INVESTMENT STRUCTURES FOR REAL ESTATE INVESTMENT FUNDS ppt

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 i

Real Estate Investment

Funds

kpmg.com

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

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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

Super Tax-Exempt

Tax-Exempt (qualified organizations)

o * ◊ * ◊ (w/TRS) * Tax-Exempt (all others) * ◊ * ◊ * ◊ (w/TRS) *

Foreign Governments (assuming blockers

are not controlled commercial entities) * ◊ * ◊ * ◊ (w/TRS) *

Legend:

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

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

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?

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

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

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)