Real Estate Deals Leveraged Abroad

These and other questions are posed every now and then by people/potential investors who find themselves with available funds and start thinking, ‘okay, why should I let my money rot away? Perhaps I should make some small “passive investment”?

By its very nature, real estate investment by private individuals is something that poses risks, and is done with small financial reserves, not a lot of know-how in the field, without any “connections”, etc.

The key for investment is proper planning: Both financial planning, as well as planning what to do, and how to do it.

This document aims at presenting the potential of leveraged real-estate deals (with high rate foreign bank financing) abroad. However, wishing to present the full process, we shall first make a simple review of the ways to invest in yielding real-estate property.

Usually, real-estate investment is quite simple, without any need for complicated economic analyses. Professional terminology used by someone unfamiliar with it (and sometimes, someone trying to fool others) could result in planning and calculation mistakes. This is often apparent when the term “yield” is used. Improper use of this term is unprofessional, and usually only confuses the small investor.

So, how to actually analyze real-estate property/deals:

1. Income from the property.
2. Expenses
3. Determining net income.
4. Calculating property capitalization rate.
5. Calculating loan repayment installments, and the investor’s yield.

In order to analyze the cash flow from any potential property, these five steps should be verified.

Would you ever buy a business, without knowing how much it brings in, how much it takes out, and how much it earns? The same thing holds true regarding real-estate investments. Actually, the investor should check the property income and expenses. This way, the investor can get the operating profit of the property, and know what the cash flow is. This flow helps form the offer to be made to the seller.

In real-estate investments, the key words are:
• Yield
• Cash flow
• Value

When making a quick initial profitability check of any real-estate investment, the first thing that should be calculated is the expected yield. For example: If you invested $100,000 in real-estate property, and this property yields $1,000 a month, then the annual yield [return] is 12%.

However, if the same property yielded $500 a month, and your yield [return] is 6%, this might make the deal economically no remunerative [unadvisable].

Step 1 – Current income from the property
Even if the property owner informs you of the level of the monthly income, you should verify this datum. Usually, it is enough to review the contracts made with the present tenants and see how much yield the property actually brings in. Income is one of the most significant factors in real-estate investments.

There are 3 different definitions for the term “income”:

Actual income – the sum total income that the property produced in the last 12 months.

Potential real income – the total income that the property could have produced in the last 12 months, if all the units in the building were rented (100% occupancy) and the property owner could have taken advantage of all income opportunities.

Future potential income – the sum total income that the property could yield, according to present-day rent levels, and if the occupancy reaches 100%, and the owners take advantage of all income opportunities, in the next 12 months.

Usually, property owners will price their property according to future potential income. However, as the buyers, you should estimate the property based on current actual income.

It should be remembered that the chances that the property will rented at 100% occupancy, from now and forever, according to the current rent rate, without any changes… are very small… Therefore, changes in occupancy and additional income sources should be calculated as well. E.g.: Commercial usage of the property, usage of parking spaces, posting signs facing the road – advertisement, etc…

Step 2 – Expenses related to operating the property

Having completed the property income estimates, expense estimate possibilities should be assessed. The goal is to get a clear picture of expenses related to the real-estate property, and to try and find ways to optimize or reduce expenses.

A profit/loss report of the property presents you with all the expenses that the property made during the last year. Thus, you can get a clear picture of how much money it would take out of your pocket in future.

Expenses usually found are:
Renovations & maintenance – considering the property age.
Utilities – data should be examined and verified with a few companies in the field.
Taxes
Insurance – data should be examined and verified with a few companies in the field.
Unexpected expenses

Current managing of the property:
Sometimes, investors think that the current handling of the property would be handed over to a property management company; however, after the purchase, they discover that the company is charging them a fortune, making the property no longer profitable, with the management company actually robbing them of all their resources… Care should be taken, and all possible expenses should be verified, before you go ahead and buy the property. Actually, these data should be calculated when the profitability of the property is being considered.

Also, attention should be paid to possibilities of reducing costs, without adversely affecting the profitability of the building.

Step 3 – Determining net income and rate of capitalization:
After you have the income and expense picture, you should find out the net income received from the property, i.e.: Income less operational expenses.

In order to discover the real value of the property that we are interested in investing, the net income should be divided by the capitalization rate of a certain real-estate property in the market where we wish to invest.

How do we calculate the capitalization rate? The property’s capitalization rate actually measures the speed at which the investment will cover itself.

Capitalization rate = net income / sale price

For example, if a building was bought for $1,000,000 and it yields an annual net income of $100,000, then:
$100,000 / 1,000,000 = 0.1 = 10%

The property’s capitalization rate is 10%

Step 4 – External financing (leveraging)

The operational income presented above does not include payments to banks that helped with their financing to purchase the property.

If the investor does not have the resources to finance the cost of the property, he will have to turn to banks in order to get external financing for a certain rate that would help him in the purchase. From our experience in the field, it is possible to get bank financing covering up to 80% of the property purchase cost. It should be mentioned that with yielding real-estate properties, the banks verify the rent agreements signed by tenant in the property, the rent term and the renters’ financial solidity. It is relatively easy to get external financing if the property is populated by top international business companies in the following fields: Banking, insurance, hotels, etc.

Post-financing property profitability estimate:

First of all, the total cost needed to invest in the property should be estimated. This cost includes:
1. Payments to the seller
2. Advisors’ commission
3. Lawyers’ & accountants’ commission
4. Taxes
5. Fees & interest promotion

After we have the total cost needed, we have to define the equity that we are interested in investing in the property. External financing has to be obtained for the entire difference, from banks and/or credit givers.

As a thumb rule, it can be said that if the internal return from the property exceeds its financing cost – then the deal is worthwhile. However, a few other issues should be examined:
1. Risk
2. Net return the investor expects to get for his money.
3. Manner of investment – individual/company
4. Other various considerations not necessarily expressed in the economic profit line.

Example for a real-estate deal leveraged abroad.

An investor considers buying a building for a total cost of 1,800,000 Euro. For this investment, the investor can raise from his own resources the sum of 360,000 Euro, amounting to 20% of the property cost.

As mentioned above, first the investor checks the property yield [return]. An in-depth review of the rent agreements reveals that the net income from the profit presently amounts to 190,000 Euro annually – i.e., 10.5%.

In order to purchase the property, the investor turns to the bank, to get external financing of 1,440,000 Euro (approx. 80% of the property’s total cost). The annual credit cost is 5.5% – i.e., approx. 80,000 Euro.

Therefore, the net return (after financing) on the property stands at 6.1%.

According to the location of the property, the following should be also checked: The potential for price increase; tax rate according to country; allocation of state benefits, etc.

On the other hand, there is a certain risk in that rent prices go down, the cost of credit goes up, with exposure to changes in the property’s value.

Example for a real-estate deal in Romania:

1. Factual background
1) The investor is an Israeli resident; therefore his tax liability is in Israel.
2) In January 2005, the investor purchased together with partners a plot of land with a building in Romania.
3) The land and building were purchased by a Romanian company owned by the investor and his partners, for a total sum of 500,000 Euro.
4) This sum was infused to the company as an owner’s loan, according to the partners’ share in the company’s capital.
5) The property is being rented long-term to regular renters – income: 75,000 Euro annually.
6) The investor has an offer to sell the company that owns the building, for the sum of 1,000,000 Euro.
7) Alternately, you have an offer to sell the property owned by the company, for 1,000,000 Euro.

2. Issues under discussion:
1) What is the tax rate that the Romanian company is obligated to pay when selling the land?
2) What is the tax that an Israeli resident must pay when selling the company or when selling the land and later closing down the company? And what effect does the tax to be paid have, resulting from the fact that part of the sum is an owners’ loan to be repaid?
3) What effect (if any) does the profit from changes in exchange rates have?
4) Are we talking about a “capital” income that is obliged with a different tax rate than “income from business”?
5) What is the tax reference regarding expenses related to actualization of the land?

3. Analysis of statutes and relevant rulings:

Introduction:
Until 2003 (eve of the reform), the basis for tax obligation in Israel was basically territorial. I.e.: Income tax was levied on income produced or grown in Israel, whether it was produced by an Israeli resident or by a foreign resident. In addition, income tax was levied on income produced or grown abroad, but initially received in Israel. (Mainly relevant to passive income, e.g.: dividends, interest, royalties, apartment rent, etc.)

Within the framework of the reform the legislature adopted a personal taxation basis. Namely: Israeli tax residents became taxable for their income in full, whether it was produced or grown abroad, not to mention if in Israel, regardless of where that income was received.

Statutes & rulings:
The local taxation principles in Romania are as follows:
1. Romanian companies are liable to a uniform tax of 16%. The same tax rate also applies to income from dividends received by the same companies. According to the tax rules in Romania, a Romanian company is a company incorporated according to the Romanian law and/or companies managed in Romania, even if registered elsewhere.
2. A Romanian resident company is taxable for its entire income, regardless of the place where this income was produced. A foreign company, on the other hand, will be taxable in Romania only for income produced in Romania.
3. Israel and Romania have signed a treaty to prevent double taxation. According to the instructions of this treaty, a Romanian company is liable for deduction of tax at source, at the rate of 15% of dividends being distributed to its Israeli share-owners who are individuals. It should be noted that these treaty instructions overrule the instructions of the Order empowered by Section 196 of the order! (See below for an extended reference to the sections of the treaty under discussion.)
4. In addition, the dividend received by share-owners who are individuals (as distinguished from companies) is taxable according to the Israeli law, at a rate of 25%; however, with credit for the foreign tax that was deducted at the source in Romania (15% tax, as mentioned). This means that eventually, Israeli share-owners who are individuals, will pay for the dividend allotted to them by a Romanian company under their ownership, a total sum of 25% (partly in Romania and partly as completion – in Israel).
5. In case of share-owners who are Israeli companies, these companies can choose to pay in Israel tax at the rate of 25% for the dividend actually received by them or alternately, to include their full relative share in the income of the Romanian company that distributed the dividend to them, in their income that is taxable for full companies’ tax, while benefiting from credit both for the relative part of the company tax paid by the same company in Romania, as well as for the tax deducted at source in Romania out of the dividend that was distributed to them. Considering the current company tax applicable in Israel (only 29%), naturally, the choice of this alternative is preferable, since the “complementary” tax that the Israeli company will be required to pay in Israel (having taken into consideration both the company tax paid in Romania, at the rate of 16% as well as the tax of 15% deducted at the source from the dividend) would be for a measly rate.

Taxation principles for foreign companies in Israel are as follows:
As mentioned above, an Israeli resident will be taxed for his entire income, both in Israel and abroad, while a foreign resident will be taxed only for income originating in Israel.

Section 1 of the Income Tax Order (new version), 1961 [“the order”] defines “an individual” who is an “Israeli resident” as: “someone whose focus of life is in Israel.”

Controlled Foreign Company
In case a few conditions exist, a Romanian company controlled by Israeli residents might be considered as a “controlled foreign company”. The principle: Obligating the controlling shareholders in Israel with tax, in case most of the company’s income or most of its profits are “passive” – dividend, interest, royalties, rent and/or capital gain from sale of property not used as a business.

Below are the accumulative principles that determine whether a company is a “controlled foreign company”:
1. The company is a foreign resident company (i.e., it was not incorporated in Israel, and its place of control and management is outside Israel).
2. Its shares or embodied rights are not traded in the stock exchange.
3. Most of its income in the tax year is passive, or most of its profits result from passive income.
4. The tax rate applicable to passive profits at the country of domicile does not exceed 20%.
5. More than 50% of the control tools are directly or indirectly owned by Israeli residents, or Israeli residents have the right to prevent essential managerial decision making.

When a controlled foreign company has profits, even if they were not paid to the controlling share holder – these profits will be seen as an conceptual dividend, when a conceptual credit will also be given to the tax that is to be completed abroad. Tax has to be paid in Israel on the conceptual dividend.

At the time of actual dividend distribution, the controlling share holder will be tax exempt up to the amount of tax already paid by him in Israel due to the conceptual dividend. Also, at the time of selling rights in the company, an Israeli resident will be given tax credit for the conceptual dividend that he paid.

Real-estate union:

According to the definition in “real-estate taxation (betterment, sale and purchase) law 1963” – a real-estate union is “an organization that all its assets, directly or indirectly, are rights in real-estate except for an organization where its rights are registered for trade at the stock exchange, as defined in the order.”

Based on this definition, the asset part of an organization’s balance is examined, and according to this it is determined whether the organization is, indeed, a “real-estate union.”

However, “real-estate” is defined by law as “land in Israel including houses, buildings and other things permanently connected to the ground” (emphasis not in the original). Therefore, it should be checked with the income tax assessor whether the real-estate taxation law applies in this case.

If the real-estate taxation law is executed, an individual will be taxable for real betterment as stated in Section 121 of the order, at a rate of up to 20%.

Capital gains according to the internal law:

In Part E of the Order, Section 88, “consideration” is defined. Among other things, it says: “The price to be expected from sale of asset by a willing seller to a willing buyer…” As the consideration exceeds the balance of the original price at the time of share sales – “capital gain” is produced. In our case – we assume that during the sale, capital gain will be produced.

4. The reference in the treaty to preventing double taxation between Israel and Romania [“the treaty”].

Section 6: Income from real estate
1. Income produced by a contracting country’s resident from real estate (including income from agriculture and foresting) located in the other contracting country, can be obligated with tax in that same other country.
2. For the purposes of this treaty, the term “real estate” will have the meaning according to the law of the contracting country where the real estate under discussion is located. At any rate, the term will include assets attendant to the real estate, livestock and equipment used in agriculture and foresting, rights where the general law instructions concerning real estate apply, rights to benefit from use of the real estate and rights for changing or constant payments in return for exploiting mineral deposits, resources and other natural resources, or for the right to exploit them; ships, boats, aircrafts, trains and vehicles used for on-land transportation – will not be viewed as real estate.
3. Sub-section 1 instructions will apply in income produced from direct usage of the real-estate, renting it out or making any other use of them.
4. Sub-section 1 & 3 instructions will apply also on income from real-estate on an enterprise and for income from real-estate used for carrying out personal services by a self-employed person.

Section 10: Dividends

1. Dividends paid by a company that is a resident of a contracting country to a resident of the other contracting country, can be taxable at that other country.
2. However, the dividends can be taxable also in the contracting country where the seat of the paying company is located, and according to the law of that country. However, where the recipient is equitably privy to the dividends, the tax levied will not exceed 15% of the gross sum of dividends.
This sub-section does not change the company’s tax liability regarding the profits out of which the dividends are being paid.
3. The term “dividends” in this sections means, income from shares, benefit shares or benefit rights, shares in mines, foundation stocks or other rights, that are not debt claims sharing in the profits, and also income from other rights in the company subject to the same law pertinent to taxes as income from stocks according to the tax laws of the country where the seat of the distributing company is located.
4. Sub-section 1 & 2 instructions will not apply, if the person equitably privy to dividends, being a resident of the contracting country, holds in the other contracting country where the dividend paying company’s seat is located, a permanent institution or base located there, and the holding right in the interest where the dividends are being paid is practically related to that permanent institution or base. In such a case, the instructions of Section 7 or Section 14 will apply, as the case might be.
5. A place where a company that is a contracting country’s resident produces profits or income from the other contracting country, that other country will not levy tax on the dividends being paid by the company, only as far as those dividends being paid to a resident of that other country or as far as the holding right in the interest where the dividends are being paid is practically related to a permanent institute or base located in that other country, and will not obligate the company’s undivided profits with tax on undivided profits, even if the dividends being paid or the undivided profits are composed, wholly or partially, of profits or income originating in the other country as aforesaid.

Section 11: interest

1. Interest originating in a contracting country and being paid to the other contracting country’s resident, can be taxable at that other contracting country.
2. However, such interest can be taxable at the contracting country of its origin, and according to the laws of that country; but, where the recipient is the equitable privy to interest, the tax levied on it will not exceed 10% of the gross interest sum.
3. The instructions of Sub-section 2 notwithstanding, any interest as cited in sub-section 1 can be taxable also at the contracting country where it is being grown, according to the laws of that country; however, if the recipient is the equitable privy, the levied tax will not exceed 5% of the gross interest sum, if the aforementioned interest is being paid:
(a) Regarding sale on credit of industrial, commercial equipment or any industrial;
(b) Regarding sale on credit of any merchandise by one enterprise to another; or
(c) On any loan of any kind given by a bank.

4. The aforesaid sub-section 2 notwithstanding, interest originating in a contracting country, being paid to a resident of the other contracting country can be taxable on in that other country if the interest was paid for:
(a) A promissory note, a debenture or another similar debt of the government of the first mentioned contracting country; or
(b) A loan given, financed, guaranteed or insured or credit given, financed, guaranteed or insured by
1. Regarding Romania, the Romanian National Bank;
2. Regarding Israel, the Israel Bank.
5. The term “interest” in this section means, income from debt claims of any type, whether they were insured by mortgage and whether not, whether they bear right of participation in the debtor’s profits and whether not, in particular income from government securities and income from promissory notes or debentures, including premiums and awards related to such securities, promissory notes or debentures, and any other income that, according to the tax laws of the country where the source of income is located, it is regarded as income from monies lent. In the context of this section, late charges due to delay in payment will not be seen as interest.
6. Sub-section 1 & 2 instructions will not apply, if the person equitably privy to interest, being a contracting country’s resident, conducts business at the other contracting country where the origin of the interest is located, through a permanent institution located there, or performs personal services as a self-employed in that other country, from a permanent base located in that country, and the related debt claim to which the interest is being paid is practically related to that permanent institution or base. In such a case, the instructions of Section 7 or Section 14 will apply, accordingly.
7. Interest will be seen as originating from a contracting country when the payer is that same country or a resident of that country. However, where the interest payer – whether a contracting country’s resident or not – has a permanent institution or base in one of the countries where in the contract with them the obligation was created resulting in paying interest, and this permanent institution or base bear the burden of the interest, the interest will be seen as originating from the country where the permanent institution or base are located.
8. Where, due to special relations between the payer and the person equitably privy, or between both of them to another person, the interest sum exceeds, paying attention to the debt claim on which it was paid, the sum that the payer and recipient would have agreed on, if these relations didn’t exist, the instructions of this section will apply only on the latter mentioned sum. In such a case, the excess part of payments will remain taxable according to the laws of each of the contracting countries, considering the other instructions of this treaty.

Section 13: Capital gains

1. Profits from transfer of real estate as defined in sub-section 2 of Section 6, can be levied tax in the contracting country where the real estate is located.
2. Profits from transfer of movables constituting part of the business assets of a permanent institute that a contracting country’s enterprise has in the other contracting country, or from transfer of movables related to a permanent base at the disposal of a contracting country’s resident in the other contracting country, for performance and personal services as a self-employed, including profits as mentioned from transfer of that permanent institute (alone or together with the entire permanent institute) or the permanent base as mentioned, can be taxable at that other country.
3. Profits from transferring ships, boats, aircrafts, trains or vehicles used for on-land transportation operated in international transportation, and transfer of movables related to the operation of these transportation vehicles, can be taxable only in the contracting country where the actual and central operational site of the enterprise is located.
4. Profits from transferring shares from the company’s capital in a company where its assets are mainly composed, directly or indirectly, of real estate located in a contracting country, can be taxable in that country.
5. Profits from transferring any asset, except for that mentioned in sub-sections 1, 2, 3 & 4, can be taxable only in the contracting country where the transferor’s seat is located.

In summary:

1. The tax rate that the Romanian company will be obliged to pay when selling the land stands at 16% – this sum will be paid by the Romanian company in Romania.
2. As in any transaction, the costs related to executing the deal should be deducted from the profit made by the sale. For example: interest for owners/bank loans, costs of arranging contracts, brokerage fees and other payments.
3. Sale of shares of the Romanian company in your possession – are tax exempt in Romania.
4. According to Section 91a of the Income Tax Order: An individual will be taxable on real capital gain as stated in Section 121, at a rate that will not exceed 20% and the capital gain will be seen as the highest step in the ladder of his taxable income. The above notwithstanding, in a sale of equities in the company where the seller is an essential share holder (10% and more) at the time of the sale or during the 12 months preceding it, the seller will be taxable not exceeding 25%. (This refers to a case not involving a “controlled foreign company”, and a case where the real estate taxing law does not apply.)
5. In a case involving a “controlled foreign company”, the foreign company’s profits are considered conceptual divided (even if they were not paid to the controlling share holder) and on this dividend, 25% tax must be paid (naturally, conceptual credit will be given also for the tax that is supposed to be paid abroad). At the time of actual dividend distribution, the controlling share holder will be tax exempt up to the sum of tax that he already paid tax for it in Israel, due to conceptual dividend. Also, at the time of sale of rights in the company, an Israeli resident will be given credit on tax on the conceptual dividend that he paid.
6. And, in case where the real estate taxation law applies (although it is problematic, as mentioned above, to adjust the case to the definition of “real estate”), the capital gains tax that applies to individuals since 1.1.2007, is 20%.
7. The tax treaty enables you, naturally, to be credited for the tax paid abroad.
8. In case where the investors choose to divide the company’s profits as dividend to its share holders, the deduction at source due to this dividend that the Romanian company will pay stands at 15%. Share holders receiving the dividend will have to complete 25% tax in Israel.
9. Regarding repayment of owners’ loan: The interest sum and linkage differentials on the owners’ loan will be recognized as expense in the Romanian company. This income (the actual interest) will be taxed in Israel according to the investor’s marginal tax rate in Israel, since he is an “essential share holder” in the foreign company. The actual capital sum (currency linked) to be returned is not supposed to be taxable with any tax whatsoever.
10. In any case, we recommend turning to the Tax Authorities for Pre-Ruling, in order to get the income tax assessor’s final position on the matter. In our estimate, the final tax rate will stand at 20%-25% in such a case.

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