Since the enactment of the Protecting Americans from Tax Hikes Act (PATH) in December 2015, private Real Estate Investment Trusts (REITs) have become the vehicle of choice for many foreign pension funds investing in U.S. real estate. A pension fund that is “qualified foreign pension fund” (QFPF) that invests in a REIT may achieve returns that are largely, or in some cases wholly, exempt from U.S. taxation. The main benefit of investing through a private REIT is that capital gains from the sale of U.S. real estate and the sale or liquidation of the REIT itself is largely free of U.S. income tax. Without a REIT, those gains would be taxable at a 21 percent or 20 percent federal rate, depending upon the type of pension fund. Ordinary income (including operating income) of a REIT will continue to be subject to U.S. income tax. However, the amount of such taxable income can be reduced by depreciation and, to a limited extent, interest.
Careful attention to the REIT qualification criteria is key. In addition to making new investments through a REIT, pension funds with existing U.S. real estate investments should consider whether moving them into a REIT can be achieved tax-free. If so, the upside of structuring into a REIT can be very material.
1. FIRPTA and QFPFs Generally
Under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), foreign investors are generally taxable on gain realized upon the disposition of a United States real property interest (USRPI). The definition of USRPI is quite broad, and includes direct interests in U.S. real estate, interests held through pass-through vehicles such as partnerships, and interests in United States real property holding corporations (USRPHC). A USRPHC is a corporation that has USRPIs with a fair market value (FMV) equal to at least 50 percent of the FMV of all of the corporation’s assets.
With the enactment of the PATH Act in December 2015, QFPFs are no longer subject to FIRPTA. At first, this would seem to open the door to a broad exemption from taxation on real estate gain. However, in practice, the scope of the exemption is limited. For example, a real estate fund structured as a partnership results in flow-through income to the fund’s foreign investors. The activities of most real estate funds give rise to a United States trade or business (USTB) for tax purposes. This generally means that gain on the sale of real estate in the fund (or sale of the fund interest) is treated as effectively connected income (ECI) with a USTB. ECI is taxable to a foreign investor independent of FIRPTA. Accordingly, in such case a QFPF is not afforded special tax treatment.
A QFPF is generally defined as a trust, corporation or other organization or arrangement organized under the law of a foreign country:
- Which is established by the country (or political subdivisions thereof), or by one or more employers, to provide retirement or pension benefits to beneficiaries that are current or former employees (or their designees) on account of services rendered;
- Which does not have a single participant or beneficiary with a right to more than 5 percent of its assets or income;
- Which is subject to government regulation and with respect to which annual information about its beneficiaries is provided, or is otherwise available, to the relevant tax authorities in the country in which it is established or operates; and
- With respect to which: i) contributions to the entity or arrangement which would otherwise be subject to tax under the relevant foreign law are deductible or excluded from the gross income of such entity or arrangement or taxed at a reduced rate, or ii) taxation of any investment income of such entity or arrangement is deferred, or such income is excluded from the gross income of such entity or arrangement or is taxed at a reduced rate.
Although there are some elements of the definition that are likely to be clarified in future regulations, the definition is generally viewed as being broad enough to cover a wide variety of foreign pension arrangements.
2. The Basics of REITs
REITs are afforded favorable treatment for U.S. tax purposes. In general, an entity qualifying as a REIT does not pay corporate tax provided it distributes at least 90 percent of its income to its shareholders. To qualify as a REIT, an entity must satisfy various organizational, operational, distribution and compliance requirements. Some of the key requirements are set forth below:
Beginning with its second taxable year, a REIT must meet two ownership tests: it must have at least 100 shareholders, and five or fewer individuals cannot own more than 50 percent of the value of the REIT's stock during the last half of its taxable year. In the case of a private REIT, the 100-shareholder requirement is typically satisfied by offering preferred shares to 100+ small investors (e.g., each investing $1,000). This is typically arranged by specialty firms that handle such offerings and administer the annual preferred dividends.
Annually, at least 75 percent of the REIT's gross income must be derived from real estate, such as rents and mortgage interest. There is also a 95 percent gross income requirement that includes investment interest and dividends. This means that no more than 5 percent of the REIT's income can be from non-qualifying sources. An example of non-qualifying income is service fees.
Quarterly, at least 75 percent of the REIT's assets must consist of real estate, or loans secured by real estate. Subject to certain limitations, qualifying assets include shares in another REIT, a taxable REIT subsidiary or a qualified REIT subsidiary.
A REIT is subject to a 100 percent tax on net income derived from “prohibited transactions," which generally includes income from the sale of property primarily held by the REIT for sale to customers in the ordinary course of a trade of business (“dealer property”). There is a safe harbor that, as a practical matter, most REITs comply with in order to avoid any doubt as to whether the punitive 100 percent tax could apply. One element of the safe harbor requires, among other things, that the REIT hold property for at least two years before disposing of it.
REITs are suitable for many assets classes, including: office, industrial, retail, lodging (including hotels and resorts), residential, timberland, healthcare and infrastructure.
3. Tax Treatment to Foreign Shareholders of a Private REIT
Distributions of REIT income are generally taxable to a foreign shareholder. Distributions of income are designated as “ordinary dividends” or as “capital gains dividends.” Distributions in excess of income are generally treated as a return of capital.
Ordinary dividends are those attributable to the ordinary (e.g., operating) income of the REIT, such as net rental income and mortgage interest. If paid to a foreign shareholder, such dividends are treated as “fixed, determinable, annual or periodic income” (FDAP) and are generally subject to a 30 percent federal withholding tax. The rate of tax may be reduced in some cases if the shareholder qualifies for benefits under an income tax treaty. For example, qualifying Danish pension funds are entitled to a zero percent rate of tax (i.e., full exemption) provided the pension funds owns no more than 10 percent of the private REIT. For Danish pension funds owning 10 percent or more, a 30 percent rate applies.
Capital gain dividends are treated as gain from the sale of underlying capital assets of the REIT. Gain attributable to the sale of U.S. real estate is generally taxable to a foreign shareholder under FIRPTA by applying a look-through concept (i.e., the capital gain dividend causes the foreign shareholder to be treated as having sold a USRPI in a taxable transaction). Corporate shareholders are subject to a 21 percent rate of federal tax on such gain whereas individuals and certain trusts may be subject to a 20 percent rate of tax. As with ordinary dividends, the REIT must withhold on capital gain dividends.
Sale of Private REIT Shares
A REIT is generally treated as a USRPHC. As such, gain on the sale of private REIT shares is generally taxable under FIRPTA. There is an exception for the sale of shares of a domestically controlled REIT. A domestically controlled REIT is one in which more than 50 percent of the value of the stock of which is owned by U.S. persons.
4. The REIT Advantage for QFPFs
The exemption from FIRPTA for REITs creates two main tax advantages for QFPFs. First, capital gain dividends are now fully exempt from taxation. This is a major change from prior law where a foreign pension fund receiving a capital gain dividend was subject to a 35 percent or 20 percent federal income tax rate, depending on whether it was treated as a corporation or trust for U.S. tax purposes. Although ordinary dividends remain taxable (subject to potential treaty reduction), depreciation and interest deductions may reduce the earnings for U.S. tax purposes such that distributions treated as ordinary dividends are reduced. This means that in many cases most (if not all) of the income from a real estate investment goes untaxed both at the REIT level and at the shareholder level.
Second, gain on the sale of REIT shares, whether domestically-controlled or not, is exempt from taxation. The buyer of the REIT shares would effectively inherit the built-in gain on the REIT shares which may impact the purchase price.
5. Planning Considerations
Many real estate funds specifically targeting foreign pension fund investors will set up REITs to facilitate the tax benefits described above. As part of the due diligence on such funds, the QFPF should inquire about steps that will be taken to ensure that the REIT qualification criteria will be maintained. Appropriate covenants should be included in the governing documents.
In many cases, a QFPF may be the only foreign pension fund investing in a real estate fund, or in a particular asset. Some funds or investment sponsors may be willing to set up and operate a captive REIT for a single pension fund. In this case, it is especially important that the pension fund understand the process for ensuring that REIT status will be achieve and maintained. Non-REIT investors and the general partner (GP) may not want to be subject to the investment restrictions applicable to REITs and the GP may not be willing to limit its investment options. In other cases, measures may be taken to help ensure that the REIT maintains its status without limiting the fund’s investment decisions. For example, there are techniques that can segregate the ineligible assets or income from the REIT.
Some pension funds may prefer to set up and maintain their own captive REIT to hold their qualifying U.S. real estate investments, including minority interests in funds. In this way, the pension fund would have more control over the ability of its REIT to maintain the qualification requirements. Cost savings may also be achieved by aggregating investments into a single REIT.
Transfer of Existing Investments
Pension funds with existing real estate investments in the form of a partnership interest or direct interest in real estate may consider transferring them to a captive REIT. As an initial matter, it must be determined whether the investments will satisfy the income and asset tests. If not, measures may be taken to segregate the good from the bad assets. Second, it must be determined whether the transfers into the REIT are tax-free. In the case of a transfer to a captive REIT, tax-free treatment is very often achievable. If the pension fund is classified as a corporation for U.S. tax purposes (as opposed to a trust), the REIT may need to hold the transferred assets for at least five years to avoid gain recognition on a sale of the transferred assets by the REIT.
Many foreign investors hold their U.S. real estate investment through a domestic “leveraged blocker” corporation. These are often Delaware corporations that have borrowed a significant amount of their capital from the foreign pension fund parent (or from a foreign fund in which the pension fund invests). There are techniques that may allow the leveraged blocker’s assets to become those of a REIT. For example, a taxable corporation with historic activities can elect to be treated as a REIT if the qualification criteria are fulfilled. In such case, the historic earnings and profits of the corporation must be distributed before the end of the first tax year of the REIT. Further, built-in gain on the corporation’s assets become taxable if an appreciated asset is sold within five years.
Finally, the safe harbor against prohibited transactions should be considered, especially the two-year holding period requirement.
As noted above, ordinary dividends may attract a 30 percent withholding tax, including in certain cases where treaty benefits are available (e.g., 10 percent shareholders). Interest is exempt from the 30 percent tax under many treaties regardless of ownership. As such, by partially capitalizing the REIT with debt, ordinary dividends taxable at 30 percent may effectively be converted into interest that is exempt from tax. New rules limiting interest expense to essentially 30 percent of EBITDA should be considered.
Setting and operating a private REIT results in additional costs over an investment through a partnership or a corporation. There are costs related to formation and determining if the proposed investments can qualify for the various REIT tests. Similar compliance costs will be incurred annually. In addition, the preferred shareholders typically receive a return that exceeds what a bank lender would charge. If the investment in U.S. real estate is large enough (e.g., several million dollars), the extra formation, diligence, compliance and financing costs will be minimal compared to the tax savings.