By Mark A. Bayer, Esq. & Benjamin D. Gehlbach, Esq.
Section 1445 of the Internal Revenue Code, also known as The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), provides that, in cases involving the sale of a U.S. real property interest by a foreign person, purchasers, certain purchasers’ agents and settlement officers are required to withhold from the seller’s proceeds ten percent of the amount realized on the sale and remit those funds to IRS as a deposit of potential capital gains taxes that could be owed by the seller. Although certain narrow exceptions apply, FIRPTA can be an impediment to greater foreign investment in the U.S. real estate market because it diverts to the IRS for what can be many months, even if no capital gains tax is actually owed, funds that could otherwise be reinvested immediately in other projects. However, a little-known investment tool is making a resurgence in an effort to attract foreign capital to the U.S. real estate market.
Real Estate Investment Trusts (REITs) are an investment vehicle created in the 1960s to provide all investors, not just the wealthy, with the opportunity to invest in large-scale and diverse real estate projects. Investors purchase an interest in the REIT and share proportionately in its profits and losses. REITs may invest directly in income-producing commercial properties, generating returns through the collection of rents, or in mortgages or mortgage securities tied to a property, generating interest income. REITs can be publicly registered with the SEC, allowing their shares to be traded on major stock exchanges, or may be held privately.
Currently, a foreign investor in an REIT owning five percent or less of a publicly-traded REIT’s stock is not subject to the provisions of FIRPTA upon the sale of the stock or the receipt of a capital gain distribution, although U.S. withholding rates still apply to dividend distributions. This is commonly referred to as the “portfolio investor” exception to FIRPTA. In addition, the sale of stock in a public or private REIT is exempt from FIRPTA if at least 50 percent of the total stock issued is held by U.S. persons. This exception to FIRPTA, referred to as the “domestically-controlled REIT” exception, is rarely employed because the REIT often lacks the information to determine whether its “small shareholders” (those who own less than 5 percent of stock) are U.S. or foreign persons.
A rare piece of bipartisan legislation introduced on Capitol Hill this year could greatly impact the use of REITs and foreign investment in U.S. real estate generally. Senate Bill 1181, introduced by Senators Robert Menendez of New Jersey and Mike Enzi of Wyoming, along with 28 cosponsors, seeks to increase foreign investment in the United States by reforming some of the criteria for when FIRPTA is triggered. [The companion bill in the House, H.R. 2870, was introduced by Reps. Kevin Brady of Texas and Joseph Crowley of New York.] These bills would expand the so-called “portfolio investor” exception to FIRPTA by increasing the threshhold from five percent to ten percent, allowing a foreign investor to own and sell a larger stake in a publicly traded REIT without triggering FIRPTA. In addition, in order to increase usage of the “domestically-controlled REIT” exception, the proposed reforms provide that a publicly-traded REIT may presume that its “small shareholders” are U.S. persons unless it has actual knowledge to the contrary. This will make it easier for a REIT to reach the 50 percent threshhold necessary for the exception to FIRPTA.
Although some of the legislative momentum for these reforms has been stunted due to other priorities currently consuming Capitol Hill, the bipartisan nature of these reforms demonstrates that both parties recognize the role foreign capital can play in reviving the housing market and adding jobs to the U.S. economy. As Washington prepares for another round of bruising budget talks, we hope that these bipartisan bills can serve as the model for a long-term budget solution which incorporates these reforms and unleashes the potential benefits that foreign capital can have on the U.S. real estate and labor markets.
All information and views expressed in this article are the solely those of Bayer Kaufman, LLP.