1 Investment Structures for Real Estate Investment Funds kpmg.com
3 Contents Investment Structures for Real Estate Investment Funds 01 Who Are the Investors? 02 In What Assets Will the Fund Invest? 03 Will There Be Leverage? 04 What Types of Investment Vehicles Are Available? 05 What May Be the Appropriate Type of Entity for Each Type of Investor and Asset? 06 Structuring to Accommodate Preferences of Different Types of Investors 11 Conclusion 12 Bios KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. Printed in the U.S.A. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International NSS
4 1 Real Estate Investment Funds Investment Structures for Real Estate Investment Funds While the real estate market has yet to experience a real recovery, fund investment in real estate appears to be experiencing a cautious but marked rejuvenation, and fund managers are beginning to raise capital to form funds. But given the experience of the economic downturn, investors who venture into real estate investments nowadays do so with greater demands to accommodate their particular needs so as to maximize their potential return while minimizing their downside risk. One of these crucial demands is for investment structures that accommodate specific tax sensitivities, given that tax consequences can negatively impact an investor s return, as well as the volatility of returns in today s real estate markets. Consequently, in structuring real estate investment funds, it is critical to understand each prospective investor s tax sensitivities. This summary and the chart below provide a general overview of some of the major factors that should be considered in structuring real estate funds that invest primarily in U.S. real property. The chart identifies the type of investment entity through which each type of investor may generally prefer to invest. As the chart illustrates, the mix of different types of investors, each with distinct tax considerations, can lead to divergent and often conflicting structuring preferences. This summary explains the investor preferences indicated in the chart and provides an overview of how alternative investment vehicles (AIVs) may be used to accommodate different types of investors within a real estate fund. Taxable Investor Classification Investment in U.S. Real Estate Structuring Summary Chart Rental Real Estate Fractions Rule Compliant (all passive, no services, incidental personal property or personal property leased with the real property) Rental Real Estate Not Fractions Rule Compliant Operating Real Estate Business (e.g., Hotels) Dealer Property Only o o o o Super Tax-Exempt Tax-Exempt (qualified organizations) Tax-Exempt (all others) Foreign Foreign Governments (assuming blockers are not controlled commercial entities) o o o o o * * (w/trs) * * * * (w/trs) * * * * (w/trs) * * * * (w/trs) * Legend: * Blocker o Flow-through REIT (assuming domestically controlled) w/trs With Taxable REIT Subsidiary
5 Real Estate Investment Funds 2 Who Are the Investors? The typical investors in U.S. real estate funds include individuals and entities, both domestic and foreign. Foreign investors may include foreign governments and their sovereign wealth funds. Tax-exempt entities, including pension funds, educational institutions, and other large charitable organizations, also may invest in U.S. real estate funds. Each of the various investor types is subject to distinct taxation regimes, as generally discussed below. Taxable investors include high net-worth individuals, corporations and flow-through entities that have high net worth individuals, and corporations as owners. Tax-exempt organizations may include state-sponsored pension funds that often are treated for tax purposes as a division of a state and are generally thought to be taxexempt based on their governmental status (i.e., super tax-exempts ). Other tax-exempt investors include corporate pension funds, educational institutions, and charitable organizations that generally are taxable on their income from unrelated businesses and on income from debt-financed investment (known as unrelated business taxable income, or UBTI), subject to certain exceptions. Foreign governments and their integral parts and controlled entities generally are not taxable on certain types of income, including U.S. investments in stocks or bonds or other securities, certain financial instruments, and interest on deposits in banks in the United States. Funds identified as sovereign wealth funds may be considered a foreign government, integral part thereof, or an eligible controlled entity; however, not all sovereign wealth funds are eligible for tax-exempt treatment. Foreign governments are taxable on income derived from commercial activities or received from controlled commercial entities (as generally explained below). Also, the exemption for foreign governments does not apply to certain investments in U.S. real property that are covered by the Foreign Investor Real Property Tax Act (FIRPTA). Notably, income or gain from real property that the foreign government holds directly or through a flow-through entity is not exempt from U.S. taxation. Finally, foreign investors may include individuals and foreign entities that are taxable on a net basis on income that is effectively connected to a U.S. trade or business. These foreign taxpayers are subject to the FIRPTA regime, which generally taxes foreign persons on the disposition of U.S. real property as though they were engaged in a U.S. trade or business.
6 3 Real Estate Investment Funds In What Assets Will the Fund Invest? The consequences to each of the types of fund investors (see chart on page one) vary significantly depending on the type of real estate asset in which the fund invests. For example, dealer property (i.e., property held primarily for sale to customers in the course of business, such as condominiums or residential lots) will present income character issues for virtually all tax-exempt and foreign investors. Likewise, the operation of commercial properties (e.g., hotels) almost always will require structuring to facilitate investment by tax-exempt and foreign investors. Considerations will be more varied for office, industrial, and residential rental properties. Foreign investors will likely still require structure modifications, while tax exempt investors may, in some cases, be able to hold the property directly through the fund.
7 Investment Structures for Real Estate Investment Funds Will There Be Leverage? In addition to the type of asset in which a fund invests, the type of financing used by the fund affects the tax treatment of certain investors. When property is financed with leverage, income from the property generally is taxable to tax-exempt entities (other than governmental divisions) as income from unrelated debt-financed property unless certain exceptions apply. Certain tax-exempt investors that are qualified organizations, including pension funds, educational institutions, title holding companies, and certain church retirement income accounts, may avoid being taxable on debt financed income from real property when the fund complies with strict income allocation requirements, referred to as the fractions rule, and when the financing otherwise meets certain requirements. 4
8 5 Real Estate Investment Funds What Types of Investment Vehicles Are Available? Just as the type of investor, type of real estate asset, and type of financing critically impact the tax treatment of investors, the type of entity through which investors invest in funds also affects the tax consequences. The fund itself generally is formed either as a partnership or a limited liability company taxable as a partnership for U.S. federal income tax purposes. Thus, the fund itself is not taxable, and the fund s income, loss, deduction, and credit flow through to its partners. Also, any trade or business conducted, directly or indirectly, by the fund will be attributed, for many purposes, to its investors. On the other hand, when an investor invests through a corporate entity, referred to as a blocker, the trade or business of the underlying flow-through entity generally is not attributed to a partner. Thus, holding such an interest would not cause a foreign investor to be treated as engaged in a U.S. trade or business. Also, dividend income from a corporate blocker would be passive income that generally would not be treated as UBTI for tax-exempt investors. Finally, an uncontrolled blocker similarly protects a foreign government from being connected to a commercial activity and from being taxable on the income from the entity. The trade-off for this blocker protection is that these corporate entities are subject to an entity level tax. In addition, if the blocker is a domestic entity, dividends and interest payments made to a foreign investor generally are subject to withholding at a rate of 30 percent (unless reduced by applicable treaty or exempted by statutory exemption). If the blocker is a foreign entity operating through a branch in the United States, it may also be subject to a 30 percent (unless reduced by applicable treaty) branch profits tax on the branch s effectively connected earnings and profits to the extent that income is treated as repatriated under the branch profits tax rules. Another type of entity often used to block certain types of income is a real estate investment trust (REIT). Although REITs are taxable as corporations for most federal income tax purposes, they are permitted deductions for dividends paid and thus, effectively, are not taxable at the entity level so long as taxable income is distributed on an annual basis. REITs are subject to a separate taxation regime. Formed as corporations for U.S. federal income tax purposes, REITs block the attribution of a trade or business and generate dividend income that generally is not treated as UBTI for tax-exempt investors. However, REITs are subject to restrictions on the types of property they may hold and the activities in which they may engage. REITs are largely restricted to holding rental real estate assets and mortgages as well as a limited amount of other passive investment assets. REITs are discouraged from holding dealer property through the imposition of a 100 percent penalty tax imposed on any gains derived from the sale of such property. However, REITs may form taxable REIT subsidiaries (TRSs) subject to certain rules, which may engage in many activities that a REIT could not undertake directly. Thus, the chart indicates the potential use of a REIT for investments in rental real property and for investments in hotel property if used together with a taxable REIT subsidiary. With the foregoing as background, this section of the summary will discuss each of the types of investors included in the structuring summary chart above, with reference to the various types of real estate investments included in the chart. It is important to note that the types of entities indicated in the chart with respect to each investor and type of investment are merely general recommendations. However, when structuring funds, the individual facts and circumstances for each investor and investment must be separately considered in each case to ensure that all potential consequences have been considered.
9 Real Estate Investment Funds 6 What May Be the Appropriate Type of Entity for Each Type of Investor and Asset? Domestic Taxable Investors Taxable investors who are U.S. citizens may include individuals and entities that are either taxable as corporations or are themselves flow-through entities with taxable partners. Domestic individuals and entities taxed as corporations may invest directly in a fund or through partnerships formed to invest in other funds. These investors typically do not want to incur an entity-level tax on their investments. As a result, they generally do not want to invest in a fund through a taxable corporation and they do not want the fund to invest in real estate through a taxable corporation. State-Sponsored Pension Funds and Other Super Tax-Exempt Investors Certain U.S. pension funds that are considered to be an integral part of a state or political subdivision are thought not to be taxable for U.S. federal income tax purposes on any of their income. Thus, as shown in the chart, such investors are not particularly sensitive to the type of real estate asset to be invested in, the structure through which the investment is made (other than through a taxable corporation), or the use of leverage. Accordingly, similar to taxable investors, these investors may prefer to invest through flow-through entities so as not to incur an entity-level tax. Due to some uncertainty, however, as to the nature of the tax exemption applicable to these investors, some may prefer structuring alternatives more generally applicable to other types of tax-exempt entities in order to provide an additional level of safety in their tax structuring. Tax-Exempt Investors Tax-exempt investors (other than the state-sponsored investors discussed above) are taxable on income from unrelated businesses and on income from debt-financed property. However, tax-exempts generally are not taxable on rents from real property, unless such property is financed with leverage. If tax-exempt investors are to be allocated income from a fund that would be subject to tax as UBTI, the tax-exempt investors would be required to file U.S. tax returns in addition to paying the required tax. Many tax-exempt investors that would be subject to U.S. tax on allocable fund income prefer to invest through corporations (i.e., blockers) that are required to pay the tax and file U.S. tax returns. Although such a structure may not result in any tax savings for the tax-exempt entity, the structure will allow the tax-exempt entity to avoid paying tax directly or filing tax returns. As mentioned above, certain tax-exempt investors that are qualified organizations, such as educational institutions and pension funds, may avoid UBTI from debt-financed real property when a fund complies with the fractions rule and the financing meets certain requirements. In broad terms, the fractions rule prescribes onerous requirements with respect to partnership allocations that are intended to prevent the shifting of tax benefits from tax-exempt partners to taxable partnerships. Where financing meets certain requirements, the fund is able to comply with the fractions rule, holds only real property generating rental income, and does not otherwise engage in another trade or business, qualified organizations will prefer to invest directly in the fund and enjoy flow-through treatment. It is important to note, however, that, depending on the services offered to tenants of the rental property or the level of personal property associated with the real estate, such income nevertheless may be taxable as UBTI, even to a qualified organization.
10 7 Real Estate Investment Funds Because it is rare that a fund would invest in real estate without leverage, we assume for purposes of the chart and the summary that all fund investments are debt-financed. Thus, where the fund does not comply with the fractions rule, qualified organizations may prefer to invest through a blocker. Because tax-exempt entities that are not qualified organizations are not protected from UBTI associated with debt-financed property by compliance with the fractions rule, such entities also may prefer to invest through a blocker. When the fund engages in operational activities with respect to real estate that go beyond rental activities, as in the case of a fund that holds and manages hotel properties, tax-exempts, including qualified organizations, will often prefer to invest through a blocker to avoid recognizing UBTI. Similarly, when a fund invests in dealer properties such as condominiums, tax exempt investors will often prefer to invest through a blocker to avoid UBTI. Assuming a tax-exempt entity did not incur debt to acquire its shares, dividends from a corporation (including a REIT) are generally not taxable as UBTI to a tax-exempt entity. When pension funds are direct or indirect investors in a REIT, it is important to be aware of rules relating to pension-held REITs. A REIT is a pension-held REIT if (1) it would not have qualified as a REIT but for being allowed to meet the REIT minimum shareholder requirement by looking through to the beneficial ownership of its qualified trust owners, and (2) at least one qualified trust holds more than 25 percent (by value) of the interests in the REIT, or one or more qualified trusts (each of which own more than 10 percent by value of the REIT interests) hold in aggregate, more than 50 percent (by value) of the REIT interests. When a pension fund holds more than 10 percent (by value) of a pension-held REIT, a portion of the pension fund s dividends from the REIT may be treated as income from an unrelated business and taxable as UBTI to the extent such amounts would be UBTI if recognized directly by the pension fund (and provided the UBTI amounts exceed five percent of the REIT s total income). Finally, it is important to understand that, although investing through a corporate blocker may provide certain advantages to a tax-exempt entity, as more particularly discussed above, investing through a blocker may, in some circumstances, increase a tax-exempt s overall tax rate. First, to the extent that some property in the blocker generates good income that otherwise would be exempt from tax (i.e., rents from real property), that income would be subject to an entity-level tax inside the blocker. Second, even though property generates operating income that is UBTI, in many situations, gain from the sale of that property may not generate UBTI. Third, operating income and disposition gain from leveraged property, whether held directly or through a partnership, may be taxable by reference to a fraction that is the relevant debt over the relevant adjusted basis. If held in a blocker, the entire amount of income and gains is subject to an entity-level tax. Tax-exempt investors may mitigate some portion of the corporate-level tax imposed on non-reit blockers through the use of leverage (and deductible interest on such leverage), although the protection provided by the blocker will be compromised if the blocker is a controlled entity. Foreign Investors Foreign investors typically do not want to trigger a U.S. income tax return filing obligation. Property operations often will rise to the level of a trade or business, such that the income attributable to such operations would constitute taxable, effectively connected income to a foreign investor. Similarly, the FIRPTA rules generally would cause gains from the disposition of U.S. real estate to be subject to U.S. tax with respect to such investors and may require the filing of a U.S. income tax return. For this purpose, real estate includes direct interests in U.S. real property as well as stock in certain domestic corporations that hold primarily U.S. real property that are United States Real Property Holding Corporations (USRPHCs).
11 Investment Structures for Real Estate Investment Funds REIT blockers are often a foreign investor s first choice because they effectively do not pay tax if they make the required distributions each year. However, REIT blockers can be used only if the fund invests in activities that permit the blocker to be a REIT. Dispositions of REIT shares are not taxable to foreign investors under the FIRPTA rules if the REIT is domestically controlled. A REIT is domestically controlled if, during the shorter of the five-year period ending on the date of the disposition or the period it was in existence, less than 50 percent in value of the stock was held directly or indirectly by foreign persons. Ordinary dividends from a domestically controlled REIT are treated as any other dividends received by a foreign person, subject to withholding at a fixed rate of 30 percent, as reduced by treaty, if applicable. However, when a domestically controlled REIT disposes of real property and distributes a capital gain dividend, the portion of the dividend designated as a capital gains dividend will be treated under the FIRPTA rules as income from the disposition of U.S. real property, subject to FIRPTA withholding and possibly the branch profits tax (where the investor is a foreign corporation), and necessitating the filing of a U.S. federal income tax return. 8 When the use of a REIT blocker is not possible for example, when the types of properties to be held by the real estate fund include dealer property foreign investors typically prefer to invest through a corporate blocker entity. As with investment through a REIT blocker, a foreign investor avoids attribution of the property-related trade or business activity by investing through a corporate blocker, and the ownership of blocker stock, in itself, does not trigger a U.S. income tax return filing obligation. When the corporate blocker is formed as a domestic entity, it will be required to file a U.S. income tax return, and dividends and interest paid by the blocker to the foreign investor generally will be subject to withholding at a flat rate of 30 percent as payments of fixed or determinable annual or periodic income. The withholding tax on dividends may be reduced or eliminated by treaty, if applicable. If the domestic corporation is a USRPHC, the withholding rules become more complicated and treaty benefits may be limited to a 10 percent gross tax. In addition, a blocker s effective tax rate may be reduced, subject to certain limitations, by the use of leverage to provide deductions for the blocker, thereby reducing its taxable income. Furthermore, when foreign investors fund
12 9 Real Estate Investment Funds capital as debt to the blocker, interest payments to the investor may, in certain circumstances, qualify as portfolio interest, which is statutorily exempt from the 30 percent withholding tax. Alternatively, interest payments paid by the blocker debtor to a foreign investor may qualify for a reduced withholding rate under an applicable treaty. It is important to note that a domestic, non-reit blocker may constitute a USRPHC, depending on its percentage of U.S. Real Property Interests (USRPIs) relative to other property. If the blocker is a USRPHC, then the transfer of its shares is generally taxable under FIRPTA, and the transferee of the shares would be required to withhold 10 percent of the gross proceeds from the sale. Thus, a typical exit strategy involves the sale of assets beneath the blocker, with the blocker making a liquidating distribution of its share of the sales proceeds to its shareholders. After the taxable sale of all real property held (directly or indirectly) by the blocker (assuming all its dispositions of USRPIs in the past five years were taxable), the blocker would no longer be a USRPHC. As a result, FIRPTA would not apply to the liquidation of the blocker. If, instead, a foreign blocker is used, the blocker would be subject to FIRPTA on the disposition of its USRPIs, which would include its interest in the real estate fund. The blocker would be treated as engaged in a U.S. trade or business and therefore required to file a U.S. tax return. Further, the foreign blocker could be subject to the 30 percent branch profits tax. In addition, a branch interest tax may apply to interest payments made by the foreign blocker. As with the 30 percent withholding tax on dividends and interest, the branch profits tax and the branch interest tax may be reduced by treaty, if applicable. Foreign Governments, Integral Parts of Foreign Government, and Controlled Entities Generally, a foreign government is not subject to tax in the United States on certain U.S. source investment income, including income from stocks, bonds, or other domestic securities owned by such foreign governments. In addition, a foreign government is not taxable on the sale of stock of a USRPHC, unless the foreign government controls the USRPHC. For purposes of this exemption, a foreign government includes its integral parts and controlled entities. Regulations provide that foreign pension funds that meet certain requirements are controlled entities for purposes of the exemption.
13 10 Investment Structures for Real Estate Investment Funds The exemption, however, does not apply to income derived from the conduct of any commercial activity (whether within or outside the United States), income received from a controlled commercial entity, or income derived from the disposition of any interest in a controlled commercial entity. A controlled commercial entity is an entity that engages in commercial activities either within or outside of the United States, in which a foreign government holds (directly or indirectly) 50 percent or more of the interests (by vote or value) or holds (directly or indirectly) an interest that provides the foreign government effective control of the entity. Importantly, a foreign government is not exempt on income earned from a USRPI or income from the disposition of a USRPI. Historically, in order to preserve its exemption from U.S. taxation, a foreign government investor would, in all circumstances, prefer to invest through a blocker entity that is subject to U.S. tax. Recently issued regulations, which eliminate attribution of commercial activities to minority limited partners with limited management rights, mitigate the need for blocking commercial activities in many instances. Nonetheless, foreign government investors still generally will use blockers for the same reasons as more traditional non U.S. investors. The foreign government investor will receive dividends attributable to such blocker entities that are exempt from U.S. tax. In preserving the exemption available to foreign governments, it is critical that the blocker not constitute a controlled commercial entity, so other investors should own more than 50 percent, by vote and value, of the direct or indirect interests in such entity. Accordingly, the chart assumes that any blocker entity is not a controlled commercial entity.
14 11Real Estate Investment Funds Structuring to Accommodate Preferences of Different Types of Investors As illustrated in the chart on page one, and the above discussion, different types of real estate fund investors often have varying, and sometimes conflicting, structuring preferences (e.g., certain investors may require a blocker while others prefer not to use a blocker) relating to their particular tax sensitivities. In order to meet the needs of all the types of investors in any given real estate fund, it often becomes necessary to introduce fund structures that use alternative investment vehicles, or AIVs. In the simplest structure, all investors who desire blocker protection could invest through a single blocker. However, as explained above and as illustrated in the chart, not all investors will desire to block all investments. Consequently, a fund manager may be asked to create separate partnerships that meet the needs of specific types of investors where investors desire that only certain investments be blocked. Further, it may be preferable that some investments are blocked using corporate blockers, while others are blocked using REIT blockers. In addition, the investors may have different preferences regarding whether the blocker is inserted in the structure above or beneath the fund. Although this discussion focuses on the tax sensitivities and preferences of the investors, it is important to note that the sponsor is also affected by the structuring choices dictated by the varying needs of the investors, as blockers can affect the sponsor s income due to entity-level taxes. In addition, the use of AIVs in certain structures may complicate economic arrangements relating to the sponsor s carried interest. Finally, as the complexity of a structure increases to accommodate the needs of different investors as well as the sponsor, special attention should be paid to the overall economic substance of the investment plan. This includes examination of the governing terms of the various entities employed, as well as the terms of any special agreements that may be required between entities and/or the investors.
15 Real Estate Investment Funds12 Conclusion As the discussion above makes clear, when structuring funds that will invest in U.S. real property, it is critical to consider the type of investments the fund will make and the likely investors in the fund, and to understand the sensitivities of those investors. With careful analysis and planning, different investors with varying needs can be accommodated within an AIV structure that takes those needs into consideration.
16 13Real Estate Investment Funds Bios James Sowell James Sowell is a principal in the Passthroughs group of the Washington National Tax Practice of KPMG LLP, focusing primarily on tax issues relating to partnerships and REITs and debt workouts for such entities. He currently leads the Real Estate practice for Washington National Tax. Mr. Sowell previously was with the U.S. Department of the Treasury (Office of Tax Policy) where he served first as an attorney advisor and then as an associate tax legislative counsel. Mr. Sowell is a former chairman of the Real Estate Committee of the American Bar Association (Tax Section) and is a former vice chairman of the Tax Policy Advisory Committee of the Real Estate Roundtable.
17 Real Estate Investment Funds14 Jim G. Tod Jim G. Tod is a partner in the Passthroughs group for KPMG s Washington National Tax Practice. The Passthroughs group is responsible for providing advice to KPMG professionals and clients regarding the federal taxation of partnerships, real estate investment trusts and S Corporations across all major industries. In addition, the Passthroughs group advises on specialty areas such as like-kind exchanges, oil and gas, leasing, and excise taxes. Mr. Tod has over 19 years of experience focusing on alternative investment funds and the use of partnerships and limited liability companies in merger and acquisition transactions. He also has extensive experience in real estate, debt restructurings, and alternative energy and has served as a member of the AICPA s Partnership Technical Resource Panel and a project leader for the American Bar Association.
18 15Real Estate Investment Funds Ossie Borosh Ossie Borosh is a senior manager in the Passthroughs group of the Washington National Tax Practice of KPMG LLP. Ms. Borosh has more than 10 years of experience in providing tax services to clients with an emphasis in the partnership taxation area and has experience in a broad range of partnership and real estate transactions and debt restructurings. Ms. Borosh is the chairman of the ABA Tax Section Real Estate Committee s Subcommittee on Tax-Exempt Investor issues.
19 Real Estate Investment Funds16
20 For more information on this topic, please contact: Jim Sowell kpmg.com ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. Printed in the U.S.A. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International NSS
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