January 13, 2023

Proposed Treasury Regulations Reverse Guidance on Domestically Controlled REITs

Holland & Knight Alert
Mark A. Melton | Alan Schwartz


  • Recent guidance from the U.S. Department of the Treasury and IRS proposes to modify the definition of a real estate investment trust (REIT) that is "domestically controlled."
  • If finalized, this guidance would disallow a structuring technique currently used to attract foreign investors in REITs.
  • Stakeholders have until Feb. 27, 2023, to comment on this guidance and should otherwise prepare for these potential changes.

The U.S. Department of the Treasury and IRS on Dec. 29, 2022, published proposed regulations (Proposed Regulations) under Section 897 of the Internal Revenue Code of 1986, as amended (Code). The Proposed Regulations (REG-100442-22) would modify the definition of a "domestically controlled" real estate investment trust (DC-REIT).

If finalized in its current form, the Proposed Regulations would disallow a common structuring technique used to attract foreign investors to invest in REITs using "foreign-owned" domestic corporations to create a DC-REIT.


While foreign investors generally are not subject to U.S. federal income tax on capital gains, including gains on the sale of stock, Section 897 of the Code (commonly referred to as FIRPTA) imposes U.S. federal income tax on gains arising from the disposition of a United States real property interest (USRPI). A USRPI includes an interest in a domestic United States real property holding corporation (USRPHC), which generally is defined as any corporation if 50 percent or more of its real estate and business assets are USRPIs.

A REIT generally would be classified as a USRPHC because most of its assets are comprised of domestic real property holdings, but the Code explicitly provides that a DC-REIT is not treated as a USRPI. Accordingly, gain or loss on the disposition of stock in a DC-REIT by a foreign investor (other than by liquidation of the DC-REIT) is not subject to U.S. federal income tax.

In general, a REIT is a DC-REIT if less than 50 percent of its stock (by value) is held "directly or indirectly" by foreign persons at all times during the five-year period ending on the date of the disposition. Prior to the issuance of the Proposed Regulations, the phrase "directly or indirectly" was not defined by the Code or Regulations. In Private Letter Ruling 200923001 (PLR), the IRS concluded that the taxpayer need not look past a direct or indirect shareholder that was a domestic C corporation, even if its owners were foreign. The conclusion in the PLR was later bolstered by the legislative history of the Protecting Americans from Tax Hikes Act of 2015 (PATH Act), which referred to the PLR's conclusion that, for purposes of the DC-REIT exception, the term "indirectly" does not require looking through a domestic C corporation to its owners.

Based on the PLR and, prior to that, based on other available authorities, domestic C corporation blockers have been used to create DC-REIT structures. For example, real estate funds often structure investments as a single-asset REIT, and in a manner such that the REIT will be treated as a DC-REIT. Using this structure, the eventual sale of the REIT stock, instead of the underlying real property, would exempt any foreign investors from tax on such a sale.

Even when there were no additional U.S.-based investors, many foreign investors concluded they could form a REIT in which they would hold a direct interest in 49 percent of the REIT's stock and own the remaining 51 percent through a domestic C corporation blocker. These foreign investors took the position that the REIT would be treated as a DC-REIT because it was owned 51 percent by a domestic C corporation, despite the fact that the owners of that C corporation were identical to the foreign investors owning a direct 49 percent interest in the REIT. While this structure subjected 51 percent of the gain on a sale of the REIT to U.S. corporate tax, it resulted in complete tax exemption with respect to the 49 percent held directly by the foreign investors.

The Proposed Regulations

The Proposed Regulations would abruptly end the viability of this type of structure, and existing structures utilizing such domestic C corporation blockers would find themselves without the benefit of a grandfathering exception.

The Proposed Regulations attempt to define "indirect" ownership by introducing a new concept of "look-through persons" and "non-look-through persons." Determining the foreign and domestic ownership of a REIT, and thereby determining whether it is a DC-REIT, would require looking through each direct and indirect shareholder of the REIT that is a look-through person until a non-look-through-person is reached, at which point the non-look-through-person's effective ownership percentage of the REIT would be allocated as domestic or foreign based on such person's status.

Additionally, the Proposed Regulations generally treat domestic C corporations as non-look-through persons. But a special look-through rule applies to non-publicly traded domestic C corporations in which foreign persons hold, directly or indirectly, 25 percent or more of the fair market value of the corporation's outstanding stock (Foreign-Owned Domestic Corporation). Whether a non-public domestic C corporation is a Foreign-Owned Domestic Corporation is determined by applying the same look-through rules that apply in determining whether a REIT is domestically controlled. In the case of a Foreign-Owned Domestic Corporation, the direct and indirect ownership of such a domestic C corporation by foreign persons, and not the domestic status of such a C corporation itself, is taken into account in determining the "indirect" ownership of the REIT by foreign persons in applying the DC-REIT exception.

Further Considerations

The Proposed Regulations apply to "transactions" occurring on or after the date the regulations are published as final regulations. Because the relevant "transaction" is likely the sale of REIT stock, and because a DC-REIT must satisfy the 50 percent domestic ownership test at all times during a five-year lookback period, existing REIT structures may fail to qualify as a DC-REIT and may not be able to rectify the structure in a timely manner, depending on when final regulations are issued. This could require foreign investors to block their entire interest in the REIT, subjecting any gains to U.S. corporate tax, yet still avoiding direct U.S. tax filing requirements.

Also noteworthy is that the Proposed Regulations indicate that the IRS may challenge positions contrary to the Proposed Regulations even before the issuance of final regulations. This appears to be an unusual measure, and it is not clear whether or how this enforcement would be applied in practice. It may be that the IRS intends to challenge some of these positions in the courts to determine whether or not to include such provisions in final regulations.

Next Steps

Impacted stakeholders have until Feb. 27, 2023, to submit comments to the Proposed Regulations.

During the interim period, real estate sponsors, fund managers and REITs should review their existing and contemplated tax structures, in addition to their organizational documents, to evaluate the impact of the Proposed Regulations. Importantly, this review should include any side-letter arrangements with investors to determine whether commitments or covenants relating to DC-REIT status have been provided to investors.

For additional information or assistance and guidance with the Proposed Regulations, or to discuss preparing comments, please contact the authors.

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.

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