How to Get in on the Offshore Fund Flow to US
LOS ANGELES—A recent report estimates that foreign investors are on track to spend more than $70 billion on US commercial real estate in 2015. And another report says that nearly a quarter of all recent commercial real property sales in its survey involved offshore investors. “Foreign investment in U.S. real estate is growing so rapidly it may well surpass the previous record, set in 2007,” says Tom Muller, co-chair of land use and real estate practice at Manatt, Phelps & Phillips LLP. In the exclusive commentary below, Muller takes a closer look.
The views expressed in the column below are the author’s own.
Part of the explanation for the rapid growth in foreign investment is that the US is among the world’s most stable economies. Another important part, though, is that unlike some countries, the U.S. has minimal legal impediments to offshore investors investing in US properties. In fact, the Federal EB-5 program, granting foreign investors permanent residence status in return for job-creating investment in US businesses or projects, actively encourages that investment.
That doesn’t mean that it’s easy for a foreign investor to invest here, however. For one thing, every country has its own business culture and legal system, and it’s difficult to make a significant investment in any country without understanding its markets, customs and rules. This undoubtedly accounts for the fact that perennially the largest investors in US real estate are Canadian.
That strangeness dissuades offshore investors from direct investment in real estate. Many decide to use a joint venture with reputable US owners to get the advantage of market knowledge and familiarity with the rules and customs, giving the foreign investor the opportunity to learn from the experts.
US tax laws also strongly disincentivize foreign direct investment in US real estate. The Foreign Investment in Real Property Tax Act of 1980 imposes withholding taxes on gains recognized on real property. Foreign investors must also pay tax on their income from US real property if they are deemed to be engaged in a US trade or business.
Fortunately, there are mechanisms available to permit foreign investors to enjoy many of the benefits of investment in US real estate while minimizing or eliminating US taxation.
Foremost among these is the use of so-called “baby REITs”, which are newly-created, privately held real estate investment trusts, converting, as far as the IRS is concerned, the investment in real estate to an investment in a company—the REIT. While REITs are generally designed to facilitate widespread public ownership of real estate, and have complex rules relating to ownership, including requiring at least 100 owners, there are fairly straightforward ways to comply with these requirements even in a closely-held setting where the beneficial owners are companies with diverse ownership.
Even with the REIT structure, the foreign investor may need to comply with other arcane rules ensuring it is not a majority owner of, or otherwise viewed by the IRS as having significant control over, the business.
But there are ways to accomplish this while preserving most of the attributes an investor would really need in a real estate joint venture. And while the tax rules in this area are quite complex and require an unusually high degree of thoughtful structuring, given the amount of inbound investment, the rewards for those willing to navigate them are high.
