In late 2015, the president signed the Protecting Americans from Tax Hikes (PATH) Act into law. In addition to extending a number of expiring tax provisions, the act makes significant changes to the tax treatment of 1) foreign persons (both individuals and entities) owning U.S. real estate and 2) real estate investment trusts (REITs). Here are some of the highlights.
The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) provides that a foreign person’s gain on the disposition of a U.S. real property interest (USRPI) is “effectively connected” with the conduct of a U.S. trade or business. Therefore, it is subject to U.S. income tax.
The PATH Act makes several changes to FIRPTA, including:
- Providing that qualified foreign pension funds (“QFPF”), like domestic pension funds, are exempt from FIRPTA. The exemption also extends to entities wholly owned by qualified foreign pension funds. The Act eliminates the disparate tax treatment between foreign and domestic pension funds. The PATH Act amended the definition of a foreign person to provide that QFPFs are not treated as a foreign person except as otherwise provided by the Secretary. This change is effective for dispositions and distributions after December 18, 2015.
- Certificate of non-foreign status: In the case of any disposition of a USRPI by a foreign person (i.e. transferor), the transferee (or buyer) has a withholding obligation if it does not fall under any of the exceptions. Under the regulations, if the transferor is not a foreign person, withholding is not required. In order to establish that the transferor is not a foreign person, the transferor must provide a certificate of non-foreign status. Since the definition of a foreign person has been modified to exclude a QFPF as a foreign person, a QFPF can provide a certificate of non-foreign status in order to avoid withholding on the disposition of a USRPI. The transferor must provide the certificate at the time of, or prior to, the transfer in order to avoid withholding.
- Increasing — from 5% to 10% — the maximum percentage of stock a foreign person may hold in a publicly traded REIT without triggering FIRPTA. Generally, gain on a disposition of stock in a U.S. real property holding corporation (“USRPHC”) is taxed under FIRPTA as income effectively connected with the conduct of a U.S. trade or business. Under pre-Act law, a foreign person owning 5% or less, actually or constructively, of publicly traded REIT stock was not subject to FIRPTA on the sale of the REIT stock or upon the receipt of a REIT capital gain dividend. The PATH Act increases the maximum ownership permitted under the exemption from FIRPTA for publicly traded REITs from 5% to 10%. This change is effective for dispositions and distributions after December 18, 2015.
- Permanently extending the exclusion of domestically controlled regulated investment companies (RICs) from the definition of USRPI, retroactive to Jan. 1, 2015.
- Eliminating the “cleansing rule” for REITs and RICs. If a USRPHC disposes all of its USRPIs in taxable transactions within a five-year period preceding the date of disposition of stock in the USRPHC, the stock interest ceases to be a USRPI. The PATH Act modified the cleansing rule by stating that it does not apply to any corporation that was a RIC or a REIT at any time during the shorter of the ownership period or the five-year period ending on the date of disposition of the stock. This change is effective for dispositions and distributions on or after December 18, 2015.
- The act also increases the FIRPTA withholding rate on certain distributions and dispositions of USRPIs from 10% to 15%. The increased withholding tax applies to dispositions and distributions made after February 16, 2016. The 10% rate continues to apply to transferees who acquire a personal residence for $1 million or less.
Dividends Received Deduction
Code Section 245 allows a dividends-received deduction (“DRD”) by a domestic corporation that receives dividends from certain foreign corporations. The Act clarifies that for purposes of determining whether dividends from a foreign corporation are eligible for a DRD, dividends paid by RICs and REITs to the foreign corporation are not treated as dividends from domestic corporations.
Follow the PATH
The PATH Act has made several other changes to the FIRPTA and REIT rules not covered here. Your tax advisors can provide you with more information and guide you in assessing the act’s impact on your real estate activities.