December 8, 2015
Late last night, House Ways and Means Committee Chairman Kevin Brady (R-TX) introduced an amendment to a Senate-passed bill, H.R. 34, (the Act) that would extend generally through December 31, 2016 a number of tax provisions that traditionally have been extended for one- or two-year periods (generally referred to as extenders).
In addition, the Act would implement substantial reforms to the Foreign Investment in Real Property Tax Act (FIRPTA) that NAREIT has supported for many years as well as a number of REIT-specific tax modifications connected to both the 2012 NAREIT-supported U.S. REIT Act and “H.R. 1,” the 2014 comprehensive tax reform bill introduced by former House Ways and Means Committee Chairman Dave Camp (R-MI).
Here is the summary of the Act prepared by the House Ways and Means Committee.
The Act substantially incorporates the provisions of H.R. 2128, the Real Estate Investment and Jobs Act of 2015, as introduced by Chairman Kevin Brady and Representative Joe Crowley (D-NY). Notably, H.R. 2128 is sponsored by almost all of the Members of the House Ways and Means Committee. This part of the Act would make two significant specific changes to FIRPTA.
First, the Act includes a proposal that would increase the current "portfolio investor" exception for sales of stock and capital gains dividends of listed REITs from 5 percent to 10 percent, including for qualified non-U.S. collective investment entities investing in U.S. real estate. This provision, a version of which the House passed by a vote of 402-11 as a stand-alone bill in 2010 and which the Senate Finance Committee passed unanimously on Feb. 11, 2015, would conform the definition of "portfolio investor" for FIRPTA purposes to the definition used in U.S. tax treaties and which is applicable to foreign investment in U.S. debt securities. As noted here, REIT dividends paid to non-U.S. portfolio investors would remain subject to U.S. withholding (but not FIRPTA) tax.
Second, the Act would treat foreign pension funds the same as domestic pension funds under FIRPTA, therefore exempting investments from foreign pension funds from FIRPTA altogether, attracting investment from a large and growing source of foreign capital into the U.S. real estate market. This part of the Act is based on a proposal made by President Obama that has been included in his last two budget proposals.
The changes made by both FIRPTA-related provisions would be effective for dispositions and distributions made on or after the date of enactment.
U.S. REIT Act
The Act also includes most of the provisions of H.R. 5746, the Update and Streamline REIT Act (the U.S. REIT Act) that was introduced on May 12, 2012 by Representatives Pat Tiberi (R-OH) and Richard Neal (D-MA) and ultimately sponsored by almost all of the members of the House Ways and Means Committee. Most of the U.S. REIT Act was later incorporated in H.R. 1, the comprehensive tax reform legislation introduced in 2014 by former Chairman Dave Camp.
The following summarizes the U.S. REIT Act provisions incorporated into the Act; for a detailed explanation of the U.S. REIT Act changes, click here.
1. Improvement in Asset Management Capabilities: Modification of Dealer Sales Safe Harbor
A REIT may be subject to a 100 percent tax on net income from sales of property in the ordinary course of business (prohibited transactions or dealer sales), but the tax Code provides a bright line safe harbor test for determining whether a REIT’s property sale constituted a prohibited transaction. The current law safe harbor exception for rental property provides that a sale may avoid being classified as a prohibited transaction if it meets several requirements, including: a) the REIT did not make more than seven sales of “property” during the year (Seven Sales Rule) or b) either i) the aggregate adjusted bases of all “properties” sold during the year do not exceed 10 percent of the aggregate bases of all of the REIT’s assets as of the beginning of the year, or ii) the fair market value of all “properties” sold during the year does not exceed 10 percent of the fair market value of all of the REIT’s assets as of the beginning of the year (10 Percent Rule).
Effective for taxable years beginning after the date of enactment, the Act would modify the 10 Percent Rule so that a REIT would have the option to calculate the 10 percent threshold over a three-year average, with a cap of 20 percent in any particular year, or to use the current safe harbor methodology. Depending on a REIT’s sales over a three-year period, this change could effectively double the sales a REIT could make and still satisfy the dealer safe harbor. The Act would not make a corresponding change to the separate safe harbor for the sale of timber. Also, the Act would allow a REIT’s taxable REIT subsidiary (TRS) to sell a REIT’s property under the safe harbor test to the same extent that an independent contractor can.
2. Repeal of the Preferential Dividend Rule for Publicly Offered REITs
Just like mutual funds, REITs are allowed a deduction for dividends paid to shareholders (the DPD) and are required to distribute annually most of their income to shareholders so long as the dividend is not a “preferential dividend.” A dividend is considered to be preferential unless it is distributed pro rata to shareholders, with no preference to any share of stock as compared with other shares of the same class, and with no preference to one class compared with another except to the extent the class is expressly entitled to such preference. In 2010, the preferential dividend rule was repealed for SEC-registered mutual funds.
Effective for distributions in taxable years beginning after 2014, the Act would conform the preferential dividend rule treatment of REITs to that of mutual funds. The preferential dividend rule would not apply to “publicly offered REITs”, i.e., stock exchange-listed REITs and public non-traded REITs since they have to register their securities under the 1934 Act. Furthermore, the IRS would be given the regulatory authority to cure inadvertent failures of the preferential dividend rules for other REITs.
3. Improving and Modifying the REIT Income and Asset Tests
A. REIT Debt Securities. The Act would classify certain REIT debt securities as real estate assets. This section would classify debt securities of a publicly offered REIT as a “real estate asset” while limiting the amount of unsecured debt securities a REIT may own in another REIT to 25 percent of the investing REIT’s gross assets.
B. Leases and Loans with Associated Personal Property. The Act would conform REIT income and assets tests by: a) treating personal property leased with real property (e.g., kitchen appliances in an apartment) as a real estate asset if its value does not exceed 15 percent of the associated total value of leased property; and, b) treat other property that, in connection with real property, secures a mortgage loan (e.g., furniture in hotel rooms), as real property (and all of the interest generated by such mortgage would be qualifying real estate income) if its value does not exceed 15 percent of the total value of the real and other property securing the loan.
C. Hedging Rule. Under current law, income attributable to certain “qualifying hedges” is not considered gross income provided the hedges are identified on the same day as entered into. The Act would: 1) include as qualifying hedges those entered into to counteract a qualifying hedge; and, 2) for purposes of the REIT hedging rule, include hedges for which the curing regulations under section 1221 apply.
All of the above would be effective in taxable years beginning after 2015.
4. Modification of Earnings and Profits (E&P) Rule to Minimize Duplicative Taxation of REIT Shareholders
In order to minimize duplicative taxation of REIT shareholders, the E&P rules would be modified for taxable years beginning after 2015 to allow for reduction of E&P by deductions that were allowable to reduce taxable income in either the current year or prior years. A conforming change would be made to a similar rule that increases a REIT’s E&P solely for purposes of the DPD by the total amount of gain recognized on the sale of property. As a result, this provision would ensure that the REIT would have sufficient E&P to meet its DPD obligation while eliminating duplicate taxation of REIT shareholders.
Additional REIT Reforms
The Act also includes variations of three proposals originally in H.R. 1 as introduced last year by former Chairman Dave Camp (R-MI) dealing with tax-free spin-offs of REITs by non-REIT C corporations, the eligibility of percentage rents as REIT income in certain cases and the maximum size of taxable REIT subsidiaries.
1. Section 355 and REIT Spin-offs
Under H.R.1, the tax-free spin-off rules under Code section 355 would not have applied when a non-REIT C corporation distributed the stock of a REIT (including a non-REIT corporation that elects REIT status within 10 years following the spin-off) to its shareholders or when a REIT distributes the stock of either a REIT or a non-REIT corporation (including a TRS) to its shareholders. Accordingly, both the distributing corporation and its shareholders would be subject to tax.
Under the Act, these rules would go into effect for distributions made on or after Dec. 7, 2015 except that section 355 would continue to apply to a REIT’s spin-off of another REIT or of a TRS that the REIT held as a TRS for at least 3 years.
2. Percentage Rents and Interest Limited if not Sufficiently Diversified From Tenants
Under the current REIT income test, qualifying real estate rents do not include amounts based on the income or profits of a tenant (other than rents based on a fixed percentage of receipts or sales). Further, interest income attributable to mortgages secured by real property is considered qualifying real estate income for the 75 percent gross income test while interest income attributable to unsecured debt is considered qualifying passive income for the 95 percent gross income test.
H.R. 1 would have tightened this rule by excluding as qualifying rent or interest payments under the REIT rules any fixed percentage rents and interest payments received by the REIT from a single C corporation (other than a TRS) if such rents or interest payments comprised more than 25 percent of all the fixed percentage rents or interest payments received by the REIT in a taxable year.
The Act incorporates this proposal except that the fixed percentage rent and interest income would be measured against ALL of a REIT’s rents and interest payments rather than just its fixed percentage rents and interest payments. The provision would be effective in taxable years after 2015 with respect to leases entered into after 2015.
3. Reduction of TRS Limit
Effective for taxable years beginning after December 31, 2017, the Act would reduce from 25 percent to 20 percent the percentage of gross assets a REIT could hold as securities in TRSs.
Congress is currently expected to leave for the year in the next two weeks, but before then it must pass an omnibus appropriations bill (or at least a continuing resolution to keep the government running). Negotiations among the House leadership, Senate leadership and White House on these year-end spending and tax issues are very fluid and on-going, and it is quite possible that Congress might not resolve these issues until December or later.
For further information, please contact NAREIT's Executive Vice President & General Counsel, Tony Edwards, at firstname.lastname@example.org; NAREIT's Senior Vice President, Policy & Politics, Cathy Barre, at email@example.com; or NAREIT's Vice President & Senior Tax Counsel, Dara Bernstein, at firstname.lastname@example.org.