Alert June 15, 2007

IRS Takes Aim at Domestically Controlled REIT Structures

On June 13, 2007, the IRS issued Notice 2007-55, stating its position that two common uses of the domestically controlled REIT structure do not achieve their intended result of allowing non-U.S. investors to avoid U.S. income tax and withholding under the Foreign Investment in Real Property Tax Act (“FIRPTA”) with respect to gains from U.S. real estate. In particular, the Notice claims that liquidating distributions from domestically controlled REITs are taxable under FIRPTA. The Notice also claims that foreign governments are subject to tax under FIRPTA on distributions of U.S. real property gains from REITs, including both current distributions and liquidating distributions.

FIRPTA provides, with an exception for small holders of publicly traded stock, a “look-through rule” under which distributions from a REIT to foreign shareholders are taxable to the foreign shareholders under FIRPTA to the extent that the REIT’s distributions are attributable to gains from sales of U.S real property interests. At the same time, FIRPTA also provides that gain received by a foreign shareholder from the sale of its stock in a domestically controlled REIT is exempt from taxation under FIRPTA. For general tax purposes, a liquidating distribution is treated from the shareholder’s perspective as a sale of stock. Many REITs, foreign investors and withholding agents have taken the position that the general tax characterization of a liquidation as a sale of stock trumps the FIRPTA look-through rule and have reported (albeit with widely acknowledged risk) liquidations of domestically controlled REITs as free of FIRPTA tax and withholding. The Notice rejects that position. The Notice also rejects the position that redemptions of REIT shares are exempt from the look-through rule. It should be noted that the foreign shareholder’s taxable gain under the FIRPTA look-through rule may be determined without reference to the price paid by the foreign shareholder for its REIT shares, so the foreign shareholder who buys into a domestically controlled REIT with built-in gains on its properties faces the prospect of phantom tax gain under the look-through rule.

The Notice also addresses the interaction of the FIRPTA rules and the special rules governing investments in U.S. stocks and securities by foreign governments. Foreign governments are generally exempt from U.S. tax on their investments in stocks and securities, including REIT stocks, but not on their gains from U.S. real estate. The interaction of the foreign government exemption and the FIRPTA look-through rule has been unclear. Many foreign governments, REITs and withholding agents have taken the position that the general foreign government exemption trumps the FIRPTA look-through rule and have not reported FIRPTA tax or withholding on U.S. real property gain distributions to foreign government shareholders. The Notice rejects this position as well.

Real estate fund sponsors should anticipate that foreign investors will place greater emphasis on covenants that require asset sales to be structured as sales of REIT stock, or in some instances may no longer prefer REIT structures. At the same time, sellers of REIT stock may face greater difficulty in selling to buyers who have foreign investors.

While the Notice states that the IRS intends to issue regulations adopting the Notice’s guidance effective for REIT distributions occurring on or after June 13, 2007, the Notice also states that the IRS intends to challenge under current law the positions taken by taxpayers and withholding agents described above.