* Government seeks to spur investment as growth slows
* REITs have become a top pick among foreign funds
* Move could entice dollar inflows, bolstering currency
* Government says effect on exchange rate to be minimal
By Guillermo Parra-Bernal and Alonso Soto
SAO PAULO/BRASILIA, Jan 31 (Reuters) - Brazil on Thursday exempted foreign investors from paying a financial transaction tax on purchases of real estate investment trusts traded on the country's stock exchange, hoping to spur investments and support an economic recovery.
For the last year the government of President Dilma Rousseff has aimed to develop funding alternatives for local builders, many of which are overly dependent on loans from state development bank BNDES, the main source of long-term corporate financing in Brazil.
The tax exemption will likely increase U.S. dollar inflows and thus help keep the local currency strong. However, a senior government official said the measure was designed mainly to boost investments in the country's buoyant real estate market.
"The objective here is to stimulate long-term investment in the real estate sector," Dyogo de Oliveira, a senior finance ministry official, told reporters in Brasilia. "This measure should not have a relevant impact on the currency."
BM&FBovespa SA's IFIX Index, which tracks the most-traded real estate investment trusts, or REITs, in the Sao Paolo Stock Exchange, rose 0.62 percent on Thursday afternoon in the wake of the announcement.
The move, which zeroes a 6 percent financial transaction tax known as the IOF, was announced in the government's official gazette. The IOF tax can be lowered or increased at any time depending on market conditions, government officials said.
"On the back of low yields across global assets, these funds should arise as an interesting alternative to international investors," BTG Pactual Group analyst Alexandre Muller said in a note. "Due to the general scarcity of good yields available in most of the financial assets ... we anticipate new buyers for local real estate funds."
REITs are usually inflation-adjusted, since rent contracts in Brazil are linked to a consumer and wholesale price index known as the IGP-M, offering an attractive investment opportunity in an otherwise slow-growth market where interest rates are at a record low.
Currently yields on an average local REITs, depending on size, can offer interests of between 7 percent and 8 percent, compared with less than 4 percent for a 10-year, local government inflation-linked bond, data by BTG Pactual showed.
Last year about 14 billion reais ($7.04 billion) worth of REITs and similar instruments were sold in initial public offerings in Brazil, compared with 7.66 billion reais a year earlier, data by the country's securities regulator CVM showed. In 2009, sales of REITs, known in Brazil as FIIs, reached 2.88 billion reais.
In a bid to foster more investment in the industry, the government reduced payroll taxes for construction firms in December, a few days after reporting surprisingly weak economic growth figures.
Brazil, Latin America's largest economy, probably grew just 1 percent in 2012, according to most forecasts, a disappointing performance for an economy that grew 7.5 percent in 2010.
The government is betting on the construction industry to breathe some life into an economy struggling to recover after two consecutive years of weak growth. A surge in the middle class over the last decade has made real estate in Brazil very appealing for investors.
Brazil ranked first as the most attractive emerging market country for commercial and residential real estate, topping China for the first time in three years, according to a survey conducted by the U.S.-based Association of Foreign Investors in Real Estate.
Sao Paulo, Brazil's largest city, climbed to 4th from 26th on the list of top global cities for foreign investment in real estate, the association said.
Nevertheless, some Brazilian builders are facing problems after years of poorly managed growth and runaway construction costs. Major Brazilian homebuilders like PDG Realty SA are scaling back operations to focus on executing old projects and generating cash to reduce debt.
Government officials said foreign investors, who have little participation in REITs, could bring some needed cash to the industry.
Brazil's Byzantine tax system is often blamed as one of the reasons for its chronically low investment levels. Foreign investors also complain about measures taken in recent years to curb dollar inflows.
Foreign investments in domestic bonds are taxed at 6 percent, while stock portfolios are exempt from the IOF tax. De Oliveira said the government has no plans to cut the IOF tax on foreign investments in fixed-income instruments.
The Brazilian real weakened 0.2 percent on Thursday to 1.9908 per dollar. It was its second consecutive day of losses, following a rally early in the week that took the currency past the mark of 2 per dollar for the first time in nearly seven months.
The country reported $2.693 billion in dollar outflows in the first four weeks of the year, according to the central bank.