Investment Structures for Real Estate Investment Funds kpmg.com © 2012 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. 26701NSS Investment Structures for Real Estate Investment Funds Who Are the Investors? In What Assets Will the Fund Invest? Will There Be Leverage? What Types of Investment Vehicles Are Available? What May Be the Appropriate Type of Entity for Each Type of Investor and Asset? Structuring to Accommodate Preferences of Different Types of Investors Bios Conclusion Contents 01 02 03 04 05 06 11 13 12 © 2012 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. 26701NSS Investment Structures for Real Estate Investment Funds1 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. Investment in U.S. Real Estate Structuring Summary Chart Investor Classification 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 Taxable o o o o Super Tax-Exempt o o o o Tax-Exempt (qualified organizations) o * ◊ * ◊ (w/TRS) * Tax-Exempt (all others) * ◊ * ◊ * ◊ (w/TRS) * Foreign * ◊ * ◊ * ◊ (w/TRS) * Foreign Governments (assuming blockers are not controlled commercial entities) * ◊ * ◊ * ◊ (w/TRS) * Legend: * Blocker o Flow-through ◊ REIT (assuming domestically controlled) w/TRS With Taxable REIT Subsidiary © 2012 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. 26701NSS Investment Structures for 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 tax- exempt 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. © 2012 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. 26701NSS Investment Structures for Real Estate Investment Funds3 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. © 2012 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. 26701NSS Investment Structures for Real Estate Investment Funds 4 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. Will There Be Leverage? © 2012 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. 26701NSS Investment Structures for Real Estate Investment Funds5 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. © 2012 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. 26701NSS Investment Structures for 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. © 2012 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. 26701NSS Investment Structures for Real Estate Investment Funds7 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). © 2012 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. 26701NSS [...]... reserved Printed in the U.S.A The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG International 26701NSS Investment Structures for Real Estate Investment Funds 11 Investment Structures for Real Estate Investment Funds © 2012 KPMG LLP, a Delaware limited liability partnership and the U.S member firm of the KPMG network of independent member firms affiliated... well as the terms of any special agreements that may be required between entities and/or the investors 12 Investment Structures for Real Estate Investment Funds 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... KPMG International 26701NSS 9 Investment Structures for 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... International 26701NSS 15 Investment Structures for Real 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... 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 16 Investment Structures for Real Estate Investment Funds © 2012 KPMG LLP, a Delaware limited liability partnership and the U.S member firm of the KPMG network of independent member firms affiliated... 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... 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 26701NSS Investment Structures for Real Estate Investment Funds © 2012 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... former vice chairman of the Tax Policy Advisory Committee of the Real Estate Roundtable 14 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... 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 26701NSS Investment Structures for Real Estate Investment Funds © 2012 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... 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 . International. 26701NSS Investment Structures for Real Estate Investment Funds1 Investment Structures for Real Estate Investment Funds While the real estate market. International. 26701NSS Investment Structures for Real Estate Investment Funds 2 Who Are the Investors? The typical investors in U.S. real estate funds include