US tax rules support investment in real estate by favouring the Real Estate Investment Trust (REIT), which provides a tax break to retail investors by allowing flow-through treatment of rental income. The advantage of a REIT is that rental income earned is generally not subject to ‘entity level’ tax, allowing that income to be distributed to owners tax-free.

In several recent high profile cases, US state taxing authorities have challenged the use of REITs by US public companies. Businesses were renting property through wholly owned subsidiaries called captive REITS to shelter income from other operations, often retailing. While there is generally no net effect on federal taxable income, states maintain these companies were not intended to benefit from tax-breaks available through a REIT structure; their use of a REIT is an abuse. To shut them down, state and local taxes are being applied to captive REITs.

Anti-abuse legislation that taxes the activity of a REIT can sometimes intentionally or unintentionally affect foreign owned REITS. Over the last decade, several prominent foreign investment funds, (e.g. Australian REITs and sovereign funds) have invested in US real estate. The primary tax paid on rental income derived by foreign owned REITs is US federal withholding tax on distributions, (e.g. a 15 per cent rate on distributions to Australian REITs).

US real estate is often held by a REIT that is wholly owned by a foreign owned investment vehicle. Foreign real estate managers were concerned that since the REITs owned by foreign investors are majority owned by offshore investment funds, proposed rules designed to attack US companies with abusive captive REITs would inadvertently impact these foreign owned REITs, denying their benefit of flow-through treatment and imposing state taxes in addition to the applicable withholding tax.

The Multistate Tax Commission has now issued a resolution that specifically exempts REITs owned by Australian REITs and many other foreign investment funds from the captive trust rules being implemented to prevent abuses. It is likely to be adopted by many US states, halting proposed tax increases on foreign owned investments.

This resolution would be a victory for the international fund industry and is a big step towards preserving the status quo for non-US fund investments in US real estate so that these investments can continue to benefit from low US taxes.

David Lifson & Peter Bentley,
New York, United States
dlifson@haysco.com
PBentley@haysco.com