1 “U.S. Cities Lead Way for Global Foreign Real Estate Investment,” the James A. Graaskamp Center for Real Estate, University of Wisconsin, http://www.bus.wisc.edu/realestate/news/afire.asp

2 Kenney, Allen, "U.S. Real Estate Deals Nearly Triple in 2010," Jan. 7, 2011, http://www.reit.com/Articles/US-Real-Estate-Deals-Nearly-Triple-in-2010.aspx

Foreign investment in U.S. real estate investment trusts (REITs) is growing.

•From2008to2010,transactionvaluesofforeigninvest-ment in U.S. REITS more than tripled, from $749 million to nearly $2.456 billion. And in the first half of 2011, foreign investors poured another $3.540 billion into U.S. REITs (Figure 1).

•DespitetheeconomicuncertaintythatmanyU.S.busi-nesses face, American real estate remains an attractive target for foreign capital. According to a recent annual study conducted by the University of Wisconsin for the Association of Foreign Investors in Real Estate (AFIRE), 60 percent of foreign investors surveyed say that the United States offers virtually the best potential for capital appre-ciation. This figure is 54 percentage points ahead of China, the second-most popular destination for foreign investment, and is virtually the highest U.S. percentage since AFIRE first asked the question in 2000.1

•Real-estate-orientedmergerandacquisition(M&A)activity is also on the rise. According to a study by mergermarket, the number of U.S. real estate mergers and acquisitions increased from 20 in 2009 to 36 in 2010, and the combined value of these transactions nearlytripled,from$3.8billionto$11.0billion.2

Foreign investors are looking to put capital to work in U.S. real estate. However, before participating in REITs, foreign investors should understand:•HowREITsarestructured,•WhatimplicationstheForeignInvestmentinRealPropertyTaxActof1980(FIRPTA)canhaveonthetaxation of REIT income, and

•Whatstrategiesareavailabletohelpmitigatetheeffectof FIRPTA on REIT gains?

The impact of FIRPTA on foreign investment in U.S. REITs

Figure 1

Source: Capital IQ

Transaction values of foreign investment in U.S. REITs ($MM)

0

1000

2000

3000

4000

2011201020092008

M&A Insights — Industry FocusNovember 2011

Merger & Acquisiton Services

M&A Insights — The impact of FIRPTA on foreign investment in U.S. REITs 2

REIT requirementsThe tax regime for REITs was created for the specific purpose of encouraging widespread ownership of real estate.

Basically, a REIT is an entity, otherwise taxable as a U.S. corporation, that meets certain technical requirements and that elects REIT status. The key difference between a conventional U.S. corporation and a REIT is that a REIT is allowed a tax deduction for dividends paid to its share-holders. To qualify for this special treatment, a REIT must annually distribute at least 90 percent of its net taxable income exclusive of capital gains to its shareholders.

REIT requirements fall into three categories:

•Ownership: There must be 100 or more owners, and no five (or fewer) individuals may own directly or indirectly more than 50 percent of the total value of the REIT stock.

•Assets: At least 75 percent of the total value of the REIT’s assets must consist of cash, real estate, loans secured by real estate, or U.S. government securities.

•Income: At least 95 percent of the REIT’s gross income must be composed of interest, dividends, and rents from real property, plus six other specified sources of income. In addition, 75 percent of the REIT’s gross income must consist of rents from real property, interest on loans secured by real estate, and seven other sources of income.

REITs must adopt a calendar year as their tax year. Existing U.S. corporations that wish to elect REIT status must distribute all pre-election earnings and profits for tax years accumulatedafterFebruary28,1986.IfaREITmeetstheforegoing requirements, it may avoid tax at the corporate level by distributing all net income currently to share-holders, thereby eliminating the normal double taxation of corporate income. REITs, similar to all US corporations, are not subject to the second level of U.S. tax imposed by the branch profits tax (BPT). REITs are permitted to have 100-percent-owned subsidiaries, each of which are essentially treated as disregarded entities for income tax purposes. Alternatively, a REIT may elect to treat a subsid-iary as a “taxable REIT subsidiary” or “TRS”. Such an entity is treated like a regular taxable U.S. corporation and can be used to own assets/businesses that are not otherwise REIT qualified.

Implications for foreign investorsThe taxation of REIT distributions depends on whether the distributions are attributable to ordinary operating profits or to gain from sales or exchanges of U.S. real property interests.

To the extent the REIT makes a distribution to a foreign investor attributable to gain from sales or exchanges of U.S. real property interests by the REIT, the distribution is treated as effectively connected income (ECI) which means the distribution is taxed for U.S. purposes as income from a U.S. trade or business.

In general, FIRPTA withholding rules apply to require the REIT to withhold 35 percent of the amount distributed to its foreign shareholders that is attributable to the REIT’s sale or exchange of U.S. real property interests. Although, nonresident alien individuals and other non-corporate foreign investors (e.g., many non-U.S. pension funds) may be subject to tax at the lower individual capital gain rates, the withholding rate is set at the higher corporate rate of 35% until regulations are issued. Reduced withholding tax certificates or planning using a U.S. partnership to invest in the REIT may mitigate potential over-withholding for non-corporate investors. U.S. tax treaties may not be used to reduce FIRPTA withholding or the final FIRPTA tax. Non-US corporate REIT shareholders are also subject to a 30% BPT on the after-tax amount of such distributions. U.S. income tax treaties may lower the rate or possibly eliminate the BPT altogether. Because such distributions are treated as ECI, foreign investors would generally be required to file a U.S. tax return to report the distribution and pay the BPT (or claim a lower treaty rate on BPT). One exception to this rule applies to distributions with respect to a class of stock of the REIT which is regularly traded on an established securities market where the foreign investor did not own more than 5% of such class of stock at any time during the 1-year period ending on the date of such distribution. In this case, the distribution to such foreign investors is not subject to FIRPTA and is, instead, taxable like an ordinary dividend described below.

To the extent the REIT makes a distribution to a foreign investor attributable to gain from sales or exchanges of interests by the REIT which are not U.S. real property interests (e.g., non-FIRPTA mortgage loans or non-U.S. real property), provided the distribution is designated as a capital gain, the distribution is not taxable to foreign investors. While there is potentially conflicting language in the statute and regulations, the view of the authors is that the REIT would also not be required to withhold on such designated capital gain distributions.

M&A Insights — The impact of FIRPTA on foreign investment in U.S. REITs 3

To the extent a distribution is not designated as a capital gain dividend and not otherwise subject to FIRPTA classifi-cation, the distribution generally is treated as an ordinary dividend of non-ECI subject to the 30 percent statutory withholding tax rate for dividends or a lower treaty rate, if applicable, to the extent such distribution is attributable to the REIT’s current or accumulated earnings and profits. If a lower treaty rate applies, a US tax return would be required to report the claim of the lower treaty rate. Careful attention should be paid to claiming treaty benefits as the use of transparent entities to hold shares in the REIT can potentially result in denial of treaty benefits in certain circumstances.

Distributions not otherwise subject to FIRPTA classification which are in excess of the REIT’s current or accumulated earnings and profits would generally be a nontaxable return of capital to the extent of a foreign investor’s tax basis in the REIT. If the REIT is either (i) “domestically controlled”, which generally means that less than 50 percent or more in value of the REIT stock is directly or indirectly held by foreign investors for a period of five years, (ii) not a US real property holding company (e.g., a mortgage REIT), or (iii) the class of stock to which the distribution relates is regularly traded on an established securities market and, in general, the foreign investor has held no more than 5 percent of such class of stock for 5 years (the 5% Public Exception), the REIT is not required to withhold on such nontaxable distributions paid to foreign investors. If none of the above exceptions apply, the REIT must withholding tax at 10% on such distributions under the FIRPTA rules. A foreign investor would be required to file a US tax return to claim a full refund for such tax. A reduced withholding certificate or planning using a US partnership to invest in the REIT may mitigate this fully refundable withholding tax.

Distributions not otherwise subject to FIRPTA classifica-tion which are in excess of both (i) the REIT’s current or accumulated earnings and profits and (ii) the foreign investor’s US tax basis in the stock of the REIT are treated as proceeds received with respect to the disposition of shares in the REIT. If the REIT is either (i) domestically controlled, (ii) not a US real property holding company, or (iii) the 5% Public Exception applies, the distribution is tax free to the foreign investor, and the REIT does not have an obligation to withhold. If none of the above excep-tions apply, the distribution is taxable at 35% to corporate foreign investors and the lower individual capital gain rate (currently 15%) to non-corporate foreign investors (e.g., nonresident alien individuals and many non-US pension plans). The REIT would be required to withhold tax at 10% on the gross amount of such distributions. The foreign investor would be required to file a US tax return to either pay the remaining amount owed or otherwise claim a refund for any over-withholding. BPT would not apply on such distributions.

Generally, foreign investors that dispose of shares in a REIT are likely to be subject to U.S. tax on their gain due to the fact that, other than mortgage REITs, most REITs are U.S. real property holding companies the disposition of which is taxable under the FIRPTA rules. Accordingly, any gain subject to tax is treated as ECI, and the foreign investor must file a U.S. tax return and report the gain. The gain would be taxable at 35% to corporate foreign investors and the individual capital gain rate (currently 15%) to non-corporate foreign investors (e.g., nonresident alien individuals and many non-US pension plans). BPT would not apply to such taxable sales. The transferee of the REIT stock is required to withhold 10% of the gross proceeds paid to the foreign investor. This withholding tax can be reduced with a reduced withholding tax certificate received from the IRS if the final tax is lower than 10% of the gross proceeds.

However, if the REIT is either domestically controlled or if the 5% Public Exception is met, gain on the disposition of REIT shares would not be taxable.

A changing view of foreign investment

FIRPTA was established at a time when some US govern-ment leaders wanted to discourage foreigners from investing in U.S. real estate by requiring that they paid the same amount of US tax as any US investor upon disposi-tion of U.S. real estate. The new law implemented this policy by taxing foreign investors on real estate gains as if such gains were attributable to income which is effectively connected with the conduct of a US trade or business.

M&A Insights — The impact of FIRPTA on foreign investment in U.S. REITs 4

Since that time, the federal government has come to view foreign investment in U.S. real estate as a natural part of the global real estate market, but it has kept FIRPTA in place because of the revenue that the law generates.

Morerecently,pressuresresultingfromtheturmoilincommercialrealestatehave sparked a number of federal legislators to support major changes to the FIRPTA rules that would likely lessen the tax consequences for foreign investors and encourage more investment in U.S. real estate from abroad, particularly in distressed assets.

Even without legislation, foreign investors may be able to reduce the impact of FIRPTA by investing in domestically controlled REITs and publicly traded REITs.

•Domestically controlled REITs: Non-US investors may avoid FIRPTA’s reach on gains by purchasing shares in REITs controlled by U.S. shareholders. In general, as long as foreign investors own less than 50 percent of the value of a REIT for the lesser of 5 years or the time during which the REIT has been in existence, they will owe no taxes under FIRPTA when they sell their shares. However, distributions to all investors — domestic as well as foreign — are taxable.

•Publicly traded REITs: Another option for avoiding tax on gains under FIRPTA is for foreign investors to own no more than 5 percent of publicly traded REITs for the lesser of 5 years or the time during which the REIT has been in existence. Proposals in Congress would increase this threshold to 10 percent, but there is no guarantee if or when such a change may take place.

One downside to these two techniques is their size. While 49 percent of a domestically controlled REIT may satisfy some foreign investors’ appetite for U.S.realestate,5percentofapubliclytradedREITmaybetoosmall.Mostrecent legislative proposals seek to increase this to 10%.

Moreadvancedstrategiesmayhaveevengreaterpotentialtoreducetaxesonforeign investment in U.S. real estate. As such, before making any real estate investment decisions, foreign investors should consult their U.S. tax advisers.

ContactsFor more information, please contact:

James DeJesusPartnerDeloitte Tax LLP+1 212 436 2645 jdejesus@deloitte.com

Mark DiamondPartnerDeloitte Tax LLP+1 404 220 1151mdiamond@deloitte.com

Patrick KelleyPartnerDeloitte Tax LLP+1 404 631 3303pmkelley@deloitte.com

Jeff RubinPartnerDeloitte Tax LLP+1 404 942 6600jerubin@deloitte.com

This publication contains general information only and is based on the experiences and research of Deloitte practitioners. Deloitte is not, by means of this publication, rendering business, financial, investment, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte, its affiliates, and related entities shall not be responsible for any loss sustained by any person who relies on this publication.

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