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REIT Foreign Currency Gains

For certain REIT test failures, it may be able to simply pay a monetary penalty and bring itself into compliance. Read more in this article.

October 25, 2007
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REITs (Real Estate Investment Trusts) are subject to a number of rules to ensure that their primary focus is commercial real estate activity. REITs must meet two gross income tests. First, at least 95 percent of a REIT’s annual gross income must be from specified sources, such as dividends, interest, rents, and other enumerated qualifying passive income sources [IRC § 856(c)(2)]. In addition, at least 75 percent of a REIT’s annual gross income must consist of real property rents, mortgage interest, gain from the sale of real estate assets, and certain other real estate-related sources, with a number of qualifying income items enumerated [IRC § 856(c)(3)].

REITs must also meet several asset diversification tests. At the end of each quarter of the taxable year, a REIT must have at least 75 percent of the value of its total assets represented by real estate assets, cash and cash items, and government securities [IRC § 856(c)(4)(A)]. Other asset diversification requirements restrict the securities that may be included in a REIT’s asset composition [IRC § 856(c)(4)(B)].

Failure to meet the above tests can result in loss of REIT status. For some failures, however, if a REIT can show reasonable cause, it may be able to simply pay a monetary penalty and bring itself into compliance [IRC § 856(c)(6), (7)].

How Foreign Currency Gains Fit Into the REIT Picture

If a foreign currency depreciates against the U.S. dollar (i.e. the U.S. dollar strengthens in relation to that currency), the value of a REIT’s investment in securities and other assets denominated in that currency will decline. With the plummeting of the value of the U.S. dollar against the euro, the Canadian dollar, and other currencies in the past several years, the converse has occurred. The weakening of the U.S. dollar, particularly against the euro, has caused the value of many REIT investments in assets denominated in other currencies to increase significantly. This can result in significant foreign currency gains that can skew a REIT’s income.

The IRS Clarifies the Issue for Foreign Currency Gains

Until recently, it wasn’t clear how the currency conversion gain should be treated under the REIT income and asset tests.

In May 2007, the IRS released Revenue Ruling 2007-33 [2007-21 IRB 1281] and Notice 2007-42 2007-21 IRB 1288]. These releases clarify that in the vast majority of cases, a REIT’s foreign currency gains earned in the operations of a foreign real estate business will be qualifying income under the REIT rules.

In Revenue Ruling 2007-33, the IRS ruled that foreign currency gain that is recognized by a REIT will be qualifying income under the REIT gross income tests to the extent that the underlying income so qualifies.

Notice 2007-42 [2007-21 IRB 1288] — issued at the same time as Revenue Ruling 2007-33 — provides guidance regarding the proper treatment of IRC Section 987 gains. The Notice states that the IRS intends to amend the proposed regulations under IRC Section 987 to include guidance concerning the proper characterization under the REIT income tests of the foreign currency gains recognized by a REIT on a remittance from a QBU (Qualified Business Unit) of the REIT.

Impacts of Revenue Ruling 2007-33 and Notice 2007-42

The most immediate impact of the IRS guidance is that REITs will no longer have to obtain a private letter ruling to determine how most of their foreign currency gains will be treated under the REIT income tests. An even more favorable longer–term impact is that absence of uncertainty regarding the treatment of foreign currency gains is likely to accelerate further international investment and overseas expansion by REITs.

Legislation on the Horizon

At least two bills have been introduced in Congress [see S. 2002, H.R. 1147] to codify the position of the IRS in Revenue Ruling 2007-33. Each bill would specify by statute that qualified REIT income under the REIT gross income tests includes any foreign currency gains derived by a REIT with respect to its business of investing in foreign real estate assets [new IRC § 856(c)(2)(I), (c)(3)(J) (proposed)].

The bills also address related REIT foreign currency problems that were not resolved by Revenue Ruling 2007-33 or Notice 2007-42. Although Revenue Ruling 2007-33 in particular was welcome, it took the IRS nearly four years to issue it because of questions about the extent of the government’s regulatory authority in the area.

For further discussion on IRC § 856 and additional IRC sections related to REIT, see LexisNexis Tax Advisor — Federal Code on LexisNexis Tax Center.For a topical discussion on REIT, see Tax Advisor — Federal Topical.

Request your free copy of the Matthew Bender treatise, Federal Taxes Affecting Real Estate.