By Chris Rising & John Golden

On December 18th, 2015, President Obama signed the Protecting Americans From Tax Hikes (PATH, or the Act) Act of 2015 into law, which enacted major reforms to the Foreign Investment in Real Estate Property Tax Act (FIRPTA) of 1980. In short, this is a total game changer that will allow qualified foreign pensions to make real estate investments in the United States without getting taxed upon sale.

Foreign investors have flocked to U.S. real estate since the global economic meltdown, drawn by the relative yields and perceived safety of assets from office towers and shopping centers to apartments and warehouses. The demand has helped drive commercial real estate prices to record highs. Many foreign investors structured their purchases to make themselves minority investors and bypass FIRPTA taxation. In fact, paying law firms large sums to “paper around” the FIRPTA issues has become a part of doing business for many sovereign wealth funds.

Foreign investors generally don't face U.S. federal capital gains tax upon the disposition of investments across most asset classes, including equity securities and bonds. As such, the U.S. is generally considered very tax friendly to foreign investors. However, Internal Revenue Code enacted FIRPTA in 1980 and imposed U.S. federal tax obligations on most non-U.S. investors with respect to capital gains of U.S. real property interests. This included investments in individual properties and stock in REITs. The disposition of a U.S. real property interest by a non-U.S. investor is subject to the FIRPTA income tax withholding. Persons purchasing U.S. real property interests from foreign investors were required to withhold 10% of the associated gross sales proceeds payable to the non-U.S. investors. In most cases, the buyer is the withholding agent.

Prior to FIRPTA’s amendment by the Act, special exemptions generally applied to 5%-and-smaller positions in publicly-traded real property holding companies and stock in “domestically controlled” REITs.

The public perception was that FIRPTA was a response to the surge of Japanese investment in trophy U.S. property in the late 1980s and early 1990s, including Rockefeller Center and Pebble Beach. However, the act was actually passed in 1980 to curb international investors buying U.S. farmland. Under the old rules, foreign majority sellers had to pay 10 percent of gross proceeds from the sale of U.S. real estate as well as additional federal, state and local levies that could increase the total tax burden to as much as 60 percent, according to the National Association of Real Estate Investment Trusts (NAREIT). Under pre-Act law, foreign pension funds were subject to U.S. federal capital gains taxation on the disposition of U.S. real property interests under FIRPTA, while U.S. pension funds were generally exempt from capital gains tax. As mentioned, foreign pension plans were generally forced to engage in sophisticated structuring to minimize U.S. federal tax liabilities. One common way to bypass FIRPTA required non-U.S. institutional investors like Norway’s Government Pension Fund Global and the Abu Dhabi Investment Authority (ADIA) to structure purchases to make themselves minority investors.

The reality is that while there has been significant growth in foreign investment in US real estate, on a percentage basis, foreign ownership is quite small. The major reason for this has been the aggressive tax penalties created by the old FIRPTA rules. “By breaking down outdated tax barriers to inbound investment, the FIRPTA relief will help mobilize private capital for real estate and infrastructure projects,” Jeffrey DeBoer, president and chief executive officer of the Real Estate Roundtable, an industry lobbying group, said in a statement.

Cross-border investment in U.S. real estate totaled about $78.4 billion in 2015, or 16 percent of the total $483 billion investment in U.S. property, according to Real Capital Analytics Inc. Pension funds accounted for about $7.5 billion, or almost 10 percent, of the foreign total, according to the New York-based property research firm.

It is our house view that the U.S. real estate market will clearly see increased interest from foreign investors. Given the recent volatility in equity and commodity markets in emerging and developing economies, foreign pension funds will likely view U.S. commercial and multifamily real estate as a “safe haven” relative to other investment options. We fully expect California to be a high priority for foreign investors, especially those from the Pacific Rim. The tax burdens brought about by FIRPTA have likely made direct investment in U.S. property a non-starter for hundreds of billions of dollars worth of foreign pension capital, and the Act could result in tens of billions of new capital flows into U.S. real estate. We at Rising see this as a tremendous opportunity to partner with foreign investors in their pursuit of investment in California real estate.