Proposed Tax Extenders Legislation Would Limit “Opco/Propco” Spinoffs, Modify FIRPTA and Affect Treatment of REITs: Proposed Legislation Would Limit Opco/Propco Spinoffs and Make Changes to Treatment of Some Foreign Investment in U.S. Real Estate and to Real Estate Investment Trusts

Sullivan & Cromwell LLP - December 17, 2015

On December 15, 2015, the joint leadership of the House of Representatives and the Senate tentatively agreed to an amendment to H.R. 2029 (the “Bill”) entitled the “Protecting Americans From Tax Hikes Act of 2015”.  The Bill was passed by the House of Representatives on December 17, 2015, and it is expected that the Bill will be passed by Senate and that the President will sign the Bill into law in substantially its current form.  The Bill, which would extend certain provisions of the Internal Revenue Code (the “Code”) set to expire, would make significant changes to the U.S. federal taxation of real estate.  The Bill would (i) limit the establishment of so-called “Opco/Propco” structures through tax-free spinoffs, (ii) extend favorable treatment to certain foreign investment in real property, and (iii) make other technical changes to REIT provisions of the Code.

The Bill includes provisions intended to limit tax-free spinoffs establishing so-called “Opco/Propco” structures by disqualifying spinoffs from tax-free treatment if either (but not both) the distributing corporation (“parent”) or the distributed corporation (“spinco”) is a real estate investment trust (“REIT”), and prevents either parent or spinco from electing REIT status for 10 years after a tax-free spinoff.

Second, the Bill includes amendments to the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) that would affect the ability of foreign persons to invest in U.S. real estate, including by:

  • increasing the rate of FIRPTA withholding on gross purchase price from 10% to 15%;
  • excluding REIT and regulated investment company (“RIC”) stock from the FIRPTA “cleansing rule” for former United States real property holding corporations;
  • exempting qualified foreign pension funds from FIRPTA tax and withholding;
  • increasing the 5% shareholder limit to a 10% shareholder limit under the “publicly traded exception” under FIRPTA in the case of REITs; and
  • allowing REITs that are publicly traded in the United States to presume that less than 5% shareholders are United States persons for purposes of the domestically controlled REIT (“D-REIT”) exception from FIRPTA.

Third, the Bill would modify certain other rules relating to the U.S. federal taxation of REITs, including:
  • reducing the percentage of a REIT’s assets that may constitute securities in taxable REIT subsidiaries (“TRSs”) from 25% to 20%;
  • permanently extending the reduced five-year recognition period during which a REIT is subject to entity-level tax on built-in gain property;
  • treating unsecured debt instruments issued by publicly offered REITs as “real estate assets” for purposes of the REIT asset qualification requirements;  
  • treating certain personal property ancillary to real property as well as mortgages securing both real property and ancillary personal property as “real estate assets” for purposes of the REIT asset qualification requirements;
  • permitting REITs to use a three-year averaging method to qualify for the safe harbor for sales of 10% or less of assets from the 100% tax imposed on “prohibited transactions” (subject to a 20% current-year limitation);
  • repealing the limitations on preferential dividends for publicly offered REITs; and
  • clarifying that the dividends received deduction otherwise allowed to corporations for dividends received through certain 10%-owned foreign corporations is not allowed to the extent attributable to dividends paid by REITs or RICs to the foreign corporation.