Real Estate Investment Trusts (REITs) and the Foreign Investment in Real Property Tax Act (FIRPTA): Overview and Recent Tax Revisions

Summary

The Consolidated Appropriations Act of 2016 (P.L. 114-13) made several changes to the tax treatment of Real Estate Investment Trusts (REITs) and the Foreign Investment in Real Property Tax Act (FIRPTA, enacted in the Omnibus Reconciliation Act of 1980, P.L. 96-499) as it relates to REITs. REITs are corporations that issue shares of stock, are largely invested in real property, and do not generally pay corporate tax. REITs distribute and deduct most income as dividends to shareholders. U.S. individual shareholders pay tax at ordinary individual income tax rates on those dividends (rather than the lower rates normally applied to dividends on corporate stock).

REITs were initially introduced, in part, to allow taxpayers of more modest means to invest in real estate. The size and scope of REITs has been increasing in past years, due in part to legislative and regulatory changes. REITs today are estimated to own $1.8 trillion in real estate. Legislative changes have meant REITs are increasingly not only owning and renting property as a passive investment, but also managing it through taxable subsidiaries. U.S. corporations have been spinning off (transferring to a separate corporation organized as a REIT) buildings (and other assets defined as real estate) in a tax-free reorganization. The scope of these spin-offs as well as new REITs has been increased through legislative and regulatory changes that treat assets such as timber, cell towers, and billboards as real estate. The expanding scope and size of REIT activities has raised issues as to whether the intent of the preferred treatment is still appropriate.

Another issue concerning REITs is that provisions in FIRPTA have been discouraging foreign investors from purchasing REIT shares by taxing investments that exceed 5% of the REIT’s shares. Capital gains paid to foreign investors are generally exempt from U.S. tax. FIRPTA, however, imposes a capital gains tax on foreign investments for gains related to real estate, with an exception for a less than 5% ownership of a REIT. Investment in other types of securities is not subject to the U.S. capital gains tax.

The Consolidated Appropriations Act makes several changes in response to these issues. The act

disallows tax-free spin-offs of assets into a tax-exempt REIT by a regular corporation;

increases from 5% to 10% the amount of ownership in a REIT by a foreign investor before the capital gains tax applies; and

exempts foreign pension funds investing directly or indirectly in real estate from the FIRPTA capital gains tax.

These provisions, taken together, result in federal tax revenue losses. There are also some smaller (in revenue effect) provisions affecting foreign investors that gain revenue.

In addition to these rules, P.L. 114-13 includes some minor provisions, the most significant of these changes relating to the treatment of taxable REIT subsidiaries.

The changes in the Consolidated Appropriations Act may lead to a period with no further REIT revisions. If tax reform is considered, however, additional REIT base broadening provisions might be considered. For example, former Chairman of the House Ways and Means Committee Dave Camp’s proposed Tax Reform Act of 2014 (H.R. 1, 113th Congress) contained more restrictive provisions relating to spin-offs as well as other provisions primarily focused on the definition of real estate. Changes in a tax reform, such as lowering the corporate rate or allowing a corporate dividend deduction, could also affect the relative tax benefit of REITs.

This report describes REITs and FIRPTA, provides historical developments, presents an overview of REIT size and activity, explains the provisions in the Consolidated Appropriations Act, and discusses possible policy issues in the future.