Royal Bank of Scotland Group Plc and private equity giant Blackstone Group LP are set to finalise a deal in which the bank will relinquish control of 1.4 billion pounds of distressed property loans to the American group, a source familiar with the matter said on Monday.

The handover of the loans to a Blackstone-managed real estate fund - a transaction the source said was dubbed Project Isobel - represents a watershed in state-controlled RBS's bid to free itself from its legacy of profligate lending before the financial crisis.

RBS began deleveraging its property book in 2009, after the global credit crisis saw real estate prices plunge and many loans either default or risk default, bringing a swift end to the bank's aggressive commercial real estate strategy.

Speculation that a deal would not be reached grew earlier this year, when sources said Blackstone was unable to arrange required debt funding from banks, including Goldman Sachs Group Inc , Citigroup Inc and HSBC Holdings Plc , on terms that would make it attractive.

With European banks tightening their purse strings and shedding assets to meet more stringent capital requirements in light of the euro zone debt crisis, private equity groups see major credit investment opportunities in the sector.

Like other buyout firms such as KKR & Co LP and Apollo Global Management LLC , Blackstone has sought to diversify beyond its buyout roots into other alternative assets such as real estate and distressed debt.

In October, Blackstone's credit arm, GSO Capital Partners, acquired Harbourmaster Capital, which manages and advises on about 8 billion euros of debt assets, boosting its European leveraged loan platform to 11.5 billion euros.

RBS and Blackstone declined to comment when contacted by Reuters.

(Reporting by Greg Roumeliotis in New York and Alessandra Prentice in London; editing by Andre Grenon)