Proposed regulations issued on December 29, 2022 include a new look-through rule that will affect the determination of whether a real estate investment trust (“REIT”) is considered to be domestically controlled. A REIT is domestically controlled if less than 50% of its outstanding interests are held by foreign persons. Sales of stock in a domestically controlled REIT by foreign persons are not subject to taxation as U.S. effectively connected income under the Foreign Investment in Real Property Tax Act (“FIRPTA”). Prior to the introduction of the proposed regulations, a domestic corporation with meaningful ownership by foreign persons would not have been treated as a foreign person under FIRPTA. The proposed regulations will make it more difficult for a REIT to qualify as domestically controlled by effectively disregarding any investment in the REIT through domestic corporations with 25% or more foreign ownership, which could significantly impact foreign investment in nonpublic REITs. 

The preamble states that the look-through rule is intended, among other things, to prevent the use of intermediary domestic corporations (“blockers”) by foreign investors to create domestically controlled REITs to avoid taxation under FIRPTA.

Applying the Look-Through Rules

A REIT is not domestically controlled if more than 50% is owned by foreign persons. The proposed regulations would “look through” a nonpublic domestic corporation if at least 25% of such corporation’s stock is owned by foreign persons. This means that if a foreign corporation owns 40% of the stock of a domestic corporation, which owns 80% of a REIT, the look-through rules would attribute 32% of the REIT stock (i.e., 40% x 80%) to foreign owners, despite a substantial majority of the REIT (80%) being owned by a domestic corporation. Suppose the remaining 20% of the REIT interests were held by another foreign person. In that case, the REIT would not be domestically controlled because the rules would attribute more than 50% of the REIT’s interests to foreign owners. As such, any foreign persons who have invested directly in the REIT will be subject to U.S. income tax on the sale of REIT stock. In addition, any foreign persons who have invested indirectly in the REIT through a blocker will no longer be able to sell an interest in the blocker tax free because the blocker would be considered a United States real property holding corporation, the sales of which are subject to FIRPTA. The blocker itself would also be subject to tax on any sale of its REIT stock, although that would be the case regardless of whether the REIT is domestically controlled.

Broad Impact

The proposed regulations would upend long-standing tax law that treats a domestic corporation as a single domestic person in the FIRPTA context (as well as most other contexts). What is more, although the look-through approach will take effect when the IRS publishes the final regulations, the preamble states that the IRS could challenge positions that are inconsistent with the proposed regulations even before the regulations are finalized. This causes further uncertainty for taxpayers and also raises the question of whether the look-through approach will be confined to this particular area or whether this is the beginning of a broader push to discourage the use of “blocker” corporations.