Magazine article Real Estate Issues

Focus on Legal Issues: Using Private REITs for Joint Ventures with Foreign Investors

Magazine article Real Estate Issues

Focus on Legal Issues: Using Private REITs for Joint Ventures with Foreign Investors

Article excerpt


In recent years there has been increasing interest in structuring a joint venture between one or more U.S. investors in real estate and one or more foreign investors as a private real estate investment trust, or REIT. (The term "investor," as used below, is equally applicable to a plurality of investors.) This piece will 1). set forth an outline of this structure and its tax implications; 2). describe (as an illustration) a transaction on which I and others in my law firm worked recently that might be described as "the latest thing off the boat" in this sector; and then 3). analyze some variations that may be made on the theme, depending upon the status of the parties to the investment and their respective tax and other requirements.

A REIT is a corporation, or a business trust taxable as a corporation, that essentially pays no federal income tax at the REIT level. Rather, the shareholders are taxed on dividends received from the REIT - at the shareholder's ordinary-income rate on dividends corresponding to the REIT's ordinary income or at the shareholder's capital-gain rate on "capital gain dividends" corresponding to the REIT's capital gains. By way of contrast, as a general rule, a corporation is taxed at the corporate level and its dividends are taxed a second time at the shareholder level. Thus, REITs for the most part share the characteristic of "tax transparency" with partnerships and with limited partnerships and limited liability companies not electing to be taxed as corporations.

In years gone by, REITs were subject to numerous, complex, and very burdensome legal requirements, including severe restrictions on management and the rule that they must pay out as dividends at least 95 percent of their REIT taxable income. These were, and are, not applicable to the other tax-transparent entities. Partnerships and limited partnerships were therefore the preferred vehicles for many years for U.S. /foreign joint investment in U.S. real estate. (The limited liability company is a form of entity that has received widespread acceptance in just the last few years.)

Since then, Congress and the IRS have lightened up considerably on REITs. The applicable legal requirements are still numerous and complex but they are now just tolerably burdensome. Among the major remaining strictures is that the REIT's gross income must consist, to at least a specified minimum percentage, of income related to real estate (informally called "good REIT income"). In addition, effective January 1, 2001, the minimum dividend payout rate will drop from 95 percent to 90 percent. At the same time, there have been major changes in the international tax field which have boosted the popularity of private REITs.

Until 1980, if a foreign investor's investment in U.S. real estate--directly or through a tax-transparent entity-was properly planned, there would never be any federal income tax payable, including tax on capital gain realized at the time of sale. In December 1980, Congress enacted the Foreign Investment in Real Property Tax Act, or FIRPTA, making it effective retroactively for some six months. (In the last 20odd years, Congress has become very fond of retroactivity in tax legislation.) FIRPTA introduced a broad-based tax, at rates ranging from 20 percent to 35 percent, on a sale by a foreign investor of U.S. real estate or an interest in a tax-transparent entity or corporation holding U.S. real estate. Capital gain dividends paid by a REIT are also subject to FIRPTA. Section 897(h)(2) of the Internal Revenue Code provides an exemption for dispositions of shares of a domestically-controlled REIT (a "USREIT"), defined as a REIT more than 50 percent by value of the shares of which are owned by U.S. persons; the U.S. investor must, of course, be prepared to make a genuine investment equal to more than half the value of the USREIT. This exemption is not applicable to capital gain dividends paid by a USREIT. …

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