Using a REIT to optimize the tax consequences of foreign ownership of real property
Foreign owners of U.S. real property often use REITs within their structure to optimize the withholding requirements of the foreign owners. REITs are often used when purchasing even a single parcel of rental real estate. When this occurs, the result is what is commonly referred to as a “baby REIT.”
Foreign ownership of real property in the United States can generate additional tax consequences when the property is sold. If a non-U.S. investor holds any of the real property, the transaction could trigger withholding requirements under the Foreign Investment in Real Property Tax Act (FIRPTA). The law allows an exception to these requirements for shares of a “domestically controlled REIT,” a REIT in which less than 50 percent of the fair market value of outstanding stock was directly or indirectly held by foreign persons during the five-year period ending on the determination date.
The above tax motivations have prompted the use of baby REITs by investment groups that include non-U.S. investors. While the sale of the baby REIT stock qualifies for the exception to the FIRPTA, most buyers are unwilling to purchase REIT stock, instead of the underlying real estate itself. This is because most buyers wouldn’t be able to retain the entity’s qualification as a REIT post-acquisition. Also, most buyers can’t liquidate the acquired REIT in a tax-efficient manner. However, unlike most buyers, REITs can acquire the stock of domestically controlled REITs. This allows the seller to avoid the FIRPTA and still permits the buyer REIT to get a “step-up” in the real estate it has indirectly acquired.
This structure can qualify for an exception from FIRPTA, but buyers may need to jump through extra hoops to get stepped-up basis.
The high-level summary of the series of transactions that a buyer REIT and target baby REIT will need to undertake to achieve their respective goals are as follows:
- Buyer REIT forms a wholly owned taxable REIT subsidiary (TRS).
- Buyer REIT and the TRS create “Acquisition LLC” with 79 percent owned by Buyer REIT, and 21 percent by TRS.
- Acquisition LLC acquires the stock of Target Baby REIT (TBR). Owners of TBR are paid cash.
- Acquisition LLC liquidates TBR and distributes target’s real estate assets to Acquisition LLC in the redemption of ownership.
- The liquidation of TBR creates a deemed sale of assets that results in taxable income to TBR.
- The income resulting from TBR’s liquidation is pushed out of TBR by the distribution of assets and qualifies for the dividends paid deduction.
- Acquisition LLC will have acquired the stock of TBR shortly before liquidation, so it should be able to recognize no taxable income upon the redemption of its stock.
- At some point in the year after the transaction, it’s expected that the TRS would be liquidated. No “deemed-sale” reporting would be required as the transaction should qualify as a tax-free liquidation of a subsidiary.
This summary provides a very high-level look at a process that may achieve the buyer’s demand for stepped-up basis in the acquired real property and the seller’s desire to qualify for an exception from the FIRPTA withholding requirements. While a quick overview like this can give you some idea of the process, significant care and attention must be given to ensure the intended tax reporting outcome.
If you have any questions about this process or would like to discuss how it might apply to your REIT, please give us a call.