Taxation of foreign shareholders of REIT stock

The taxation of disposition of REIT shares is subject to the provisions of the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”). Prior to the passage of this legislation, foreign taxpayers were not subject to tax on capital gains realized from investments in the US. In the late 1970’s, Congress grew concerned at the increasing amount of foreign investment in US real property and wanted to put foreign owners that disposed of interests in US real property on an equal footing with US taxpayers.

FIRPTA treats foreigners as realizing income from the disposition of real property in the US that is “effectively connected” with the operation of a US business (“ECI”) and thus subject to the graduated rates of taxation that US taxpayers are subject to. Under the current rates of taxation, a foreign individual is subject to a maximum rate of 20% on gain realized from the sale of REIT shares and corporations are subject to a 21% rate of tax. Unlike FDAP, this rate of taxation cannot be reduced by treaty.

FIRPTA applies to the disposition of a US real property interest (“USRPI”) that consists of (i) an interest in real property, or (ii) an interest in a US Real Property Holding Corporation (“USRPHC”), defined as a corporation in which the value of its US real property interests is at least equal to the sum of the value of its US real property interests, real property abroad and assets used in the trade or business at any time during the five-year period ending on the date of disposition.

Because the value of US real property held by an equity REIT is generally in excess of its total real estate assets plus assets used in the trade or business, a REIT is an USRPHC and subject to the FIRPTA rules. An interest “solely as a creditor” with respect to either of these investments is not treated as an USRPI.

One example of a non-creditor interest is debt secured by real property that provides for a percentage of gain on sale in addition to periodic interest payments. Consequently, an interest in a REIT that holds mortgages that provide solely for periodic payments of interest would not be subject to the FIRPTA rules.

There is an additional way that REIT shareholders are subject to FIRPTA taxation which is not applicable to a non-REIT USRPHC. A “look-through” rule imposes tax on REIT shareholders if the REIT disposes of an USRPI at a gain and distributes the proceeds therefrom. This provision is intended to make sure that FIRPTA tax is paid even though a shareholder has not disposed of its shares.

There are several exceptions to FIRPTA taxation of REITs. A REIT that is “domestically controlled” (whether publicly traded or not) is not treated as an USRPT and the sale of shares therein is not subject to FIRPTA. A REIT is “domestically controlled” if the foreign ownership of the value of its shares is less than 50%, at all times, during the five-year period ending on the date of disposition. This is the most widely-used exception to FIRPTA.

In addition, the sale by a shareholder that owns 10% or less of a publicly traded REIT is not subject to FIRPTA. This also applies to the look-through rule, and thus, to a shareholder that receives a distribution of proceeds from the sale of an USRPI by the REIT.

Finally, there are special types of shareholders that are not subject to FIRPTA. A “Qualified Shareholder” that owns shares in a REIT will not be taxed on both the sale of shares and distributions under the look-through rule. A Qualified Shareholder is (i) either a publicly traded entity that qualifies for treaty benefits or is a publicly traded foreign partnership; (ii) qualifies as a Collective Investment Vehicle; and (iii) complies with certain record-keeping requirements. Additionally, a Qualified Foreign Pension Fund (“QFPF”) is exempt from FIRPTA (regardless of whether or not it invests in a REIT) on both sales of REIT shares and distributions under the look-through rule.

Please contact your Mazars professional with any questions about the foreign taxation of REITs and their shareholders.

Published on January 6, 2022