Wall Street experts, financial newspapers and magazines highlight the machinations and volatility of the stock markets. Business television shows endless flashes from charts to graphs and back again, presenting the up-to-the-second stock market reports. Flashes of sound bites appear with Federal Reserve Chairman Powell or Secretary of the Treasury Yellen or some European counterpart as the background for media talking heads on panel shows hyperventilating over talking points.
Lost in all this deafening media noise are three critically important investment principles.
First is that trading is a far different exercise than investing. Second, safety is defined by an assured return of principle before return on principle. Third, the true measurement of return is the amount of positive after-tax cash flow.
Investors all over the world are looking to invest their money in a country and in assets which are safe – or safer than the alternatives. Every country has never ending risk. China is crippled by demographic and geological problems, suffering from vast misallocation of capital resources, political corruption, and a totalitarian political system. Russia which gave birth to Maoism, is similarly undermined. India is crippled by its culture of corruption and in-bred demographic problems, among other serious risk factors. Japan is insular. Investment into Sub-Saharan Africa has always been only for those with a high tolerance for risk and conflict. Central and South American countries are wrapped in socialist/communist economics and all that goes with that. The United Kingdom and European Union are well along the road to their suicide of Western civilisation. Middle-East countries suffer from geography and the deeply ingrained inherent risk of being Islamic.
The United States with its demographics, resources, location, with its origins forged into a free-market capitalist economy. It is at the apex in the hierarchy of nations.
Despite global turmoil and commotion, the United States remains the world’s largest and most secure economy.
Even for countries lower on the national hierarchy, when it comes to ranking investment options against investment risks, real estate ranks highest in safety potential for investment returns and invariably ranks as the lowest risk of capital loss. Critically, the United States provides the most secure legal system in acquiring property. Once the decision is made to invest in the US, the question then becomes how to secure the investment whether made directly or indirectly.
The US enables a wide range of structuring option in acquiring financing and operating. Real estate is a real asset capable of being directly owned or by a legal arrangement like a limited liability company or a trust where the investor owns a proxy legal interest. Pooled funds formed by licensed professional managers in compliance with governmental regulatory bodies or by a well-established exception to securities laws are widely used.
The US is a big country and real estate investment is a fractionalised industry. There is room for big and small players, and for everyone in between. Funding a real estate project is accomplished by equity, debt, or some combination. Equity provides the opportunity for growth in property values as well as income but involves the risk of ownership and possible loss of investment. Debt or leverage as it is referred to, is typically used for property acquisition. Some financing arrangements combine characteristics of debt and equity.
Debt has the benefit of a senior claim on the real estate and its income and can benefit from growth of value if built into the interest rate computation. For those non-US investors looking for safety of their capital, the likely investment strategy of choice is debt financing most often accomplished by a first mortgage or through a secondary mezzanine loan.
A typical structure for a foreign investor making loans to US equity real estate interest would be a US real property owner, generally a limited liability company (USCO) which borrows money from a foreign company (FORCO) and secures it with a mortgage on the property and security interests in related collateral such as rents. It is true that the US has enormously complicated and convoluted taxation of every kind of investment transaction, but there is a long-standing exception called “portfolio interest” applicable to “portfolio debt”.
Investors Investment Criteria
Whether a specific real estate opportunity is viable depends on clarifying the specific goals of the investors, whether in publicly listed funds, professional restricted funds, individual investment, or privately organised commingled fund arrangements.
Criteria to be considered includes:
Understanding Portfolio Debt
The United States is a free-market capitalist country whose economy depends on encouraging foreign capital investment into the US while discouraging capital from leaving.
Unfortunately, there is confusion between the fiscal policy of incentivised foreign investment as against a pervasive tax-the-rich politically driven domestic policy. The bright spot in the US federal tax code that gives a substantive edge to a foreign investor in the US is where money that is invested qualifies as portfolio debt. Then the interest payment, the cash flow, to the foreign lender is free from tax.
For the US, the portfolio debt exception to normal withholding tax accomplishes several economic purposes. Primarily, it encourages foreign capital markets and investors to place money directly in the US. Effectively, it eliminates convoluted offshore structures such as the so-called Dutch Sandwich.
Non-resident alien individuals and foreign corporations are subject to withholding tax on gross basis on US source income not effectively connected with the conduct of a trade or business within the United States or fixed or determinable type income (aka FDAP income). This type income, which would usually include periodic interest payments, is subject to withholding on the gross amount of the payment, without any deductions, at a rate of 30 per cent. Examples of FDAP income include interest, dividends, rents, and royalties. The 30 per cent withholding tax is due at the time of payment. Income that is, or is deemed to be, effectively connected with the conduct of a trade or business within the United States (ECI) is not subject to withholding but taxed like other US businesses.
Certain types of US source interest income of a foreign person qualify for statutory exemptions from tax and withholding:
How It Is Done
The basic requirements to qualify interest payments from the US to foreign investors free of the 30 per cent withholding tax are fairly straightforward. A US person or company – a LLC or partnership (say a USC) – is a domestic borrower from a foreign lender (say a FC) resident for tax purposes in a non-US country.
Mr. USC signs a written debt instrument to Mr. FC and requests Mr. FC to provide a Form W-8BEN certifying his foreign status, and in turn lends money to Mr. USC. The actual exchange of money is performed by an Escrow Agent for the Borrower and Lender who obtains all the required signed documents, files on public record mortgages, lien documents as a UCC-1, and fulfills other terms of the transaction, and then releases the money to Mr. USC.
In structuring a portfolio debt transaction, the tax code requirements are highlighted by the questions which are expectedly raised by the IRS:
A foreign person may invest in debt issued by a US person that qualifies for the portfolio interest exemption and avoid the withholding tax for the interest paid on the debt. The foreign person provides the US person (withholding agent) a Form W-8BEN for Form W-8BEN-E to certify that he is a foreign person. The parties to the debt may be individuals, corporations, partnerships, trusts, or estates.
Compliance And Sanctions
Tax and creditor/debtor laws are not the only concerns in international investments. Impacting all international and domestic financed transactions are wide variations involving complicated differences in US, UK, and EU economic sanctions, boycotts, anti-money laundering, kleptocracy prohibitions, and other economic and legal measures targeting countries and related persons deemed bad actors. Interesting, and in a strange way, to me amusing, is the fact that the US, UK, and EU generally overlook their own errant ways and miscreants. This is true of other countries such as Switzerland, Canada and Japan which also impose convoluted knee-jerk politically driven rules impacting routine activities and day-to-day operations for the mass of businesses and citizens, while accomplishing little benefit that is measurable. No doubt, the governments feel better, in terms of public relations, that they are striking back against wrongdoers. It gives the bureaucrats of the Administrative State lots of reasons for make-work conferences, memorandums and pronouncements which ultimately accomplish nothing of value.
Whether the laws are worthy or useless, everyone must obediently comply with their requirements. The additional legal and other professional expenses are unavoidable overhead costs, basically another indirect tax like inflation. In this atmosphere of political schizophrenia, investors are encouraged to invest their private capital while at the same time are presumed by the Administrative State to be guilty of crimes and violations unless due diligence shows they are innocent. In fact, some are held guilty anyway despite innocence.
The potential of sanctions applies not only to the parties involved but also intermediaries and third-party advisors. Of course, there is a problem for an investor complying with one country’s disclosure and confession laws by which creates exposure by counter-sanctioning country or its allies. It is not only that the costs of compliance are becoming inordinately burdensome, but it is a growing question of whether compliance is with any reasonable degree of confidence possible.
Sanction enforcement and regulation is highly discretionary involving unpublished interpretive guidance, informal practices, a wide degree of authorities, and little to no accountability over the exercise of power. Rarely, if ever, does any person in the bureaucratic hierarchy ever claim to be responsible as the person in charge preferring to divert to others or claim governmental immunity. On the positive side, this new compliance/sanction industry is a boom to the legal profession.
The current economic and political turmoil has occurred in one form or another at various times in US history. Fortunately, the economy of the US is very broad and deep. The growth in US population driven by immigration has been the backbone for the expansion of its productive economic base. As a result, the real estate segment of its economy continually develops.
After determining the United States is the place to invest and that using a portfolio debt structure will be the mechanism, then consideration naturally focuses on which part of the real estate market.
In broad terms, the US real estate marketplace can be categorised for investment purposes in three ways:
Growth or Core: This represents long-term, low risk/reward strategy. Investors are looking at real estate because of its stable bond-like qualities, value in diversification, and inflation hedging benefits. Generally, this means existing well-leased and high-quality properties in established markets. Primarily these are focused on office, industrial, retail, and multi-family. A high proportion of total return is anticipated to be generated from current income and positive cash flow. Property appreciation plays a lesser role particularly with lower of moderate leverage which further minimises risk in times of financial volatility.
Value-Added: The spans of spectrum of investments from less risky core plus higher leverage plays to higher risk, more opportunistic transactions. Fundamentally, this involves acquiring property, improving it somehow, and selling at an opportune time. Usually, the sale is at capital gain rates without depreciation recapture. Capital appreciation is a significant part of the investment return. These kinds of properties are ones that may have management problems, or operational issues, or need physical improvements.
Opportunistic: This is generally considered the highest risk/return strategy. Generally, this is the realm of private equity which has flexible risk parameters and investment discretion. These may include distressed assets, development projects, or emerging market transactions which focus on returns and not necessarily concerned with diversification by property type or geographic region. These sorts of investments are more complex, may involve non-traditional or specialised property types, financial re-structuring, highly leveraged transactions or ground-up developments.
Whichever way someone classifies or sorts potential real property investments in the United State, any one or all represent an opportunity to secure wealth current and into the far future.
The is no questioning that the world is a messy place full of dangers. For those with investible wealth, it is a mobile world where money, stocks, and bonds can move around at the speed of the internet. But the real wealth of the global economy and its future is based on the foundation of real estate. Investing in real property requires that wealth goes to it and not the other way around. Financial centres are only as safe as they can be defended from external threats or internal conflicts. Unless a major money centre is located in a country that is secure then the capital held is not really safe. While which country is the safest is debatable, but on any list of countries, clearly the United States would be first or a close runner-up. Similarly, any listing of fundamentally secure investments would put real estate at the top. And if that investment could create tax free earnings like portfolio debt then that would be a real global winner.
Denis Kleinfeld is highly regarded as a lawyer, teacher and author. His private legal practice, Kleinfeld Legal Advisors, is located in North Miami Beach Florida. He is an Adjunct Professor at the LLM Wealth and Risk Management Program, Texas A & M School of Law. His private practice focuses on strategy planning of domestic and international tax, legal, financial, matters involving the wealth and risk management for private clients and private businesses. He is co-author of the two-volume treatise, “Practical International Tax Planning,” 4th Ed. published by Practicing Law Institute. He is the contributing author on Foreign Trusts published in “Administration of Trusts in Florida” by The Florida Bar and authored chapters for the American Bar Association’s in “Asset Protection Strategies: Wealth Preservation Planning with Domestic and Offshore Entities Vols. I and II.” He is a contributing author to the “LexisNexis Guide to FATCA”.