February 5, 2015
Obama FY 2016 Budget on REITs and Real Estate Investment
On February 2, 2015, the Obama Administration released its Fiscal Year (FY) 2016 budget proposal (the Budget). The President's budget reflects the Administration's priorities and is generally viewed as the opening bid in negotiations with the Congress, which is currently controlled by the Republican party.
Several proposals in the Budget relevant to REIT-based real estate investment are highlighted below. For further information about these and the other tax provisions in the FY 2016 Budget, see the General Explanations of the Administration's Fiscal Year 2016 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.
While no legislative language is currently available, 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. A similar provision was included in the Administration’s FY 2015 Budget, and statutory language was included in a discussion draft released by former Senate Finance Committee Chair Max Baucus (D-MT). The FY 2016 Budget proposal would be effective for dispositions of U.S. real property interests occurring after December 31, 2015. The provision is scored as costing about $2.4 billion over 10 years.
Repeal of Preferential Dividend Rule for Publicly Offered REITs
The existing preferential dividend rule can lead to the loss of the dividends paid deduction, or even the loss of REIT status for a REIT's inadvertent error, or "foot fault," in distributing dividends. The Administration proposes to repeal the preferential dividend rule for both listed REITs and public non-listed REITs. The Treasury Department would also be given explicit authority to provide for cures of inadvertent violations of the preferential dividend rule when it continues in effect and, when appropriate, to require consistent treatment of shareholders.
This proposal is similar to one included in the Administration's previous three budgets. The revenue score for enactment of this provision would be negligible.
Limit Like Kind Exchange Rules for Real Property
Under section 1031 of the Internal Revenue Code, no gain or loss is recognized when business or investment property is exchanged for "like kind" business or investment property. President Obama’s FY 2015 Budget proposal included a provision that would have limited the deferral of gain from real property like kind exchanges to $1 million (indexed for inflation) per taxpayer per taxable year. In December 2014, NAREIT and a coalition of real estate industry groups had sent a letter to President Barack Obama requesting that his Administration’s FY 2016 Budget proposal omit the FY 2015 like kind exchange proposal. However, the FY 2016 Budget again includes the FY 2015 Budget’s like kind proposal regarding real estate exchanges. It also would eliminate like kind treatment for art and collectibles. This proposal would be effective for like kind exchanges completed after December 31, 2015. The provision is scored as raising $19.5 billion over 10 years.
Impose Financial Fee on Large Bank and Non-bank Financial Firms
The Budget would assess a financial fee of seven basis points on certain liabilities of banks, bank holding companies and "nonbanks," such as insurance companies, savings and loan holding companies, exchanges, asset managers, broker-dealers, specialty finance corporations and financial captives with worldwide consolidated assets of $50 billion or more. Although no legislative language is currently available, according to the Treasury Department, "[t]he financial fee is designed to reduce the incentive for large financial institutions to leverage, reducing the cost of externalities arising from financial firm default as a result of high leverage." It would be effective as of January 1, 2016 and is scored as raising $112 billion over 10 years.
Impose 14% Tax on Accumulated Foreign Earnings and 19% on Future Foreign Earnings
The FY 2016 proposes a one-time 14% tax on accumulated foreign earnings of controlled foreign corporations that were not previously subject to U.S. tax. The proposal would be effective on the date of enactment and would apply to earnings accumulated for taxable years beginning before January 1, 2016. The tax would be payable ratably over five years.
Further, effective for taxable years beginning after December 31, 2015, under the FY 2016 Budget, certain future foreign earnings would be subject to minimum U.S. tax rate of 19% regardless of whether repatriated to the U.S. Together, these provisions are scored as raising about $474 billion over 10 years.
Require Mark-to-Market Accounting for Certain Derivative Contracts and Require Current Inclusion of Market Discount
The FY 2016 Budget would require that gain or loss from a derivative contract be marked to market yearly. A derivative contract would include any contract the value of which is determined, directly or indirectly, in whole or in part, by the value of actively traded property. A derivative contract that is embedded in another financial instrument or contract would be subject to mark to market if the derivative by itself would be marked to market. Business hedging transactions would be exempt from the mark to market proposal. This proposal would raise approximately $19.8 billion over 10 years and would apply to contracts entered into after December 31, 2015. This proposal is a narrower version of a similar provision in H.R. 1 from the last Congress (the fundamental tax reform bill introduced by then-Chairman Dave Camp (R-MI)). It is not clear how this proposal would apply to many ordinary business transactions, such as "To Be Announced" contracts to purchase mortgage-backed securities issued by Fannie Mae, Freddie Mac, and Ginnie Mae in connection with the financing of single family homes.
In addition, the FY 2016 Budget generally would require current inclusion in income of "market discount" (basically the difference between a debt instrument's purchase price on the secondary market and its stated redemption price at maturity). Market discount generally arises when a bond is purchased at less than its principal amount because either interest rates have increased or the creditworthiness of the borrower has declined (e.g., in the case of "distressed debt"). In the case of distressed debt, an upper limit would be placed on the amount of market discount included in current income. The proposal is scored as raising $391 million over 10 years and would apply to debt securities acquired after December 31, 2015.
Impose Corporate Tax on Publicly Traded Partnerships Invested in Fossil Fuels
Publicly traded partnerships (also known as "master limited partnerships," or PTPs) are generally subject to the corporate income tax. However, if they derive at least 90% of their gross income from depletable natural resources (including fossil fuels) or real estate or commodities, they are taxed as partnerships.
As one of the parts of the Administration’s larger goals of ending subsidies to fossil fuels because it believes that the subsidies result in market distortion "detrimental to long-term energy security ... inconsistent with the Administration’s policy of supporting a clean energy economy, reducing our reliance on oil, and reducing greenhouse gas emissions," the Budget proposes to tax PTPs that invest in fossil fuels as corporations. This provision would be effective after December 31, 2020 and is scored as raising $1.7 billion over 10 years. The proposal would not affect PTPs that earn other types of qualifying income, such as that from real estate.
For further information, please contact NAREIT's Senior Tax Counsel, Dara Bernstein, at firstname.lastname@example.org or NAREIT's Executive Vice President & General Counsel, Tony Edwards, at email@example.com.