Structuring a U.S. Real Estate Fund: A How-To Guide for Emerging Managers – Part Three

By Michael A. Bloom and Sung H. Hwang – Venable LLP (New York)

Read Parts One and Two.

C.   Corporate Blocker with Leverage.

Often a corporate blocker will be funded with a combination of debt and equity from the foreign investors.  U.S. tax-exempt investors avoid this form because this can easily turn their investment income into UBTI for technical reasons beyond the scope of this article.  This debt-equity package (often known as “interest stripping”) is still popular with foreign investors, because interest on debt can be used to offset the taxable income of the corporate blocker at the federal, state, and local levels, which, when combined, represents a significantly higher tax rate than the withholding tax on interest paid to the foreign investor.  In other words, the U.S. tax benefit of the interest expense deduction often exceeds the U.S. tax cost on the corresponding interest income.  If the foreign investor qualifies for an exemption from, or reduction of, the withholding tax on the interest, this tax arbitrage can result in even higher savings for foreign investors.

However, because of a series of rules enacted and adopted to curb interest stripping, as well as significantly enhanced documentation and reporting requirements, this form of interest stripping is not as popular as it once was.  As a general rule, foreign investors cannot leverage the corporate blocker to an extent greater than a loan an unrelated lender would have made against the same assets of the corporate blocker.

In our example, Maple Leaf Pension ultimately decides against an interest stripping strategy because the tax savings are not significant enough to justify the leverage, because of limitations on interest deductions under U.S. tax rules.

D.   REIT.

A U.S. real estate fund often invests with a real estate investment trust (REIT) or uses a REIT as a legal vehicle for a joint venture with a tax-exempt investor or a foreign investor.  A REIT is, in summary, any U.S. business entity that acts like a mutual fund with a real estate concentration.  To qualify as a REIT, the U.S. business entity has to make an election to be taxed as a REIT, and satisfy on an ongoing basis a number of ownership diversification, real estate asset and income concentration, active business prohibition, and distribution requirements, among others.  When it does, just like a mutual fund, it will be treated as a corporation that does not pay corporate income tax on its distributed income.

A REIT is generally not suitable as the primary vehicle for a U.S. real estate investment fund because of the numerous and technically difficult qualification requirements.  For example, the rigid distribution rules applicable to a REIT will be inconsistent with the flexibility required of a typical real estate fund distribution waterfall.

Instead, a REIT is often used to create investment opportunities with tax-exempt investors and foreign investors because, like a corporation generally, it can serve the function of a corporate blocker or reduce the tax cost from investment in significant ways.  For example, a REIT may be a suitable joint venture vehicle for a real estate fund that seeks to team up with a pension fund to acquire a large hotel that the fund could not acquire alone because of its size, whereas a pension fund will shy away from direct investment in a hotel because of the UBTI concerns.  Properly structured, a hotel REIT will shield the pension fund from UBTI concerns while allowing the real estate fund to make an investment that it otherwise could not have made.

Similarly, a REIT will be an enticing opportunity for a foreign investor if the U.S. real estate fund does not have significant foreign investor ownership and is willing to take more than a 50% interest in the REIT.  In such case, again, properly structured, the foreign investor will be able to take advantage of a special rule that allows it to exit its investment tax-free through the sale of its REIT stock (the so-called domestically controlled REIT rule), while allowing its U.S. real estate fund partner an investment opportunity that it otherwise would not have been able to close.

In our example, the Coffee Fund most likely will not be interested in teaming up with a REIT, because it has sufficient funds raised from the seed investors for its intended investment goal: to acquire a 30-property Dunkin Donuts portfolio in the first 3 years of its life.  Moreover, because the Coffee Fund has significant foreign investor ownership (i.e., more than 50%), it would not qualify for the “domestically controlled REIT” rule noted above.

Thus, one can see from this example how a structuring analysis is highly fact-dependent, and it is difficult to distill general rules of thumb.

5 Tax Law Changes.

Tax law will undergo many changes this year and in the near future, as the new administration and new Congress will try to “fix” laws and regulations that are perceived as “unfair” or “not working.”  For example, there is a great debate regarding how a carried interest is taxed, while an entirely new idea of creating a new tax rate for income earned through flow-through entities is also being entertained.  Thus, the way a U.S. real estate fund is structured may change soon, in reaction to how tax law changes.

6 Conclusion.

The aggregation of triple-net leased real estate can produce a very attractive real estate fund model.  As illustrated by the Coffee Fund example, there is no “one size fits all” approach to structuring a U.S. real estate fund.  The proper fund structure will depend on the facts and circumstances.  As indicated above, the key facts and circumstances include (i) investor type (e.g., taxable versus tax-exempt), and (ii) the business strategy of the fund.  In addition, compliance with applicable securities laws is a critical component of a successful fund launch.  Although launching your first real estate fund in the U.S. is an extremely complex process, we hope that this article gives the reader a better understanding of the analysis that goes into structuring a U.S. real estate fund.


Michael Bloom is counsel in Venable’s Tax and Wealth Planning Group, where he provides tax advice on all types of corporate transactions, such as mergers & acquisitions, restructurings, and venture capital investments. He is based in New York. In particular, Michael’s tax practice focuses on advising emerging fund managers on fund formation and portfolio acquisitions.

Sung H. Hwang

Sung Hyun Hwang is a partner in Venable’s Tax and Wealth Planning practice, based in New York. He focuses on the full spectrum of business tax law, from complex structured financial products to multi-partner business joint ventures. Mr. Hwang has significant experience in domestic and cross-border transactions involving real estate partnerships and funds, private equity funds, hedge funds, asset managers, family offices, and financial institutions. Mr. Hwang also has significant experience in the tax credit space, including the energy-based tax credit area.

Venable LLP

Venable ( has taken a two-pronged approach to building its global reach, one which delivers superior value, and maximizes the quality lawyering and client service that its clients expect. In many cases, it provides counsel directly to U.S. and foreign-based companies, institutions and individuals. Venable frequently deliver value to its clients in a number of very specialized areas where international recognition and scope are imperative. Examples include: FCPA; Tax; Privacy, Data Protection and Internet; International Trade; Intellectual Property; Advertising, Marketing and New Media.

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