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
10 REAL ESTATE FORUM MAY/JUNE 2009
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 firstname.lastname@example.org.
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