Real Estate Forum - May/June 2009

International Beat
By Dorothy L. Alpert
Foreign Investors May Have Edge
In Buying US Distressed Debt

FOREIGN INVESTORS—INSTITUTIONAL PLAYERS, sovereign wealth funds and high-net-worth individuals— should be aware of the favorable tax treatment they may enjoy when purchasing distressed US real estate debt.

The economic malaise infecting global markets and the recent efforts of the Obama Administration to counter the downturn may give rise to greater investment in distressed US real estate, particularly loans, notes and mezzanine interests. Capitalization rates dropped close to historic lows in recent years, aided by plentiful and inexpensive capital markets debt. However, today, with liquidity issues in the credit markets freezing transactions, investors may pursue institutional-quality assets that they refrained from buying under prior frothy market conditions.

Recent estimates by Real Capital Analytics value US

Nearly 380 investment funds targeted
or obtained more than $228 billion of
commitments through the third quarter.

distressed property at more than $120 billion with growth potential, based on a total face value for US real estate of $6 trillion, according to the Real Estate Roundtable. Also, corporate default rates on leveraged loans, of which 80% are distressed, have jumped from under 1% in 2007 to greater than 3.5% in 2008, reports Debtwire North America.

Nearly 380 investment funds targeted or obtained more than $228 billion of commitments through the third quarter of 2008, according to Prequin, to pursue distressed debt and assets. According to Real Estate Alert, targeted returns for funds that are high-yield- and distressed debt-focused is 14.2%. With proper planning, an investment in these opportunities may be structured to have minimal US income tax impact for foreign investors.

By way of background, foreign investors’ income is broadly subject to US federal income tax in cases of ECI, income generated in connection with a US trade or business. Or in instances of FDAP, income, dividends, interest, rent, royalties or other similar type of payments that are not connected with a US trade or business. Foreign investors that generate ECI are subject to net basis taxation on their US ECI and must file US income tax returns to report their

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activities. Payments of FDAP income to foreign investors are generally subject to a 30% gross basis withholding tax, which can be reduced by an income tax treaty or under domestic tax law.

A foreign investor’s gain on the sale of a US Real Property Interest is treated as effectively connected income fully subject to US tax. A USRPI is an interest other than solely as a creditor in US real property or in stock of a domestic corporation. Foreign investors are also taxable on gains from the sale of a partnership that holds USRPI. However, a straight mortgage loan is not a USRPI. A loan with the right to share in the appreciation in, or gross or net profits from, a USRPI would be considered a USRPI.

US income tax law does not clearly define a trade or business within the US. However, an exception applies to the trading in stocks or securities, including debt instruments, for the taxpayer’s own account. Foreign investors could structure their real estate debt investments to take advantage of this statutory exemption from ECI, and if the debt instrument does not have equity-like characteristics, such as contingent interest, it would not be treated as an interest in real property.

Interest income received by a foreign person from a US debtor is generally subject to a 30% gross basis withholding tax. However, many treaties reduce this tax significantly and can even eliminate it for qualified residents of the treaty country. Also, US domestic law excludes taxation on portfolio interest. While there are detailed requirements for an interest to meet this definition, generally it is interest that is received by nonresident alien individuals or foreign corporations on an obligation that is in registered form or that is a bearer instrument meeting certain foreign targeting requirements. This is provided that the holder of the debt instrument does not have a 10% or greater ownership interest in the debtor. Therefore, if a debt instrument can be structured to qualify for this exemption, the investor does not need to rely on a specific income tax treaty to reduce or avoid US withholding tax on its interest income. ◆

The views expressed in this column are those of the author and not REAL ESTATE FORUM.

Dorothy L. Alpert is the national managing director, real estate, hospitality and construction for Deloitte LLP in New York City. She may be contacted at dalpert@deloitte.com.