European investor interest in the US is strong, but the FIRPTA tax law remains a serious impediment. Stephanie Schwartz-Driver reports
In its 2012 annual survey of members, the Association of Foreign Investors in Real Estate (AFIRE) analysed the influence that a ‘good news' event has in international investment flows into US real estate: 32% of survey respondents said the repeal of the Foreign Investment in Real Property Tax Act (FIRPTA) would have the greatest influence on their investment decisions, and 25% said it would have significant influence. Only "improved property fundamentals" was considered more influential than FIRPTA.
It is important to note that this represents the opinion of current investors in US real estate, Jim Fetgatter, AFIRE's chief executive, points out. "What we did not survey is those people who do not invest in the US because of FIRPTA," he says.
But there is a perception that there are few loopholes to FIRPTA. "FIRPTA could be the biggest impediment to foreign investment in US real estate today," Fetgatter says.
Broadly speaking, FIRPTA levies a 35% tax specifically on foreign owners of real estate. According to Jeffrey DeBoer, chief executive officer of the Real Estate Roundtable, when "branch profits taxes" as well as state and local taxes are added in, foreign investors can find themselves paying as much as 54% tax on any capital gain stemming from real estate transactions. In addition to this are administrative costs and the costs of structuring investments.
In contrast, no other asset class is taxed in the same way as real estate: for example, non-US investors are not subject to US taxes on capital gains resulting from the sale of US securities; interest income from bank deposits and debt obligations that produce portfolio interest similarly are not subject to US tax when held by non-US investors.
The Real Estate Roundtable is engaged in promoting tax reform, calling for the repeal of FIRPTA in order to spur foreign investment in US real estate.
These taxes carry greater weight in the current investment environment, says Henry Cohn, partner in the law firm Wilkie Farr and Gallagher, which represents both European investors who want to invest directly and real estate operators who market to non-US investors. "In the past, returns from investment in US real estate were spectacular," he says. "Then people were not as focused on tax. In recent years, however, the returns have not been so great, and investors are paying a lot of tax."
There are bills in Congress, introduced in September 2011, to eliminate some of its more restrictive measures. Both bills have bipartisan support. "These bills nibble away at FIRPTA, but they certainly do not repeal it," said Fetgatter. These bills are not the first efforts to moderate FIRPTA, but their broad base of support is a positive sign.
The bill in front of the Senate, the Real Estate Investment and Jobs Act of 2011, was introduced by Robert Menendez, a Democrat from New Jersey, and Michael Enzi, a Republican from Wyoming. On the same day, a bill was introduced in the House by Kevin Brady, Republican from Texas, and Joseph Crowley, Democrat from New York: the Real Estate Jobs and Investment Act of 2011. Both these bills would propose some measure of relief from FIRPTA taxation, with the goal of encouraging non-US investment in US real estate investment trusts (REITs).
Among the changes proposed, these bills would, importantly, increase the amount of stock minority shareholders can hold in publicly traded companies, such as REITs, and still benefit from FIRPTA tax relief: from 5% to 10%. They also would reverse a 2007 IRS notice allowing redemptions and liquidating distributions to be treated the same as sales of stock instead of real estate. Foreign investors are not usually subject to US taxation on capital gains resulting from the sale of US stocks.
Although these bills have broad support in Congress, no action is expected this year, because of the presidential elections in November. In addition, there is a feeling in Washington and in the real estate community that the Treasury Department is not in favour of any repeal.
By opening US real estate further to non-US investors, advocates of a FIRPTA repeal assert that it will broaden the capital base for US real estate operators, very valuable in the current public market environment. It would also allow US sponsors to develop deeper relationships with a broader range of capital sources. Ultimately, a broader capital base will help stabilise domestic lending markets and eventually lead to economic growth.
The most common route for non-US investors is through domestically controlled REITs. "Investors can escape the tax burden as long as the majority of the stock of the REIT is owned by US investors," says Cohn. Domestically controlled REITs, under FIRPTA, have an exemption from US tax being levied on sales of the REIT stock.
To qualify as domestically controlled, more than 50% of the value of the REIT shares must be owned by US investors. The fund must fulfil all the qualifications of a REIT, including the distribution of income (although private REITs have some flexibility compared with public REITs and can agree to reinvest some proportion of the income as long as they pay at least 10% in cash). Five or fewer individuals cannot hold more than 50% by value of the REIT's shares; in effect, individual owners cannot hold more than a 10% stake in the REIT. Overall the REIT must have more than 100 direct shareholders. To avoid tax liability, it cannot liquidate while the foreign investors hold their shares.
There are also more complex REIT strategies, such as using tiers of REITs, which are more aggressive strategies that allow larger holdings but still avoid FIRPTA taxation. Cohn noted that he has not yet seen anybody implement this type of scheme.
Another solution for non-US investors is to search out commingled funds that are structured to provide some tax relief. "We have a lot of non-US investors in our commingled funds as well as directly in property," says Max Swango, managing director and director of client port-folio management at Invesco Real Estate. "They prefer to invest as passive investors in minority positions, because it helps them to achieve lower taxes.
"They rely on US investors and their US peers, and they are very happy to be passive partners," he adds. "It works very well for US investors to have a partner to co-invest, and to provide capital."
European investor interest in the US has been slowly building for around three years now, according to Swango. "What is driving investors to the US is that many have significant exposure to their own domestic markets," he says. "They are looking to diversify and the most obvious place is the US." He points out that "non-US investors are taking a very measured look" at the US now. "If they do not invest this year, they are ok about it," he says. "They are looking for opportunities but investments must be compelling or today's investors are content to pass and wait."
The US real estate market is effectively competing with Asian property markets when it comes to European investors looking to go global. The investment story for the latter is more broadly about economic growth and urbanisation, but the US is appealing for its "stability, transparency and the sophistication of its investment managers," Swango says.
Because European investors have other options, FIRPTA is a great hindrance to US investment, says Fetgatter. "It is true that at the moment Europe is not looking so good, but in spite of that, there are other places to go. When FIRPTA was passed there were a lot of obstacles to other markets, and we in the US had a monopoly on foreign capital. This is not so now," he says. "We are competing for capital with a lot of different countries, but the tax code is bogged down in 30-year-old thinking."
FIRPTA was originally conceived in the 1970s as a way to prevent foreign parties from acquiring too much agricultural land; the rule was enacted in the 1980s.
Passive positions in commingled funds offer one route to invest in the US, but according to Adam Fenner and George Rogers of Skyline Wilshire, which was set up three years ago to raise European capital for US real estate operators, FIRPTA does not necessarily dissuade all European investors from direct investments.
According to Rogers, the attraction of US real estate should overcome the handicap represented by FIRPTA. "For some UK and European investors, even a year ago, the US was definitely intriguing; China was high on the list, and there was a comfort level in continental European investment," he says. "Today, however, China is less attractive and may have peaked. With the ongoing dislocation in the euro-zone, the US is perceived as a relative safe haven, and the view is that the fundamentals are solid."
Many European investors are looking for a closer relationship to their investments, according to Fenner. "We are at a time when European capital sources familiar with the commingled fund model also want access to the real estate operators on the ground, to have a closer relationship to the assets," he says. While REITs and other commingled funds may be structured to provide some relief from FIRPTA, there are also means to make direct investments in a tax-efficient manner.
Fenner says Skyline Wilshire "has worked with leading counsel and accountants on a tax-efficient blocker structure for debt and equity investment" on behalf of European investors. Essentially, the non-US investor invests via the ‘blocker' entity, from which capital ultimately flows into the underlying assets. The blocker files tax returns with the Internal Revenue -Service (IRS) and pays taxes. This may also eliminate filing requirements for non-US investors.
But it is not a one-size-fits-all solution. Each investor is different and as a result "each blocker structure has to be implemented with the particular investment in view," Fenner says. For example, there are rules relating to the percentage of voting rights an investor working through a blocker structure can have. "With appropriate structuring, European capital is finding the risk-adjusted returns in the US to be compelling," says Rogers.
Although it is possible to structure deals to avoid the FIRPTA tax burden, there are associated costs, which Fenner acknowledges. "There is a cost associated with legal advice, but the structure is attractive," he says.
Cohn agrees with the cost issue. "All of these strategies require a fair amount of structuring, and there is also the ongoing compliance cost," he says. Expensive legal fees may not be materially detrimental for an investor buying a $500m office building, but at the lower end they are a significant disincentive.
Legal costs are a factor not only for direct investment but also for specially structured REITs. Cohn warns that the REIT rules are very complicated and noncompliance can result in being "de-REITed." Although this has not happened to any public REITs, some private REITs have had to approach the IRS for forgiveness.
"The US is very attractive: it is very transparent, and there is a tremendous history of foreign investment by UK institutions into the US, so there is strong familiarity and comfort. There is a predictable, stable and effective legal system," says Fenner. "The one area where people become twitchy is tax structuring. There is a natural inclination to go to what you know."