New IRS rules impact foreign D-REITs

The IRS recently finalized regulations (TD 9992) that could significantly impact foreign investments in real estate investment trusts (REITs) that are structured as qualifying as “domestically controlled” REITs (D-REITs). D-REITs have long been a popular investment vehicle for foreigners due to their various tax advantages. Namely, certain foreign persons can avoid filing a U.S. tax return or paying capital gains tax under FIRPTA rules when selling shares in a D-REIT.

To qualify as a D-REIT, a majority of the REIT’s shares must be owned (directly or indirectly) by U.S. persons (including business entities). Prior to the new IRS regulations, foreign investors had no influence on the calculation of the D-REIT qualifying threshold if such foreign investment was made through a U.S. C corporation that held D-REIT stock. The 2009 IRS guidance provided that C corporations would be treated as domestic holders of REIT stock for purposes of D-REIT qualification (PLR 200923001).

With exceptions, the new rules generally allow the IRS to “screen through” U.S. C corporations and determine whether the corporation’s shareholders are foreign persons. If more than 50% of the shareholders of a U.S. C corporation are foreign persons, the C corporation will not qualify as a U.S. person for D-REIT qualifying purposes. As a result, many REITs that relied on previous guidance may lose their D-REIT status under the new IRS regulations.

Fortunately for foreign D-REIT investors, the new regulations provide for a 10-year transition period for existing D-REITs to adapt to the requirements. Provided that such existing D-REITs do not cause the transition period to expire early as a result of certain new acquisitions, new foreign investments or other pitfalls under the new regulations, U.S. C-corporations will continue to be treated as U.S. entities despite majority foreign ownership shareholders, until 2034.