On December 18, 2015, President Barack Obama signed into law the Protecting Americans from Tax Hikes (PATH) Act of 2015.
This omnibus bill eases 35-year-old restrictions on foreign investment in U.S. real estate by eliminating a crucial roadblock in the Foreign Investment in Real Property Tax Act (FIRPTA), and is expected to increase the amount of foreign money flowing into U.S. real estate investment trusts (REITs).
Essentially, a REIT differs from a standard U.S. corporation in that it is required to annually distribute 90 percent of its taxable income (excluding capital gains) to its shareholders.
For this reason, REITs have continued to be an extremely tempting investment option for foreigners, despite the impact of the financial crisis of 2008 on U.S. real estate markets.
Foreign entities poured a record amount into the American real estate market in 2015, totaling close to $78 billion. Investors continue to be lured to the United States by the relative stability of the American economy and by the volatility of Asian markets, particularly the crisis currently besetting the Chinese stock market.
This year, China eclipsed Canada as the number one source of foreign real estate investment capital in the United States.
Inviting Foreign Pension Fund Investment
The most important feature of PATH is that–for the first time ever–foreign pension funds will be allowed to invest in American REITs on the same footing as their U.S. counterparts.
Foreign pension funds invest trillions of dollars in real estate worldwide, but previously FIRPTA had hampered investment in the United States.
The PATH deregulation comes at a unique time in history where bloated foreign pension funds in Europe and Japan are seeking foreign investments with reliable returns.
Initial estimates suggest that the new FIRPTA changes will generate an additional $20 billion to $30 billion in investment in U.S. commercial real estate in 2016, according to Ken Rosen, professor of economics and chairman of the Fisher Center for Real Estate and Urban Economics at the University of California, Berkeley.
New Restrictions of Note
PATH introduces many tweaks to the tax code, and not all of them are a boon to investors. For instance, as of February 16, 2016, foreign investors have been required to withhold and pay 15% of the gross proceeds of any disposition of a U.S. real property interest, up from 10% under the previous law.
“The increased withholding rate may have a chilling effect on direct and indirect investments in U.S. real estate by other non-US persons” other than foreign pension funds, suggested Matthew J. Norton, real estate law practice partner for K&L Gates.
Sales of personal residences where the amount is $1 million or less are not subject to the increased rate.
Furthermore, the regulations clamp down on a complex tax shelter system called the “REIT spinoff,” wherein corporations roll their properties into a REIT and lease them back to themselves in the hopes of saving on taxes and operating costs.
Once spun off as a REIT, the real estate trust operates as its own entity, allowing the original company to focus on the core services that it provides.
Shareholder activists had encouraged large corporations to pursue REIT spinoffs, but PATH effectively ends the tax loophole that made the spinoffs so appealing.
Driving up Costs for Americans
All things considered, this is great news for the U.S. real estate market, but less so for the average American consumer.
While foreign investment in real estate creates jobs, excessive speculation might have the unforeseen consequence of developing overpriced communities with high vacancies.
Take for example the Xinyuan Real Estate Company and its construction of a seven-story condominium on the Williamsburg waterfront in Brooklyn, NY. So far, about 20 to 30 percent of those buying property at the Brooklyn condo are Chinese individuals who are still living in China.
“The total sales volume of foreign investment in U.S. real estate was estimated at $92.2 billion — a 35% increase from the previous period’s level of $68.2 billion,” writes Dan Barnabic, consumer advocate and author of The Condo Bible.
“Nearly half, $45.5 billion, of it was attributable to nonresident foreigners, which accounted for some 3.5% of the total U.S. existing home sales market of $1.2 trillion. If this trend continues, foreigners will own over 35% of residential real estate in the U.S. over the next 10 years.”
While common sense dictates that more investment lowers prices by increasing supply, there have been global backlashes against large influxes of foreign capital, particularly from China.
In the United States, a balance will have to be struck between the needs of communities affected by property speculation and the federal government’s desire to grow the real estate industry with unhindered foreign investment.