Obama Administration released its Fiscal Year (FY) 2014 budget proposal (the Budget). Both the House and the Senate have previously passed their own, separate budget blueprints for FY 2014. The President's Budget reflects the Administration's priorities, including calling on Congress to enact revenue-neutral corporate tax reform.
NAREIT is pleased to highlight below four constructive items in the Budget related to REIT-based real estate investment. For further information about these and the other tax provisions in the FY 2014 Budget, see the General Explanations of the Administration's Fiscal Year 2014 Revenue Proposals.
Exempt Foreign Pension Funds from FIRPTA
Under current law, gains of foreign investors from the disposition of U.S. real property interests are generally subject to U.S. tax under FIRPTA, except in the following cases: 1) portfolio investments of not more than 5% of a listed U.S. real estate corporation's stock, including that of a listed REIT, and, 2) sales of stock in a REIT if most of its shareholders are U.S. persons. Additionally, 2007 IRS guidance overturned long-standing policy that treated REIT liquidating distributions and redemptions as sales of stock rather than property distributions, thus making them subject to FIRPTA. On the other hand, gains of U.S. pension funds from the disposition of U.S. real property interests (including interests in real estate corporations such as REITs) are generally exempt from U.S. tax.
During the 112th Congress, legislation was introduced in the House by Representatives Kevin Brady (R-TX) and Joe Crowley (D-NY), and in the Senate by Senators Bob Menendez (D-NJ) and Mike Enzi (R-WY), that generally would have increased the current "portfolio investor" exception for sales of stock and capital gains dividends of listed REITs from 5% to 10%, and overturned the 2007 IRS guidance. The 112th Congress adjourned without enacting these proposals.
While no legislative language is currently available, the Budget appears to take a positive, though slightly different, approach than the previously introduced legislation. The Budget would exempt from U.S. tax under FIRPTA certain gains of foreign pension funds from the disposition of U.S. real property interests. It appears that the Budget's proposal should apply to both direct investments by foreign pension funds in U.S. real property and in both listed and non-listed REITs, regardless of the ownership percentage of the foreign pension plan or other shareholders in such investments. The proposal would be effective for dispositions of U.S. real property interests occurring on or after the date of enactment.
Repeal of Preferential Dividend Rule for Publicly Offered REITs
The preferential dividend rule has the potential of causing loss of the dividends paid deduction for a REIT's inadvertent error in distributing dividends and in some cases even loss of REIT status. For distributions that are made (without regard to Code section 858) in taxable years beginning after the date of enactment, the President's Budget once again proposes to repeal the preferential dividend rule for "publicly offered" REITs. The "publicly offered" REIT term would mean, as of the distribution date, a REIT that is either publicly traded or:
1) the REIT was required to file annual and periodic reports with the Securities and Exchange Commission under the Securities Act of 1934;
2) not more than one-third of the voting power of the REIT was held by a single person (including any voting power that would be attributed to that person under the rules of I.R.C. section 318); and,
3) either the stock with respect to which the distribution was made is the subject of a currently effective offering registration, or such a registration has been effective with respect to that stock within the immediately preceding 10-year period.
It also would grant authority for the Treasury Department "to provide for cures of inadvertent violations of the preferential dividend rule" in situations with respect to which it continues in effect.
This proposal is identical to one included in the Administration's FY 2013 budget (FY 2013 Budget). Previously, the Administration had proposed repealing the preferential dividend rule for publicly traded REITs. However, beginning in its FY 2013 Budget, and continuing in the Budget released on April 10, the proposal has been expanded to repeal the rule for all publicly offered REITs, including public non-listed REITs. The proposal is presumably a response to NAREIT's past discussions with, and submissions to, Treasury officials in connection with NAREIT's request for a repeal of the rule for all REITs required to register their securities with the Securities and Exchange Commission (publicly offered REITs), consistent with a similar rule for regulated investment companies enacted in 2010.
Reform of Low Income Housing Tax Credit (LIHTC) Program and Modifications to Make LIHTCs "Beneficial" to REITs
As was proposed in the FY 2013 Budget, the President's FY 2014 Budget proposes a number of reforms to the existing LIHTC program in order to serve households in greater need and to provide incentives for creating mixed-income housing. By way of background, Congress enacted the LIHTC program about twenty-five years ago to incentivize investment in affordable rental housing. Qualified developers may receive awards of LIHTCs. Typically through limited partnership interests, developers raise equity capital from investors who utilize the tax credits. Limited partnerships pass through LIHTCs to their limited partners who use the LIHTCs to offset tax liability.
Because REITs are not pass-through entities like partnerships, they are not permitted to pass through LIHTCs to shareholders under current law. In order to increase demand for LIHTCs by REITs, the Administration proposes to make LIHTCs beneficial for REITs by allowing REITs to designate as tax-exempt some of the dividends they distribute. Under this proposal, a REIT would calculate the maximum amount of dividends that it could designate as tax-exempt by dividing the REIT's LIHTCs for the year by the highest corporate tax rate.
For example, using the highest corporate tax rate of 35%, and assuming a credit of $35 to the REIT, the REIT would be entitled to designate up to $100 of its distributions as tax-exempt. Accordingly, the after-tax result for the REIT's shareholders would resemble the result as though the REIT had distributed both a taxable dividend and the LIHTCs as well. The proposal would be effective for taxable years of a REIT that end after the date of enactment.
Modify and Permanently Extend the Section 179D Deduction for Energy-Efficient Commercial Building Property Expenditures
The FY 2014 Budget proposes to modify and permanently extend the current section 179D tax deduction for energy-efficient commercial buildings expenditures. Notably, this proposal differs from a similar FY 2013 Budget proposal that would have converted this deduction to a credit. The FY 2014 proposal includes several reforms. First, it would increase the maximum deduction and the partial deduction that is available for the installation of energy-efficient commercial building property placed in service after calendar year 2013. In addition, the Administration would enable existing buildings to qualify for a deduction, based on "measured and verified" energy savings compared to their performance prior to a retrofit. Finally, page 22 of the Treasury Department's explanation of the FY 2014 Budget proposal includes the language that was included in the FY 2013 Budget proposal on this item about providing unspecified "special rules" "…to allow the credit [sic] to benefit a real estate investment trust or its shareholders."
Although no legislative language is yet available, the FY 2014 proposal appears to encompass improvements included in legislation introduced during the 112th Congress, S. 3591, the Commercial Building Modernization Act, by Senators Snowe (R-ME), Bingaman (D-NM), Feinstein (D-CA) and Cardin (D-MD), and supported by NAREIT and other members of the real estate, construction, lending, building products manufacture and supply, and energy efficiency communities.