IRS issues two proposed regulations affecting foreign investment in US REITs

On Dec. 29, 2022, the IRS and Treasury Department issued a proposed regulation for determining whether a REIT qualifies as a domestic controlled REIT (DCR). Whether a REIT is domestically controlled or not is critical for foreigners as sale of domestically controlled REIT’s stock isn’t subject to FIRPTA. However, the sale of the stock of a foreign controlled REIT is taxable to foreigners other than 10% or less shareholders in a publicly traded REIT, qualified foreign pension funds and certain foreign governments.

Under Section 897(h)(4), a REIT is domestically controlled if less than 50% of the value of its stock is held “directly or indirectly” by foreign persons at all times during the shorter of the five-year period ending on the relevant determination date or the period during which the REIT was in existence. Thus, the question is, what is the proper interpretation of the term “directly or indirectly held”?


There are no attribution rules provided under Section 897(h). There are, however, several existing authorities relevant to determining a REIT’s DCR status. For example, regulation Section 1.897-(1) (c)(2)(i) provides that for purposes of determining DCR status, the actual owners of stock as determined under regulations Section 1.857-8 must be considered.

This section provides that the actual owner is the person who’s required to include in gross income in his tax return the dividend received on the stock. For example, if an individual owns REIT stock and receives a dividend on that stock, the individual must report it as income and the individual is treated as the owner of the REIT stock.

Applying that section, a domestic C corporation required to include gross income on its tax return on any dividend received should be treated as the owner of the REIT stock for determining DCR status. In 2009, the IRS applied this logic and issued a Private Letter Ruling that a REIT owned by two domestic C corporations, both of which were majority owned by foreigners, was a DCR.

In 2015, Congress clarified the determination of DCR status with the PATH Act, which added new ownership testing rules to Section 897(h)(4) for DCR status when the REIT stock was either publicly traded or owned by another REIT. In recognition that publicly traded REITs often have difficulty determining whether they’re domestically controlled, the PATH Act added new Section 894 (H)(4))(i), which provides that any shareholder owning less than 5% of a publicly traded REIT at all times during the testing period will be treated as a US shareholder unless the REIT has actual knowledge to the contrary.

In addition, prior to the PATH Act it wasn’t clear how domestic control of a subsidiary REIT was determined. The act provided rules for evaluating domestic control:

a)  Subsidiary REIT stock is treated as held by a US person where such stock is held by a domestically controlled public REIT. If the publicly traded REIT doesn’t qualify as domestically controlled, it’s viewed as a foreign shareholder. There is no “look through” to the parent REIT’s ownership.

b)  If the subsidiary REIT stock is held by a private REIT, such ownership by the private REIT will be considered US only to the extent the stock in the private REIT itself is held by a US person (a “look through” rule).

Based on the above authorities, since 2009, if not before then, taxpayers and their tax advisers have often structured investments in REITs using US C corporations to achieve DCR status.

Proposed regulations

The IRS proposed regulation challenges the prevailing belief and established authorities; for DCR status purposes, the statute doesn’t require a look through of a domestic C corporation. The proposed regulations provide that the statute requires the look through for any domestic corporation that’s owned directly or indirectly by foreign persons or a “foreign owned domestic corporation.” Look through is also required for non-publicly traded partnerships and S corporations, although most tax advisers believed this was already the rule regarding non-publicly traded partnerships.

Furthermore, the IRS stated that the proposed look through rules would apply throughout the testing period, meaning the look through treatment could apply to current structures or structures put in place before the proposed regulations are finalized. Accordingly, any existing structure that has relied on the existing authority is subject to challenge by the IRS if the proposed regulations are finalized in their current form. The preamble states the IRS may challenge positions contrary to the proposed regulations prior to the finalization of these rules, which would appear to imply the IRS will audit stock sales that have already occurred.

It's likely the IRS will receive many comments on the validity, retroactivity and lack of grandfather provisions of the proposed regulations. Mazars will monitor the situation and update this alert as warranted.

Section 892 proposed regulations

On the same day the 897 proposed regulations were issued, the IRS issued proposed regulations under Section 892 dealing with the US real property holding company (USRPHC) trap for sovereign wealth funds/foreign governments.

Section 892 provides that income derived by a foreign government from investments in US stocks, bonds or other securities is exempt, although income from investments in US partnerships isn’t exempt. However, the exemption doesn’t apply to any income derived from the foreign government’s conduct of “commercial activities” or received directly or indirectly from a controlled commercial entity (CCE).

The Internal Revenue Code doesn’t define the term “commercial activities.” The 1988 temporary regulations defined the term broadly to include all activities conducted within or without the US that are ordinarily conducted with a view towards the production of income or gain. Despite this broad interpretation, these regulations excluded investments in stocks, bonds and other securities, and trading in stocks, bonds, securities and commodities. However, this exception wasn’t available if undertaken as a dealer or if investments were made by a banking, financing or similar business.

A CEE is defined as a separate entity, engaged in a commercial activity anywhere in the world, and in which the foreign government directly or indirectly holds at least 50% of the interest in such entity by voter value or any other interest that provides effective control of such entity. Under the “all or nothing” rule, a controlled entity will lose the benefits of Section 892 exemption entirely if it engages in any degree of commercial activity anywhere in the world. This means that if the controlled entity engages in any commercial activity in which it earns a dollar of commercial activity income, all its income, both commercial activity income and non-commercial activity income, is tainted.

Within the definition of commercial activity is a provision that provides that if a controlled entity would be treated as a US real property holding company if it were a US corporation, it will be treated as engaged in commercial activity and therefore lose all its Section 892 exemption (the USRPHC trap). For example, assume a foreign government creates a controlled entity and the controlled entity’s only asset is a minority interest in a foreign controlled REIT. Under the 1988 regulations, the controlled entity is a US real property holding company because its only asset is a US real property interest and thus the controlled entity is treated as a commercially controlled entity and loses Section 892 exemption.

In recognition of the USRPHC trap, the proposed regulation provides that a controlled entity isn’t treated as a USRPHC solely because of its direct or indirect interest in one or more corporations that isn’t controlled by the foreign government. Thus, a controlled entity that only owns minority interests isn’t treated as a CCE and thus doesn’t lose its Section 892 status. As this proposed regulation is taxpayer favorable, it provides that taxpayers can rely on it prior to its finalization.

Mazars’ insight

The two side-by-side regulations couldn’t be more different if they tried.

The Section 897 regulations challenge long-established structuring for foreign investments in US REITs. They attempt to disregard the existing authorities and upend existing and future structures, ones that Congress could have changed if lawmakers thought the existing interpretations were incorrect.

Section 892 proposed regulations mitigate a trap that was created by the 1988 regulations. The former has been commented on and challenged by tax professionals including NAREIT, The Real Estate Roundtable and the America Bar Association Tax Section, among others, while the latter is a welcome relief for those who’ve fallen into the US real property holding company trap.

Mazars will continue to monitor developments with these proposed regulations. Please feel free to contact the authors for additional information.