Considerations for Foreign Investors of Real Estate Private Equity Funds
December 08, 2022
By Michele Rosenman
Foreign investors often make up a large number of investors in private equity funds. Real estate private equity funds should consider how having foreign investors in their funds impacts both the fund and the foreign investors from a tax and administrative perspective. Real estate private equity funds may want to consider the use of blocker corporations and/or REITs to mitigate U.S. federal income tax and filing obligations that arise from certain investments, particularly real property.
Tax Impact on Foreign Investors
Foreign investors are subject to U.S. income tax only on income that is either derived from U.S. sources or is effectively connected with a U.S. trade or business (“effectively connected income” or “ECI”), regardless of source. A foreign investor that engages in considerable, continuous, or regular business activity in the U.S. is generally considered to be engaged in a trade or business within the U.S.
Real estate private equity funds structured as partnerships for tax purposes may produce income that is ECI for foreign investors, triggering a tax liability and filing obligation. For instance, most rental income (exceptions do exist for certain triple-net-lease real estate) and gains from the sale of real estate located in the U.S. are generally considered to be ECI. The filing obligation may include federal, state, and local tax filing obligations. Therefore, many foreign investors try to mitigate ECI exposure and the tax implications.
The U.S. has income tax treaties with various countries designed to alleviate double taxation of income. The treaties typically reduce tax rates on certain types of portfolio investment income and limit taxation of other types of business profits of a resident of one country generated in the other country.
Tax Impact on the Fund
A real estate private equity fund is also subject to an additional U.S. withholding tax regime designed to make sure the federal income tax associated with a foreign investor's allocable share of the fund's ECI is withheld by the fund and remitted to the IRS.
Withholding is generally required regardless of whether any current distributions of money or property are made to the partners. This can be especially onerous on both the partnership and the foreign partner where the partnership produces phantom income for tax purposes. For example, phantom income may be incurred by the partners upon disposition of a property. Phantom income could be triggered when taxable income exceeds sales proceeds upon the disposition of real estate. This usually results from prior deductions based on indebtedness. Losses may have been deducted or cash distributions may have been received in prior years that were greater than the actual equity investment made in the property.
The disposition of a U.S. real property interest (“USRPI”) by a foreign investor is subject to the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”). FIRPTA is designed to ensure foreign investors who own U.S. real estate are subject to income tax upon the sale or transfer of the U.S. property. FIRPTA treats the gain or loss of a foreign investor from the disposition of a U.S. real property interest as income or loss effectively connected with a U.S. trade or business.
For example, whereas the sale of stock in a C corporation may initially be viewed as resulting in capital gain not subject to tax for foreign investors, FIRPTA will treat the sale of stock in a C corporation with underlying U.S. real estate as being subject to income tax.
Use of Blocker Corporations and REITs
A blocker corporation may be used to invest on behalf of foreign investors. The blocker entity acts as a barrier between the investors and the investment, and it converts any income or gains from that investment into corporate dividends distributed by the blocker corporation.
The blocker corporation blocks the potential U.S. source ECI at the blocker level so that the blocker itself, and not the owners of the blocker, is subject to U.S. tax. Similarly, the character of the income is also blocked because the corporate blocker is not a pass-through entity for U.S. tax purposes. Foreign persons invested in the U.S. through a blocker are generally not required to file a U.S. tax return for this investment. Generally, a C corporation domiciled in the U.S. will be formed to serve as the blocker corporation that will hold the real estate investment. The dividends paid by such a corporation to foreign investors will generally be considered non-ECI. However, they may be subject to certain other withholding requirements of up to 30%, which may be reduced by treaty benefits. A C corporation is also subject to tax at the corporate level. The current applicable tax rate for C corporations is 21%.
The above discussion is based on the use of a domestic C corporation. A foreign corporation may also be used as a blocker, but this option is generally more restrictive and may not be as advantageous as using a domestic corporation.
If a foreign investor disposes stock of the U.S. corporation for a gain, that gain may be subject to U.S. taxation if the U.S. corporation was a United States Real Estate Personal Holding Corporation (“USRPHC”) at any time during the five-year period ending with the disposition of the interest. In this case, the foreign investor would be subject to FIRPTA withholding.
A corporation is a USRPHC if the fair market value of its USRPI is 50% or more of the sum of the fair market values of its USRPIs, foreign real property interests, and U.S. or foreign trade or business assets. USRPI does not include an interest in a publicly traded domestic corporation unless the investor owned more than 5% of the fair market value of such stock at any time during the five-year period ending on the date of the investor’s disposition of such stock.
An alternative blocker that may be used for foreign investors is a real estate investment trust (“REIT”). A REIT is a U.S. corporation that elects to be taxed as a REIT. REITs generally distribute most of their income in the form of dividends. The dividends received by foreign investors are generally subject to the same withholding rules as dividends distributed by other U.S. C corporations that are not REITs. A key difference between a C corporation and a REIT is that a REIT does not pay any entity-level tax if it meets all the REIT requirements. Furthermore, an interest in a domestically controlled REIT (less than 50% owned by foreign investors) does not constitute a USRPI and is therefore not subject to FIRPTA. As such, the sale of stock of such a domestically controlled REIT would not be subject to FIRPTA. Conversely, dividend distributions made by a REIT to foreign investors that are attributable to the REIT’s gains from sales or exchanges of USRPI are subject to U.S. tax under FIRPTA.
Understanding a fund’s investor base in terms of how it will be taxed and the implications on the fund itself is critical when structuring the fund. Foreign investors provide specific tax and administrative challenges that can be mitigated with proper planning and structuring. There are complex tax implications that need to be considered, and consultation with an appropriate tax advisor is a key step in fund formation and compliance.